Extreme Networks Annual Report 2004

Plain-text annual report

Table of ContentsUNITED STATESSECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549 Form 10-K (Mark One)xxANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended June 27, 2004 OR ¨¨TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934 For the transition period from to . Commission file number 000-25711 Extreme Networks, Inc.(Exact name of Registrant as specified in its charter) Delaware 77-0430270(State or other jurisdiction ofincorporation or organization) (I.R.S. EmployerIdentification No.)3585 Monroe StreetSanta Clara, California 95051(Address of principal executive offices) (Zip Code) Registrant’s telephone number, including area code: (408) 579-2800 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act:Common stock, $.001 par value 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 of1934 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 filingrequirements 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 ¨ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, tothe best of the Registrant’s knowledge, in definitive proxy or information statements incorporated by reference to Part III of this Form 10-K or anyamendment to this Form 10-K. ¨ The aggregate market value of voting stock held by non-affiliates of the Registrant was approximately $854,988,624 as of December 26, 2003, the lastbusiness day of the Registrant’s most recently completed second fiscal quarter, based upon the closing price on The Nasdaq National Market reported forsuch date. This calculation does not reflect a determination that certain persons are affiliates of the Registrant for any other purpose. 120,766,498 shares of the Registrant’s Common stock, $.001 par value, were outstanding August 10, 2004. DOCUMENTS INCORPORATED BY REFERENCE The information called for by Part III is incorporated by reference to specified portions of the Registrant’s Definitive Proxy Statement to be issued inconjunction with the Registrant’s 2004 Annual Meeting of Stockholders, which is expected to be filed not later than 120 days after the Registrant’s fiscalyear ended June 27, 2004. Table of ContentsEXTREME NETWORKS, INC. FORM 10-K INDEX PagePART IItem 1. Business 3Item 2. Properties 18Item 3. Legal Proceedings 19Item 4. Submission of Matters to a Vote of Security Holders 20PART IIItem 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 22Item 6. Selected Consolidated Financial Data 23Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 23Item 7A. Quantitative and Qualitative Disclosures About Market Risk 52Item 8. Financial Statements and Supplementary Data 54Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure 83Item 9A. Controls and Procedures 83Item 9B. Other Information 84PART IIIItem 10. Directors and Executive Officers of the Registrant 84Item 11. Executive Compensation 84Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 84Item 13. Certain Relationships and Related Transactions 84Item 14. Principal Accountant Fees and Services 84PART IVItem 15. Exhibits and Financial Statement Schedules 85SIGNATURES 88 2Table of Contents PART I FORWARD LOOKING STATEMENTS This annual report on Form 10-K, including the following sections, contains forward-looking statements within the meaning of the Private SecuritiesLitigation Reform Act of 1995, particularly statements relating to our expectations for the first quarter of fiscal 2005, our expectations regarding results ofoperations, our ability to expand our market penetration, our ability to expand our distribution channels, customer acceptance of our products, our ability tomeet the expectations of our customers, product demand and revenue, cash flows, product gross margins, our expectations to continue to develop newproducts and enhance existing products, our expectations to reduce warranty expenses as a percentage of revenue, our expectations regarding the amount ofour research and development expenses, our expectations relating to our selling, general and administrative expenses, our efforts to achieve additionaloperating efficiencies and to review and improve our business systems and cost structure, our expectations to continue investing in technology, resources andinfrastructure, our expectations concerning the availability of products from suppliers and contract manufacturers, anticipated product costs and sales prices,our expected effective income tax rate, our expectations that we have sufficient capital to meet our requirements for at least the next twelve months, ourexpectations regarding the rationalization of our workforce and facilities, and our expectations regarding materials and inventory management. Theseforward-looking statements involve risks and uncertainties, and the cautionary statements set forth below and those contained in the section entitled “RiskFactors” identify important factors that could cause actual results to differ materially from those predicted in any such forward-looking statements. Wecaution investors that actual results may differ materially from those projected in the forward-looking statements as a result of certain risk factors identified inthis Form 10-K and other filings we have made with the Securities and Exchange Commission. More information about potential factors that could affect ourbusiness and financial results is set forth under “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results ofOperations.” Item 1. Business Overview Extreme Networks, Inc., together with its subsidiaries, (collectively referred to as Extreme or the Company and as we, us and our) is a leading providerof network infrastructure equipment for corporate, government, education and health care enterprises and metropolitan telecommunications service providers.We were established in 1996 to address the issues caused by slow and expensive legacy networks. We endeavored to change the industry by replacingcomplex software-based routers with simple, fast, highly intelligent, hardware-based network switches. The broad acceptance of this innovative, simplifiedapproach to networking has enabled us to become an industry leader. Our ultimate goal is to realize our technology vision of Ethernet Everywhere – aunifying network strategy that uses proven Ethernet technology to simplify each element of the network. We believe our Ethernet Everywhere vision is thefoundation for a future of easily deployable, highly scalable, comprehensively managed, ubiquitous bandwidth for networks, applications and users. Our family of switching products provides significant performance improvements compared to legacy network infrastructures, while enabling greaterflexibility and scalability, ease-of-use and a lower cost of ownership. We have achieved these advantages by utilizing Application Specific Integrated Circuits, or ASICs, as well as merchant silicon in our products and bycreating a common hardware, software and network management architecture for our products. In our products, the routing of network traffic, a functionreferred to as Layer 3 switching, is done primarily with our unique chipsets that provide faster processing of data than the CPU/software implementationsused in many conventional networking products. We believe that our unique hardware and software designs can also provide a better price/performance ratio,resulting in a higher return on investment for our customers. Since chipsets are built for specific purposes, it allows for a lower cost structure with increasedperformance compared to other alternatives. 3Table of ContentsIndustry Background Businesses, governments, educational institutions, health care enterprises and other organizations have become highly dependent on their internalnetworks and the Internet as their central communications infrastructure for providing connectivity for both internal and external communications. Newcomputing applications, such as ERP or CRM, large enterprise data warehouses and sophisticated online transaction and other e-business applications, aswell as the increased use of traditional applications such as e-mail and streaming media, require the support of significant information technology resources.The emergence of the desktop Internet browser as a standard user interface as well as the Internet Protocol, or IP, as a common, enabling network technologyhas enabled bandwidth-intensive applications that integrate voice, video and data over TCP/IP to be deployed extensively throughout organizations. Thesteady rise in application sophistication and the associated bandwidth load demands a fast, flexible and scalable network infrastructure. Networking environments can be segmented into local area networks, or LANs, wide area networks, or WANs, and metropolitan area networks, orMetros. LANs. LANs are traditional networks designed for connecting users to many types of application servers, which may be held locally or remotelythrough either private WANs or through such systems as the Internet. The LAN consists of servers, clients, a network operating system and a communicationslink to connect the LAN to other networks and to the Internet. The LAN market in which Extreme participates consists primarily of large and medium-sizedenterprise customers. WANs. WANs are communication networks that span across large geographic areas, such as counties, states or countries. The addition of WAN support to ASIC-based or merchant silicon-based network switches permits encapsulated Ethernet services to reach customerswhere integration with existing Synchronous Optical Network/Synchronous Digital Hierarchy, or SONET/SDH, infrastructure is required. The WAN market includes both incumbent local exchange carriers, or ILECs, and competitive local exchange carriers, or CLECs, multipletenant/dwelling unit service providers, or MTUs, and Internet service providers, or ISPs, as primary customers, though an enterprise may also utilize a privateWAN by using dark fiber, or unused fiber-optic cable, to connect their private LANs together. Metros. Metros are networks that link mid-sized geographic areas such as a city or an entire metropolitan area. Due to wide and steady deployment of increasingly scalable Ethernet technology, LAN traffic has achieved geometric growth in the aggregate amountsof data traffic delivered over networks and bandwidth rates, now delivered at Gigabit and 10 Gigabit speeds. Available bandwidth in WANs has also grown,as infrastructures are built out to accommodate the very rapid annual growth in Internet traffic. The Metro network has emerged as the key link between theLAN and the WAN. In recent years, the Metro network has become a critical and dynamically evolving arena within the overall IP network infrastructure landscape. Inaddition to steadily rising traffic load, the underlying network technologies, architectures and protocols are experiencing incremental change. Thecompetitive landscape for Metro service providers is shifting, with an influx of new carriers who do not necessarily depend upon legacy network transmissiontechnologies such as SONET/SDH to deliver frame relay or ATM subscriber services. The Metro market includes both ILECs and CLECs as well as alternative metropolitan service providers like utility companies, railroads andmunicipalities that provide Metro network services to connect multiple facilities. For example, a local government might build a Metro network tointerconnect agencies, such as city hall, fire departments, road and vehicle maintenance facilities, hospitals and emergency centers, social services and public 4Table of Contentslibraries. The same technologies and network architectures associated with Metros are becoming popular within large and very large corporate enterprises,which can utilize private Metros, by lighting “dark” fiber optic cabling, to create a “super campus” network, connecting facilities spread over a city-size area. A network must be scalable in the following four dimensions: Speed. Speed refers to the number of bits per second that can be transmitted across the network. Today’s network applications increasingly requirespeeds of up to 100 Mbps to the desktop. Therefore, the backbone and server connections that aggregate traffic from desktops require speeds in excess of 100Mbps. “Wire-speed” refers to the ability of a network device to process an incoming data stream at the highest possible rate based on the full capability of thephysical media, or wire without loss of packets. Wire-speed routing refers to the ability to perform Layer 3 switching at the maximum possible rate. Bandwidth. Bandwidth refers to the volume of traffic that a network or a network device can handle before traffic is “blocked,” or unable to get throughwithout interruption. When traffic was more predictable, the amount of traffic across a network link or through a network device generally grew in line withthe number of devices connected to the network. With today’s data-intensive applications accessed in random patterns from both within and outside the corenetwork, traffic can spike unpredictably, consuming significant bandwidth to the detriment of the network’s overall performance. Network size. Network size refers to the number of users and servers or end points that are connected to a network. Today’s networks must be capable ofreliably connecting tens of thousands of users and servers while providing high performance connectivity which results in maximum availability for bothnetworked applications and services. Quality of Service. Quality of Service refers to the ability to control the forwarding of traffic based upon its level of importance. Mission-criticalenterprise applications, such as Voice-over-Internet Protocol, or VoIP, require specific performance minimums, while traffic such as general e-mail andInternet surfing may not be as critical. In addition to basic prioritization of traffic according to importance, enhanced Quality of Service also allocatesbandwidth to specific applications based on a manager-defined policy. Opportunity for Next Generation Switching Solutions Several technology trends have enabled a new generation of networking equipment that can meet the four scalability dimensions required by today’senterprises and service providers and the bandwidth-intensive, mission-critical applications on which they depend. While many different network transmission technologies such as FDDI, Token Ring and ATM have been deployed in the LAN environment over thepast 25 years, Ethernet has become the overwhelmingly dominant LAN technology. According to the Dell’Oro Group, an independent research organization,Ethernet is the technology used in over 99% of the LAN market in 2003 and over 1.1 billion ports were shipped over the preceding ten-year period. Ethernetwas evolved from its original 10 Mbps form in continual and significant improvements, from 100 Mbps Fast Ethernet, to 1,000 Mbps, or “Gigabit” Ethernetto 10,000 Mbps or 10 Gigabit Ethernet, which became available during 2002. Today, Ethernet is moving beyond the LAN; Gigabit Ethernet and 10 GigabitEthernet technologies represent a viable, high-capacity transport technology option for Metro backbones based on IP, enabling broadband connections to beaggregated for transport across the core of the Metro. With the widespread adoption of Ethernet and IP, the need to support a multi-transport, multi-protocol environment is diminishing. As a result,simplified routing functionality can be embedded in fast, inexpensive chipsets to replace complex software/CPU designs used in conventional multi-protocolrouters. The resulting device, called a Layer 3 switch, functions as a less expensive and significantly faster hardware-based router. 5Table of ContentsLayer 3 switches operate at multi-gigabit speeds and can support large networks. While Layer 3 switching dramatically increases network performance, manyproducts fail to realize the potential of this technology as a result of inconsistent hardware, software and management architectures. Customers require a Quality of Service solution that supports both industry-standard bandwidth prioritization and manager-defined Quality of Servicethat maps business processes and policies to network performance. In addition, to simplify the network, customers need a family of interoperable devices thatutilize a consistent hardware, software and management architecture. The Extreme Networks Solution We provide Ethernet networking solutions that meet the requirements of today’s enterprises and service providers by providing increased performance,scalability, policy-based Quality of Service, simplicity of use and lower cost of ownership. Our products share a common hardware, software and networkmanagement architecture, are based on industry-standard routing and network management protocols and offer advanced policy-based Quality of Servicefeatures. Our switches can be managed from any browser-equipped computer or the Telnet applet supported in almost all operating systems. The Telnet appletallows access to the Command Line Interface, or CLI, which a system administrator may prefer to use. The key benefits of our solutions are: Lower cost of ownership. Our products are generally less expensive than software-based routers, yet offer higher routing performance. We believe thatby sharing a common hardware, software and management architecture, our products can substantially reduce the cost and complexity of networkmanagement and administration. This uniform architecture creates a simpler network infrastructure that leverages the resources businesses have invested inEthernet/IP-based networks, thereby requiring fewer resources and less time to maintain the network. Simplicity. Networks typically consist of many different technologies and types of equipment. This complexity often makes it expensive and difficultto effectively manage and expand networks. We meet these challenges by focusing on product consistency and simplicity. Our products share a commonhardware, software and network management architecture and enable Layer 3 switching at wire-speed in each key area of the network. This allows customersto build an integrated network environment that utilizes a consistent feature set, performance and management capabilities. Ease-of-use and implementation. Our products are designed to make networks easy to manage and administer, thereby reducing the overall cost ofnetwork ownership. Through the use of a standards-based design approach, our products can be readily integrated into existing networks. Customers canusually upgrade to our products without the need for additional training. Moreover, our ExtremeWare® operating system software simplifies networkmanagement with a consistent, robust interface available in all product families. High performance. Our products provide broadband Ethernet and IP services with the non-blocking, wire-speed performance of an ASIC-based ormerchant silicon-based Layer 3 switching engine. With our switches, customers may achieve forwarding rates that are significantly faster than software-basedrouters. Scalability. Our solutions offer customers the speed and bandwidth needed today — and the capability to scale their networks to support demandingapplications in the future — without the burden of additional training or software and system complexity. Customers who purchase standard Extremeproducts may later upgrade to advanced Layer 3 and Layer 4 features, such as server load balancing or intermediate-to-intermediate system routing protocol,or ISIS, as this upgraded functionality is designed into our products. Quality of Service. Our policy-based Quality of Service enables customers to prioritize mission-critical applications. We provide industry-leading toolsfor allocating network resources to specific applications. With 6Table of Contentsour policy-based Quality of Service, customers can use a web-based interface to identify and control the forwarding of traffic from specific applications, inaccordance with policies that the customers define. The Quality of Service functionality of our chipsets allows policy-based Quality of Service to beperformed at wire-speed. In addition to providing prioritization, customers can allocate specified amounts of bandwidth to specific applications or users. The Extreme Networks Strategy Our goal is to be the provider of the most innovative and effective network solutions that create an improved applications and services infrastructurefor enterprises and service providers. We seek to provide our customers with a best-of-breed alternative to single-sourced, highly proprietary networkingequipment from larger competitors. Key elements of our strategy include: Provide simple, easy-to-use, high-performance, cost-effective switching solutions. We offer customers easy to use, powerful, cost-effective switchingsolutions that meet the specific demands of enterprises, and service and content providers. Our products provide customers with scalability from 10 MbpsEthernet to 10 Gigabit Ethernet combined with the wire-speed, non-blocked routing of ASIC-based or merchant silicon-based Layer 3 switching. We intendto capitalize on our expertise in Ethernet, IP and hardware-based switching technologies to continuously develop new products that will meet the futurerequirements of a broad range of customers. Expand market penetration. We continue to market our products to new customers in multiple market segments. The majority of our business is withenterprise customers, including those in government, education and the health care sectors, in addition to middle to large commercial enterprises. Extremehas consistently focused on these markets since early in our history. Additionally, we aim to leverage our technology development, service and support andbusiness infrastructure resources to address the metropolitan Ethernet market. These customers include ISPs, content providers and Metro service providers.While currently most of our service provider and Metro-related business is generated outside of the United States, we believe there is a long-term growthopportunity in the metropolitan Ethernet market on a worldwide basis. Once customers deploy our products they obtain the increased benefits of our solutionby simplifying their networks, extending policy-based Quality of Service and reducing costs of ownership, while increasing performance. Extend switching technology leadership. Our technological leadership is based on proprietary technology embedded in our chipsets, theExtremeWare® operating system and network management and software. We intend to invest our engineering resources in chipsets, software and otherdevelopment areas to create leading-edge technologies that will increase the performance and functionality of our products. We also intend to maintain ouractive role in industry standards committees such as the Institute for Electrical and Electronics Engineers, or IEEE, and the Internet Engineering Task Force,or IETF. Leverage and expand multiple distribution channels. We distribute our products through select distributors and a large number of resellers. To quicklyreach a broad, worldwide audience, we have more than 300 resellers in approximately 50 countries, including regional networking system resellers, networkintegrators and wholesale distributors. We maintain a field sales force to support our resellers and to sell directly to a small number of select strategicaccounts. We are continually developing and refining our two-tier distribution channel strategy. Provide high-quality customer service and support. We seek to enhance customer satisfaction and build customer loyalty through high-quality serviceand support. This includes a wide range of standard support programs that provide the level of service our customers require, from standard business hours toglobal 24-hour-a-day, 365-day-a-year real-time response support. We intend to continue to enhance the ease of use of our products, and to invest inadditional support services by increasing staff and adding new support programs for our distributors and resellers. We are committed to providing customer-driven product functionality through feedback from key prospects, consultants, channel partners and end-user customers. 7Table of ContentsProducts We deliver effective applications and services infrastructure for enterprises and service providers based on award-winning technology that combinessimplicity, high performance, intelligence and a low cost of ownership. Our Layer 3 Summit, BlackDiamond and Alpine products share the same commonhardware and operating system, enabling businesses to build a network infrastructure that is simple, easy to manage and scalable to meet the demands offuture growth. Our award-winning 2nd Generation Inferno ASIC and 3rd Generation Triumph chipsets are incorporated in all i-series products, including theBlackDiamond and Alpine. Inferno provides the core technology for high-end Summit switches. During the past fiscal year, three leading edge products were introduced by Extreme Networks: the Summit 300-48/Altitude 300, the Summit 400 seriesand the BlackDiamond 10K series, including our 4th generation 4GNSS chipset. Additionally, we rolled out our revolutionary new Network Platform,ExtremeWare® XOS, in conjunction with the BlackDiamond 10K introduction. Our principal hardware and software products are as follows: Products Configuration/DescriptionSummit Stackable Product Family Summit1i 6 100/1000 BaseT Ethernet ports and 2 1000BaseX Gigabit Ethernet portsSummit5i 12 100/1000 BaseT Ethernet ports and 4 1000BaseX Gigabit Ethernet portsSummit7i 28 100/1000 BaseT Ethernet ports and 4 1000BaseX Gigabit Ethernet portsSummit48si 48 10/100 Mbps Ethernet ports and 2 Gigabit Ethernet portsSummit 300 48 10/100 Mbps Ethernet ports, supporting Power over Ethernet, or PoE, and wirelessfunctionality and 4 Gigabit Ethernet portsSummit 200 24 or 48 10/100 Mbps Ethernet ports and 2 Gigabit Ethernet portsSummit 400 48 10/100/1000 BaseT Ethernet ports, 4 Gigabit Ethernet 1000BaseX ports and anoptional 2-port 10 Gigabit Ethernet ModuleBlackDiamond Modular Chassis BlackDiamond 6804 Up to 384 10/100 Mbps Ethernet ports, 96 Gigabit Ethernet ports, or four 10 GigabitEthernet ports in one chassis 6 slots to accommodate a variety of up to 4 connectivity modules and 2 managementmodules 8Table of ContentsProducts Configuration/DescriptionBlackDiamond 6808 Up to 672 10/100 Mbps Ethernet ports, 168 Gigabit Ethernet ports, or eight 10 GigabitEthernet ports in one chassis 10 slots to accommodate a variety of up to 8 connectivity modules and 2 managementmodulesBlackDiamond 6816 Up to 1,440 10/100 Mbps Ethernet ports, 360 Gigabit Ethernet ports, or sixteen 10Gigabit Ethernet ports in one chassis 20 slots to accommodate a variety of up to 16 connectivity modules and 4 managementmodulesBlackDiamond 10808 480 Gigabit Ethernet ports, or 48 10 Gigabit Ethernet ports in one chassis 10 slots to accommodate a variety of up to 8 connectivity modules and 2 managementmodulesAlpine Modular Chassis Alpine 3802 Up to 64 10/100 Mbps Ethernet ports or 20 Gigabit Ethernet ports in one chassis 3 slots to accommodate a variety of up to 2 connectivity modules and 1 WAN module.Alpine 3804 Up to 128 10/100 Mbps Ethernet ports or 64 Gigabit Ethernet ports in one chassis 5 slots to accommodate a variety of up to 4 connectivity modules and 1 managementmoduleAlpine 3808 Up to 256 10/100 Mbps Ethernet ports or 128 Gigabit Ethernet ports in one chassis 9 slots to accommodate a variety of up to 8 connectivity modules and 1 managementmoduleSoftware ExtremeWare® An embedded switch operating system featuring standard protocols, web-basedconfiguration and policy-based Quality of Service. Summit Stackable Products The Summit family of switches is designed to meet the demanding requirements of Enterprise and metropolitan-Ethernet-based applications. AllInferno-chipset-based Summit switches share a common switch architecture that provides scalability in four areas: speed, bandwidth, network size and policy-based Quality of Service. The Summit product family supports Gigabit and 10/100 Mbps aggregation for enterprise desktops and servers, large Internet datacenters and broadband points of presence in Metros. 9Table of ContentsThe Summit48si and the new Summit 200 series switches allow us to remain an industry leader in Layer 3 switching for the desktop. The Summit200-24 and Summit200-48 switches offer low entry costs for sophisticated Layer 2 and Layer 3 services, respectively, at the network edge. Additionally theSummit48si switch delivers an aggregation switching solution with physical and logical access, security and user mobility features at the edge. Extreme recently introduced the Summit 400-48t, the first in a series of Summit 400 switches. Delivering the highest Gigabit Ethernet density in theindustry and matching throughput performance, the Summit 400-48t (Summit 400) enables deployment of new intelligent services faster and more efficientlythan ever before. The Summit 400 series is Extreme Networks’ latest addition to its Unified Access (UA) architecture for the enterprise edge. It enables users toavoid costly upgrades as they deploy gigabit to the edge and is the industry’s highest-performance, Layer 3, fixed-configuration switching platform with 101Mbps throughput and 48 10/100/1000 ports. The new Extreme Networks offering is also the first and only switch on the market with optional 10 GigabitEthernet uplinks. The Summit 300 provides a unique set of capabilities as Extreme’s first Unified Access Architecture product supporting both wired and wirelessEthernet connectivity. The Unified Access Architecture capabilities simplify the deployment of wireless by providing simple to install access points(Altitude 300) that are managed from a single point, reducing the cost of ownership and providing uniform approaches to security, authentication, Quality ofService and resiliency irrespective of the media connectivity type in use. The Summit 300-48 and Altitude access points enable unified access for wired and wireless applications at the network edge with the seamlessintegration of 802.11 a/b/g type high performance wireless LAN connectivity, Power over Ethernet, and integrated Layer 3 routing intelligence. UnifiedAccess Architecture is the industry’s most versatile solution for the integrated network edge where the network must progressively support an array of devicesincluding IP phones, laptop and desktop PCs and emerging devices such as IP cameras. Using Unified Access-enabled switches (the Summit 300-48) and theAltitude 300 access points, enterprises can simplify the installation and secure the operation of wired and wireless applications within a single “unified”infrastructure. Other members of the Summit product line address server-switching constraints by providing switched Fast Ethernet or Gigabit Ethernet ports and highspeed Gigabit uplinks to servers, delivering required bandwidth between servers, and to clients on attached segments. In server farms and data centers, theSummit1i, Summit5i and Summit7i switches maximize server availability and performance by combining server load-balancing with wire-speed switching. BlackDiamond 10808 (10K) Series The BlackDiamond 10808, the first in the family of next-generation BlackDiamond 10K switches, represents the future of core Ethernet networking forboth enterprises and metropolitan service providers. Based on Extreme Networks’ revolutionary 4th Generation Network Silicon System (4GNSS), theBlackDiamond 10K is the first product to deliver programmable T-Flex technology, which allows programmability of the chipset to allow changes inprotocol support as new standards and protocols emerge. BlackDiamond 6800 Series The BlackDiamond 6800 series switch delivers carrier-class scalability, redundancy and high reliability for core switching in high-density Ethernet/IPenterprise and service provider networks. These modular switches include the fault-tolerant features associated with mission-critical enterprise-class Layer 3core switching, including redundant system management and switch fabric modules, hot-swappable modules and chassis components, load-sharing powersupplies and management modules, up to eight 10 Mbps, 100 Mbps or Gigabit aggregated links, dual software images and system configurations, spanningtree and multipath routing, and redundant router protocols for enhanced system and network reliability. The BlackDiamond switch can accommodate up to16 I/O blades, including 10/100 Mbps, Gigabit and 10 Gigabit WAN interfaces. 10Table of ContentsThe network core is the most critical point in the network, serving as the convergence point for the majority of network traffic, including desktop,aggregation and server traffic. Network core switching involves switching traffic from desktops, segments and servers within the network. Owing to the high-traffic nature of the network core, the critical elements in core switching include wire-speed Layer 3 switching and routing, scalability, non-blockinghardware architecture, fault-tolerant mission-critical features, redundancy, and link aggregation capabilities. The ability to support a variety of high-densityport speeds and to accommodate an increasing number of high-capacity backbone connections is also important. The BlackDiamond 6800 series switch is certified to be compliant with Network Equipment Building Systems, or NEBS Level 3, and offers anextensive range of modules, including legacy connections such as Packet-over-SONET, or PoS, OC-3 and OC-12, and Asynchronous Transfer Mode, or ATM,metropolitan connectivity through Multi-Protocol Label Switching, or MPLS, billing capabilities through Accounting and Routing Module, opticalconnectivity with Wave Division Multiplexing, or WDM, and industry-leading 10 Gigabit Ethernet connectivity. This product line continues to be significantly enhanced through the addition of Extreme’s 3rd Generation technology, Triumph, which adds marketleading density/performance characteristics and sophisticated ingress-based rate shaping as well as innovative streaming media replication. Triumph is fullyhardware, or “backwards,” compatible with Extreme’s existing “Inferno” chipset that has been deployed in this platform for several years. This promotesexcellent investment protection and continued low cost of ownership for the customer’s continued use of a single switching platform. Alpine 3800 Series The Alpine 3800 series switch provides a simple, resilient broadband infrastructure for Metros, ISPs and mid-range enterprise networks. The Alpine3800 series provides total Ethernet coverage with support for both standard category 5 and fiber optic media as well as first mile technologies that extend thereach of Ethernet-over-VDSL and legacy WAN technologies. The Alpine 3800 series switches can be configured to scale from 8 to 56 Ethernet-over-VDSL ports. Even higher density can be achieved with acombination of Ethernet-over-VDSL and traditional copper or fiber Ethernet ports. The FM-8Vi module provides Ethernet-over-VDSL at 10 Mbps full-duplexon each port, up to 2,500 feet. This product line has been significantly enhanced through the addition of Extreme’s 3rd Generation technology, Triumph, which adds market leadingdensity/performance characteristics and sophisticated ingress-based rate shaping commensurate with the Alpine’s positioning as a low cost high density edgedevice for both Metro and Enterprise deployment. Triumph is fully hardware, or “backwards,” compatible with Extreme’s existing “Inferno” chipset that hasbeen deployed in this platform for several years. This promotes excellent investment protection and continued low cost of ownership. The Alpine switch canbe an extension of Extreme’s Unified Access Architecture with a new 24 port module that delivers Power over Ethernet and management for integrated andsecure wireless LAN connectivity. ExtremeWare® Software ExtremeWare® software is the embedded operating system software that is featured on all of our switches. It delivers the robust switching and routingprotocol support, management, control and security needed on current enterprise and service provider networks. Its standards-based, multi-layer switchingand policy-based Quality of Service give network managers the tools needed to optimize network capacity with consistent fault-tolerant behavior. Extreme Networks recognized in early 2000 that a new software architecture would be needed as converged IP networks begin to drive more and moremission-critical traffic onto a single network infrastructure. Culminating more than 3 years of research and development efforts, ExtremeWare® XOS deliversrevolutionary 11Table of Contentsbreakthroughs and industry leading capabilities that further the state-of-the-art in networking technology: Scalability, Resiliency, Security and Extensibility.ExtremeWare® XOS was made available to customers in December 2003. It provides a revolutionary software foundation that for the first time deliversadaptability, scalability and increased responsiveness for enterprise networks through its uniquely open, extensible architecture. Sales, Marketing and Distribution We conduct our sales and marketing activities on a worldwide basis through a two-tier distribution channel utilizing distributors, value-added resellersand our field sales organization. A majority of our sales are currently made to partners in our distributor and reseller channels. The first tier consists of alimited number of independent distributors that sell primarily to resellers and end-user customers. The second tier of the distribution channel is comprised ofa large number of independent resellers that sell directly to end-user customers. In addition, Extreme utilizes its field sales organization to sell direct to end-user customers, including large global accounts. Strategic Alliances. In November of this past fiscal year we entered into a mutual, non-exclusive, comprehensive strategic alliance with Avaya Inc.Avaya designs, builds and manages communications networks for more than one million businesses worldwide, including 90 percent of the Fortune 500.Focused on businesses large to small, Avaya is a world leader in secure and reliable IP telephony systems and communications software applications andservices. Avaya and Extreme are jointly developing and marketing converged communications solutions as part of this multi-year, multimillion-dollarstrategic alliance. Avaya is also reselling Extreme Networks’ data networking products and will provide comprehensive planning, design, implementation andmanagement services support through Avaya Global Services. Significant sales wins already garnered through this relationship include Radio Shack andWynn Resorts. Distributors. We have established several key relationships with leading distributors in the electronics and computer networking industries. We intendto maintain these relationships with distributors who may offer products or distribution channels that complement our own channels. Each of our distributorsresells our products to reseller and end-user customers. The distributors enhance our ability to sell and provide support to end-user customers, especiallyglobal accounts, who may benefit from the broad service and product fulfillment capabilities offered by these distributors. No distributor or customeraccounted for more than 10% of our net revenues in fiscal 2004. One distributor, Tech Data Corporation, accounted for 11% and 15% of our net revenues infiscal 2003 and fiscal 2002, respectively. Distributors are generally given privileges to return a portion of inventory to us for the purpose of stock rotationand participate in various cooperative marketing programs to promote the sale of our products and services. We defer recognition of revenue on all sales tothese distributors until the distributors sell the product, as evidenced by a monthly sales-out report that the distributors provide to us. (See “RevenueRecognition” in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.) Value-Added Resellers, or VARs. We have entered into agreements to sell our products through more than 300 resellers in approximately 50 countries.Our value-added resellers include regional networking system resellers, resellers who focus on specific vertical markets, network integrators and wholesaledistributors. We provide training and support to our resellers and our resellers generally provide the first level of support to end-users of our products. Ourrelationships with resellers are generally on a non-exclusive basis. Our resellers are not given privileges to return inventory and do not automaticallyparticipate in any cooperative marketing programs. We generally recognize product revenue from our reseller and end-user customers at the time of shipment,provided that persuasive evidence of an arrangement exists, delivery has occurred, the price of the product is fixed or determinable and collection of the salesproceeds is reasonably assured. When significant obligations or contingencies remain after products are delivered, such as installation or customeracceptance, revenue and related costs are deferred until such obligations or contingencies are satisfied. (See “Revenue Recognition” in Item 7. Management’sDiscussion and Analysis of Financial Condition and Results of Operations.) 12Table of ContentsField sales. We have trained our field sales organization to support and develop leads for our value-added resellers and to establish and maintain alimited number of key accounts and strategic customers. To support these objectives, our field sales force: •assists end-user customers in finding solutions to complex network system and architecture problems; •differentiates the features and capabilities of our products from competitive offerings; •continually monitors and understands the evolving networking needs of enterprise and service provider customers; •promotes our products and ensures direct contact with current and potential customers; and •monitors the changing requirements of our customers. As of June 27, 2004, our worldwide sales and marketing organization consisted of 328 individuals, including directors, managers, sales representatives,and technical and administrative support personnel. We have domestic sales offices located in 22 states and international sales offices located in 25countries. International sales International sales are an important portion of our business. In fiscal 2004, sales to customers outside of the United States accounted for 61% of ourconsolidated net revenues, compared to 60% in fiscal 2003 and 67% in fiscal 2002. These sales are conducted primarily through foreign-based distributorsand resellers managed by our worldwide sales organization, in addition to direct sales to end-user customers, including large global accounts. The primarymarkets for sales outside of the United States include the countries in Western Europe and Japan. Although not a significant component of total revenues todate, we have also achieved sales growth in the People’s Republic of China, countries throughout the Asia-Pacific region, South America, Canada andMexico. Marketing We have a number of marketing programs to support the sale and distribution of our products and to inform existing and potential customers and ourdistributors and resellers about the features and performance of our products. Our marketing efforts include participation in industry tradeshows, technicalconferences and technology seminars, preparation of competitive analyses, sales training, publication of technical and educational articles in industryjournals, a publicly available website, web-based training courses, advertising and public relations. In addition, we are developing e-commerce processes andsystems for our resellers, distributors and end-user customers. We also submit our products for independent product testing and evaluation. Backlog Our products are often sold on the basis of standard purchase orders that are cancelable prior to shipment without significant penalties. In addition,purchase orders are subject to changes in quantities of products and delivery schedules in order to reflect changes in customer requirements andmanufacturing capacity. Our business is characterized by seasonal variability in demand and short lead-time orders and delivery schedules. Actual shipmentsdepend on the then-current capacity of our contract manufacturer and the availability of materials and components from our vendors. We believe that only asmall portion of our order backlog is non-cancelable and that the dollar amount associated with the non-cancelable portion is immaterial. Accordingly, we donot believe that backlog at any given time is a meaningful indicator of future revenue. Customer Support and Service We offer modular and comprehensive extended warranty service contracts under our ExtremeWorks service solutions to help protect our customers’network investments and support their business goals. The markets we address, including enterprises and service providers, all seek higher reliability andmaximum uptime. Our goal is 13Table of Contentsto serve as a knowledgeable and experienced service partner who can tailor service solutions to meet the specific business needs of our customers. For theprovision of on-site hardware support to customers we have strategic partnerships in place with International Business Machines, Inc. and Equant N.V.Expenses related to these agreements are recorded in services cost of revenue on our consolidated statements of operations. We also maintain relationshipswith Flextronics International, Ltd. and Solectron Corporation for the handling of product returns and repairs covered by our warranty and service contractsin various locations worldwide. We provide our customers with our standard, limited hardware warranty, which is typically 12 months from the date ofshipment to end-users and 14 months from the date of shipment to channel partners, and our 90-day software warranty. Warranty expenses related to theserelationships are recorded in product cost of revenue on our consolidated statements of operations. Support contract expenses related to these relationshipsare recorded in services cost of revenue on our consolidated statements of operations. Our service offerings are as follows: •ExtremeWorks Professional Services •ExtremeWorks and PartnerWorks Support Programs •ExtremeWorks Education ExtremeWorks Professional Services. We specialize in providing solutions and consultative services to improve network productivity in all phases ofthe network lifecycle – planning, design, implementation, operation and optimization management. The professional services include customized andpackaged consulting services that assist customers in meeting their objectives for applications support, uptime and cost control. Our network architectsdevelop and execute customized hardware deployment plans to meet individualized network strategies. These activities include the management andcoordination of the design and network configuration, resource planning, staging, logistics, migration and deployment. We also provide customized trainingand operational best practices documentation to assist customers in the transition and sustaining of their networks. We offer our customers a variety of technical consulting services, including: •Analysis – detailed audit and analysis of customer networks •Policy-Based QoS – analysis and recommendation for deploying advanced traffic management and bandwidth prioritization features to matchactual traffic patterns •Multicasting – strategy for deploying PIM-DM, PIM-SM, or DVMRP to best suit streaming media requirements •Voice over IP – strategy and recommendations to deploy voice-over-IP utilizing our technology •Wireless LAN – site surveys, WLAN design and implementation of Unified Access solutions •Load Balancing – design and implementation of our integrated load balancing features to help maximize server response while reducingequipment costs •Security – analysis of customer security needs and recommendations on how to implement advanced security features to meet those needs •Resident engineering services – dedicated on-site technical engineering resources providing high level staff expertise ExtremeWorks and PartnerWorks Support Programs. Our support programs are designed to support a broad range of customer service requirements forour resale partners and direct customers. We meet the service requirements of our customers and channel partners through Technical Assistance Centers, orTACs, located in Santa Clara, California; Utrecht, Holland; Noida, India; and Tokyo, Japan. Our technical engineers assist in diagnosing and troubleshootingtechnical issues regarding customer networks. This is part of our effort to ensure maximum network uptime and performance. Regional systems engineersserve as on-site engineering resources 14Table of Contentsto provide consultative support and advice for network operation on an as needed basis. Development engineers work with the TACs to resolve productfunctionality issues specific to each customer. We utilize the Internet to distribute and obtain information from our customer base as an integral part of our service solution. This allows us to keepcustomers informed of the latest updates and developments at Extreme Networks, and contains up-to-date information and technical documentation enablingcustomers to research issues and find answers to technical questions. Special features include a TAC database to obtain troubleshooting assistance andinformation for configuring software, diagnosing hardware, and researching network issues. On-site support services are available in most locationsworldwide for customers who require a more comprehensive level of service and support. ExtremeWorks Education. Leveraging our Authorized Training Partner strategy, Extreme Networks licenses partners to provide education throughcertified technical experts that teach classes dealing with all of our products. The classes cover a wide range of topics such as installation, configuration,operation, management and optimization – providing customers with the necessary knowledge and experience to successfully deploy and manage ourproducts in various networking environments. Classes are scheduled and available at numerous locations worldwide. Manufacturing We outsource the majority of our manufacturing and supply chain management operations as part of our strategy to maintain global manufacturingcapabilities and to reduce our costs. We conduct quality assurance, manufacturing engineering, document control and test development at our main campusin Santa Clara, California. This approach enables us to reduce fixed costs and to flexibly respond to changes in market demand. We have a strategic partnership with Flextronics International, Ltd. for the manufacture of our OEM products in San Jose, California and Guadalajara,Mexico. Flextronics’ manufacturing processes and procedures are ISO 9002 certified. Our commitment with Flextronics is formalized through a one-yearcontract. We design and develop the key components of our products, including ASICs and printed circuit boards. We determine the components that areincorporated in our products and select the appropriate suppliers of such components. Flextronics utilizes automated testing equipment to perform producttesting and burn-in with specified tests. Together we rely upon comprehensive inspection testing and statistical process controls to assure the quality andreliability of our products. We intend to regularly introduce new products and product enhancements that will require us to rapidly achieve volumeproduction by coordinating our efforts with those of our suppliers and contract manufacturer. Although we use standard parts and components for our products where it is appropriate, we currently purchase several key components used in themanufacture of our products from single or limited sources. Our principal single-source components include: •ASICs; •merchant silicon; •microprocessors; •programmable integrated circuits; •selected other integrated circuits; •custom power supplies; and •custom-tooled sheet metal. 15Table of ContentsOur principal limited-source components include: •flash memory; •dynamic and static random access memories, or DRAMS and SRAMS respectively; and •printed circuit boards. Purchase commitments with our single- or limited-source suppliers are generally on a purchase order basis. A number of vendors supply standardproduct integrated circuits and microprocessors for our products. Any interruption or delay in the supply of any of these components, or the inability toprocure these components from alternate sources at acceptable prices and within a reasonable time, may have a material adverse effect on our business,operating results and financial condition. Qualifying additional suppliers can be time-consuming and expensive and may increase the likelihood of errors. We use our forecast of expected demand to determine our material requirements. Lead times for materials and components vary significantly, anddepend on factors such as the specific supplier, contract terms and demand for a component at a given time. We order many of our materials and componentson an indirect basis through our contract manufacturer. Research and Development The success of our products to date is due in large part to our focus on research and development. We believe that continued success in the marketplacewill depend on our ability to develop new and enhanced products employing leading-edge technology. Accordingly, we are undertaking development effortswith an emphasis on increasing the reliability, performance and features of our family of products, and designing innovative products to reduce the overallnetwork operating costs of customers. Our product development activities focus on solving the needs of enterprises, service providers and Metro markets. Current activities include thecontinuing development of a next-generation chipset aimed at extending the capabilities of our products. Our ongoing research activities cover a broad rangeof areas, including, in particular, 10 Gigabit Ethernet, Metro and Internet routing software, ASIC design, network management software, broadband accessequipment and wireless networking equipment. We have developed a new module operating system (ExtremeWare® XOS) which has been designed to provide high reliability and availability. Thisarchitecture allows us to leverage a common software architecture across different hardware and ASIC implementation. We have utilized our ongoinginvestment in this area to develop and introduce new products and enhancements, and we intend to continue with this approach for future products andenhancements. As of June 27, 2004, our research and development organization consisted of 235 individuals. Our expenditures for research and development in fiscal2004, fiscal 2003 and fiscal 2002 were $58.1 million, $58.0 million and $61.5 million, respectively. Competition The market for switches is part of the broader market for networking equipment, which is dominated by a few large companies, particularly CiscoSystems. In addition, there are a number of large telecommunications equipment providers, including Alcatel and Nortel Networks, which have entered themarket for network equipment, particularly through acquisitions of public and privately held companies. We expect to face increased competition,particularly price competition, from these and other telecommunications equipment providers. We also compete with other public and private companies thatoffer switching solutions, including Enterasys Networks, Foundry Networks, Inc., Huawei Technologies, 3Com Corporation, Hewlett-Packard Company andDell Computer Corporation. These vendors offer products with functionality similar to our products or provide 16Table of Contentsalternative network solutions. Current and potential competitors have established or may establish cooperative relationships among themselves or with thirdparties to develop and offer competitive products. Furthermore, we compete with numerous companies that offer routers and other technologies and devicesthat traditionally have managed the flow of traffic on the enterprise or Metro networks. Some of our current and potential competitors have longer operating histories and substantially greater financial, technical, sales, marketing and otherresources, as well as greater name recognition and a larger installed customer base, than we do. As a result, these competitors are able to devote greaterresources to the development, promotion, sale and support of their products. In addition, competitors with a large installed customer base may have asignificant competitive advantage over us. We have encountered, and expect to continue to encounter, many potential customers who are confident in andcommitted to the product offerings of our principal competitors, including Cisco Systems. Accordingly, these potential customers may not consider orevaluate our products. When such potential customers have considered or evaluated our products, we have in the past lost, and expect in the future to lose,sales to some of these customers as large competitors have offered significant price discounts to secure these sales. We believe the principal competitive factors in the network switching market are: •expertise and familiarity with network protocols, network switching and network management; •product performance, features, functionality and reliability; •price/performance characteristics; •timeliness of new product introductions; •adoption of emerging industry standards; •customer service and support; •size and scope of distribution network; •brand name; •access to customers; and •size of installed customer base. We believe that we compete favorably with our competitors with respect to each of the foregoing factors. However, because many of our existing andpotential competitors have longer operating histories, greater name recognition, larger customer bases, broader product lines and substantially greaterfinancial, technical, sales, marketing and other resources, they may have larger distribution channels, stronger brand names, access to more customers and alarger installed customer base than we do. Such competitors may, among other things, be able to undertake more extensive marketing campaigns, adopt moreaggressive pricing policies and make more attractive offers to distribution partners than we can. To remain competitive, we believe that we must, among otherthings, invest significant resources in developing new products and enhancing our current products and maintain customer satisfaction worldwide. If we failto do so, our products will not compete favorably with those of our competitors and that may have a material adverse effect on our business. Intellectual Property We rely on a combination of patent, copyright, trademark and trade secret laws and restrictions on disclosure to protect our intellectual property rights.Based on our commitment to build a patent portfolio, we have in process a number of patent applications relating to our proprietary technology. We havefiled patent applications in selected countries abroad as deemed appropriate. There can be no assurance that these applications will be approved, that anyissued patents will protect our intellectual property, or that third parties will not challenge these patents or applications. Furthermore, there can be noassurance that others will not 17Table of Contentsindependently develop similar or competing technology or design around any patents that we may obtain. With respect to trademarks, we have a number ofpending and registered trademarks in the United States and abroad. We enter into confidentiality or license agreements with our employees, consultants and corporate partners, and control access to, and distribution of,our software, documentation and other proprietary information. In addition, we provide our software products to end-user customers primarily under “shrink-wrap” license agreements included within the packaged software. These agreements are not negotiated with or signed by the licensee, and thus theseagreements may not be enforceable in some jurisdictions. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy orotherwise obtain and use our products or technology. There can be no assurance that these precautions will prevent misappropriation or infringement of ourintellectual property. Monitoring unauthorized use of our products is difficult, and we cannot be certain that the steps we have taken will preventmisappropriation of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States. As detailed below under “Legal Proceedings,” we are currently engaged in litigation with Lucent Technologies, Inc. (“Lucent”). Lucent is assertingclaims that allege infringement of certain patent rights, against which we are defending vigorously, but we cannot assure you that we will prevail in thislitigation. In addition to the litigation with Lucent, in the normal course of our business from time to time, we are in discussions with companies that assertcertain of our products require a license under a number of patents. Due to the number of companies with extensive patent portfolios in our industry who areor may be actively involved in licensing programs, we believe that even if we do not infringe any patents, we may incur significant expenses in the future dueto disputes or licensing negotiations, though the amounts and timing of such expenses cannot be determined with any reasonable certainty. As thefunctionality and features of our products expand, these disputes and discussions could increase or become harder to resolve. Employees As of June 27, 2004, we employed 831 people, including 328 in sales and marketing, 235 in engineering, 83 in operations, 76 in customer support andservice, and 109 in finance and administration. We have never had a work stoppage and no personnel are represented under collective bargaining agreements.We consider our employee relations to be good. We believe that our future success depends on our continued ability to attract, integrate, retain, train and motivate highly qualified personnel, andupon the continued service of our senior management and key personnel. None of our personnel is bound by an employment agreement. The market forqualified personnel is competitive, particularly in the San Francisco Bay Area, where our headquarters is located. At times, we have experienced difficultiesin attracting new personnel. Organization We were incorporated in California in May 1996 and reincorporated in Delaware in March 1999. Our corporate headquarters are located at 3585Monroe Street, Santa Clara, CA 95051 and our telephone number is (408) 579-2800. Our website can be found at www.extremenetworks.com. Investors canobtain copies of our SEC filings from this website free of charge, or on the SEC’s website at www.sec.gov. Item 2. Properties Our principal administrative, sales, marketing and research and development facilities are located in Santa Clara, California. We also lease office spaceand executive suites in various other geographic locations domestically and internationally for sales and service personnel and engineering operations. Ouraggregate lease expense for fiscal 2004 was approximately $5.4 million, net of sublease income of approximately $0.3 million. We believe our currentfacilities will adequately meet our growth needs for the foreseeable future, and we are actively engaged in efforts to sublease excess space we acquired inprior years to meet the anticipated growth at that time. 18Table of Contents Item 3. Legal Proceedings On May 27, 2003, Lucent filed suit against Extreme Networks and Foundry Networks, Inc. (“Foundry”) in the United States District Court for theDistrict of Delaware, Civil Action No. 03-508. The complaint alleges willful infringement of U.S. Patent Nos. 4,769,810, 4,769,811, 4,914,650, 4,922,486 and5,245,607 and seeks a judgment: (a) determining that we have willfully infringed each of the five patents; (b) determining that Foundry has willfullyinfringed four of the five patents; (c) permanently enjoining us from infringement, inducement of infringement and contributory infringement of each of thefive patents; (d) permanently enjoining Foundry from infringement, inducement of infringement and contributory infringement of four of the five patents;and (e) awarding Lucent unspecified amounts of trebled damages, together with expenses, costs and attorneys’ fees. We intend vigorously to defend against Lucent’s allegations. We answered Lucent’s complaint on July 16, 2003, denying infringement and assertingvarious affirmative defenses and counterclaims that seek judgment: (a) that Lucent’s complaint be dismissed and Lucent be denied all requested relief; (b)declaring that we do not infringe, induce infringement or contribute to the infringement of any valid and enforceable claim of the five patents, (c) that each ofthe five patents be declared invalid; (d) finding the case exceptional within the definition of 35 U.S.C. § 285; and (e) that Lucent pay our attorneys’ fees andcosts. The court has served the cases against Extreme Networks and Foundry. Discovery is proceeding. A claim construction hearing has been set forNovember 17, 2004. A pre-trial conference is set for January 14, 2005. No trial date has been set. Beginning on July 6, 2001, purported securities fraud class action complaints were filed in the United States District Court for the Southern District ofNew York. The cases were consolidated and the litigation is now captioned as In re Extreme Networks, Inc. Initial Public Offering Securities Litigation, Civ.No. 01-6143 (SAS) (S.D.N.Y.), related to In re Initial Public Offering Securities Litigation, 21 MC 92 (SAS) (S.D.N.Y.). The operative amended complaint is brought purportedly on behalf of all persons who purchased Extreme Networks’ common stock from April 8, 1999through December 6, 2000. It names as defendants Extreme Networks; six of our present and former officers and/or directors, including our CEO (the“Extreme Networks Defendants”); and several investment banking firms that served as underwriters of our initial public offering and October 1999 secondaryoffering. Subsequently, plaintiffs and one of the individual defendants stipulated to a dismissal of that defendant without prejudice. The complaint allegesliability under Sections 11 and 15 of the Securities Act of 1933 and Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, on the grounds that theregistration statement for the offerings did not disclose that: (1) the underwriters had agreed to allow certain customers to purchase shares in the offerings inexchange for excess commissions paid to the underwriters; and (2) the underwriters had arranged for certain customers to purchase additional shares in theaftermarket at predetermined prices. The Securities Act allegations against the Extreme Networks Defendants are made as to the secondary offering only. Theamended complaint also alleges that false analyst reports were issued. No specific damages are claimed. Similar allegations were made in other lawsuits challenging over 300 other initial public offerings and follow-on offerings conducted in 1999 and2000. The cases were consolidated for pretrial purposes. On February 19, 2003, the Court ruled on all defendants’ motions to dismiss. The Court denied themotions to dismiss the claims in our case under the Securities Act of 1933. The Court denied the motion to dismiss the claim under Section 10(a) of theSecurities Exchange Act of 1934 against Extreme Networks and 184 other issuer defendants, on the basis that the complaints alleged that the respectiveissuers had acquired companies or conducted follow-on offerings after their initial public offerings. The Court denied the motion to dismiss the claims underSection 10(a) and 20(a) of the Securities Exchange Act of 1934 against the remaining Extreme Networks Defendants and 59 other individual defendants, onthe basis that the respective amended complaints alleged that the individuals sold stock. 19Table of ContentsWe have executed a settlement agreement presented to all issuer defendants. In this settlement, plaintiffs will dismiss and release all claims against theExtreme Network Defendants, in exchange for a contingent payment by the insurance companies collectively responsible for insuring the issuers in all of theIPO cases, and for the assignment or surrender of control of certain claims we may have against the underwriters. The Extreme Networks Defendants will notbe required to make any cash payments in the settlement, unless the pro rata amount paid by the insurers in the settlement exceeds the amount of theinsurance coverage, a circumstance which we do not believe will occur. The settlement will require approval of the Court, which cannot be assured. If thesettlement is not approved, we cannot assure you that we will prevail in the lawsuit. Failure to prevail could have a material adverse effect on ourconsolidated financial position, results of operations and cash flows in the future. Other than the proceedings stated above, we are not aware of any pending legal proceedings against us that, individually or in the aggregate, wouldhave a material adverse effect on our business, operating results or financial condition. We may in the future be party to litigation arising in the course of ourbusiness, including claims that we allegedly infringe third-party trademarks and other intellectual property rights. Such claims, even if not meritorious, couldresult in the expenditure of significant financial and managerial resources. Item 4. Submission of Matters to a Vote of Security Holders Not applicable. Executive Officers of the Registrant The following table sets forth information regarding our executive officers as of August 1, 2004: Name Age PositionGordon L. Stitt 48 President, Chief Executive Officer and ChairmanStephen Haddock 46 Vice President and Chief Technical OfficerHerb Schneider 45 Vice President of EngineeringWilliam R. Slakey 46 Senior Vice President and Chief Financial OfficerAlexander J. Gray 47 Chief Operating OfficerFrank C. Carlucci 41 Senior Vice President of Worldwide Sales Gordon L. Stitt. Mr. Stitt co-founded Extreme in May 1996 and has served as President, Chief Executive Officer and a director of Extreme since itsinception. From 1989 to 1995, Mr. Stitt worked at another company he co-founded, Network Peripherals, a designer and manufacturer of high-speednetworking technology. He served first as its Vice President of Marketing, then as Vice President and General Manager of the OEM Business Unit. Mr. Stittholds an M.B.A. from the Haas School of Business of the University of California, Berkeley and a B.S.E.E./C.S. from Santa Clara University. Stephen Haddock. Mr. Haddock co-founded Extreme in May 1996 and has served as Vice President and Chief Technical Officer of Extreme since itsinception. From 1989 to 1996, Mr. Haddock worked as Chief Engineer at Network Peripherals. Mr. Haddock is a member of IEEE, an editor of the GigabitEthernet Standard and Chairman of the IEEE 802.3ad link aggregation committee and vice chairman of the 10 Gigabit committee. Mr. Haddock holds anM.S.E.E. and a B.S.M.E. from Stanford University. Herb Schneider. Mr. Schneider co-founded Extreme in May 1996 and has served as Vice President of Engineering of Extreme since its inception. From1990 to 1996, Mr. Schneider worked as Engineering Manager at Network Peripherals and was responsible for the development of LAN switches. From 1981to 1990, Mr. Schneider held various positions at National Semiconductor, a developer and manufacturer of semiconductor products, where he was involvedin the development of early Ethernet chipsets and FDDI chipsets. Mr. Schneider holds a B.S.E.E. from the University of California – Davis. 20Table of ContentsWilliam R. Slakey. Mr. Slakey has served as Senior Vice President and Chief Financial Officer of Extreme Networks since October 2003. FromSeptember 2002 to September 2003, Mr. Slakey served as Vice President and Chief Financial Officer at Handspring, Inc., a maker of wireless communicationdevices and PDA’s. From October 2001 to August 2002, Mr. Slakey was Executive Vice President and Chief Financial Officer at WJ Communications, aleading RF semiconductor company. From September 1999 to December 2000, he was Vice President and Chief Financial Officer at SnapTrack, aQUALCOMM company that pioneered a GPS-based system for pinpointing wireless devices. Prior to SnapTrack, Mr. Slakey held various financial roles atPalm Computing, 3Com Corporation and Apple Computer. Mr. Slakey holds a B.A. degree in economics from the University of California and an M.B.A.from the Harvard Graduate School of Business Administration. Alexander J. Gray. Mr. Gray joined Extreme as Chief Operating Officer in September 2002. From January 2001 through August 2002, Mr. Gray wasChief Operating Officer at LGC Wireless, a telecommunications provider. From November 1999 until January 2001, Mr. Gray worked for Replay TV, a digitalmedia provider, as Executive Vice President of Business Operations. From December 1992 through October 1999, Mr. Gray held senior managementpositions with Lucent Technologies, Inc. and Octel Communications Corporation, both telecommunications providers. Prior to that time, Mr. Gray heldpositions as Director of Information Services for American President Lines, a container shipping company, from September 1991 to November 1992 andNEXT Computer, a computer and equipment manufacturer, from July 1988 to August 1991. He also spent four years as a research and development engineerfor Hewlett-Packard Company, a computer and equipment manufacturer. Mr. Gray holds a B.S. and an M.S. in Electrical Engineering from WashingtonUniversity in St. Louis, Missouri. Frank C. Carlucci. Mr. Carlucci joined Extreme as Senior Vice President of Worldwide Sales in July 2004. From April 2000 through June 2004, Mr.Carlucci held various executive positions with Avaya, Inc., a communications equipment and applications provider. Mr. Carlucci’s last position with Avayawas as Vice President of Global Outsourcing, prior to that role he had led Avaya’s largest sales region and operations for Avaya’s product group. From August1998 to April 2000, Mr. Carlucci was the Sales Vice President for a venture of Lucent Technologies. From July 1996 to August 1998, Mr. Carlucci heldvarious management positions at Federal Data Corporation, a systems integration company. From January 1993 to July 1996, Mr. Carlucci held variousmanagement positions at Nortel Networks, Inc., a telecommunication hardware manufacturer. From May 1991 through December 1992, Mr. Carlucci was afield sales manager for Ernest and Julio Gallo Winery. Mr. Carlucci served six years as an intelligence officer in the United States Navy following graduationfrom Georgetown University with a B.S. in International Politics. 21Table of Contents PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities Our common stock commenced trading on The Nasdaq National Market on April 9, 1999 under the symbol “EXTR.” The following table sets forth thehigh and low sales prices as reported by Nasdaq. Such prices represent prices between dealers, do not include retail mark-ups, mark-downs or commissionsand may not represent actual transactions. Stock Prices High LowFiscal year ended June 27, 2004: First quarter $8.98 $4.66Second quarter $10.46 $6.15Third quarter $10.60 $6.27Fourth quarter $8.20 $4.64Fiscal year ended June 29, 2003: First quarter $12.48 $3.64Second quarter $5.84 $2.33Third quarter $5.43 $3.05Fourth quarter $7.01 $3.79 At August 10, 2004, there were approximately 360 stockholders of record of our common stock and approximately 58,000 beneficial stockholders. Wehave never declared or paid cash dividends on our capital stock and do not anticipate paying any cash dividends in the foreseeable future. We currentlyintend to retain future earnings for the development of our business. Securities authorized for issuance under equity compensation plans The following table summarizes our equity compensation plans as of June 27, 2004: Plan category Number of securities tobe issued upon exerciseof outstanding options,warrants and rights(a) Weighted-averageexercise price ofoutstanding options,warrants and rights(b) Number of securitiesremaining available forfuture issuance underequity compensation plans(excluding securitiesreflected in column (a))(c) (In thousands)Equity compensation plansapproved by security holders 18,237,120(1) $7.12 20,218,119(2)Equity compensation plans notapproved by security holders 3,035,608(3) $8.38 4,268,111(4) Total 21,272,728 $7.30 24,486,230 (1)These options were issued under the Amended 1996 Stock Option Plan.(2)Of this amount 17,568,952 shares were available for issuance under the Amended 1996 Stock Option Plan and 2,649,167 shares were available forissuance under the 1999 Employee Stock Purchase Plan.(3)Of this amount 995,375 shares were issued under the 2000 Nonstatutory Stock Option Plan and 2,040,233 shares were issued under the 2001Nonstatutory Stock Option Plan. Excludes 178,593 outstanding options with an average exercise price of $0.99 that were assumed in connection withacquisitions and no additional options are available for future issuance under such plans.(4)Of this amount 2,947,052 shares were available for issuance under the 2000 Nonstatutory Stock Option Plan and 1,321,059 shares were available forissuance under the 2001 Nonstatutory Stock Option Plan. 22Table of Contents Item 6. Selected Consolidated Financial Data Year Ended June 27, 2004(1) June 29, 2003(2) June 30, 2002(3) July 1, 2001(4) July 2, 2000(5) (In thousands, except per share amounts)Consolidated Statements of Operations Data: Net revenues $351,848 $363,276 $441,609 $491,232 $261,956Net income (loss) $(1,748) $(197,180) $(183,962) $(68,883) $20,048Net income (loss) per share — basic $(0.01) $(1.71) $(1.63) $(0.64) $0.20Net income (loss) per share — diluted $(0.01) $(1.71) $(1.63) $(0.64) $0.18Shares used in per share calculation — basic 118,348 115,186 112,925 108,353 100,516Shares used in per share calculation — diluted 118,348 115,186 112,925 108,353 111,168 As of June 27, 2004 June 29, 2003 June 30, 2002 July 1, 2001 July 2, 2000 (In thousands)Consolidated Balance Sheets Data: Cash and cash equivalents, short-term investments andmarketable securities $425,672 $402,157 $400,057 $191,502 $227,505Total assets $579,273 $550,257 $736,344 $666,348 $515,930Convertible subordinated notes $200,000 $200,000 $200,000 $— $— Other long-term liabilities $21,561 $22,313 $20,761 $266 $306(1)Fiscal 2004 net loss includes $1.1 million in amortization of deferred stock compensation, $6.5 million in restructuring charges for excess facilities,other income of $7.9 million in cash settlements from vendors, net of related expenses and other income of $2.5 million in a refund of foreignconsumption tax.(2)Fiscal 2003 net loss includes $0.7 million in amortization of deferred stock compensation, $15.9 million in restructuring charges, $12.7 million inproperty and equipment write-offs, $1.0 million in impairment of acquired intangible assets and a $132.2 million charge included in our tax provisionreflecting our provision of a full valuation allowance against deferred tax assets.(3)Fiscal 2002 net loss includes $10.2 million in amortization of deferred stock compensation, $37.2 million in amortization of goodwill and purchasedintangible assets, $73.6 million in restructuring charges and $89.8 million in impairment of intangible assets.(4)Fiscal 2001 net loss includes $4.1 million in amortization of deferred stock compensation, $33.4 million in amortization of goodwill and purchasedintangible assets, $30.2 million in write-offs of acquired in-process research and development and $5.9 million in restructuring charges.(5)Fiscal 2000 net income includes $0.1 million in amortization of deferred stock compensation and $6.7 million in amortization of goodwill andpurchased intangible assets. Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Business Overview We develop and sell a family of modular and stackable network infrastructure equipment and offer related service contracts for extended warranty andmaintenance agreements. Substantially all of our revenue is derived from the sale of networking equipment and the related service contracts. We believe thatunderstanding the following key developments is helpful to an understanding of our operating results for fiscal 2004. Increased Product Breadth We believe that continued success in the marketplace will depend on our ability to develop new and enhanced products employing leading-edgetechnology. In fiscal 2004 we introduced several new products including the Black Diamond 10K, the Summit 300-48/Altitude 300 and the Summit 400series, plus a new network software platform ExtremeWare® XOS. 23Table of ContentsConvergence of Voice, Video and Data We have a vision of providing customers with the systems to build a converged communications infrastructure that can easily accommodate voice,video and data on a seamless wired and wireless network. We believe that these two aspects of convergence: the convergence of voice, video and data, andthe convergence of wired and wireless are important underlying demand creators in the Enterprise market. In November 2003, we announced our comprehensive strategic alliance with Avaya, Inc. to jointly develop and market converged communicationssolutions. The alliance brings together Avaya’s global market leadership in IP voice and telephony with Extreme’s expertise in high performance IP datanetwork infrastructure. Under the Joint Development Agreement the companies plan to develop next generation, standards-based technologies in the areas ofnetwork management and provisioning, Quality of Service, security, and network resilience. Additionally, Avaya will sell, service and support Extreme’sentire portfolio of data networking products through their worldwide sales organization and the Avaya Global Services organization. Business Environment In the late 1990’s and through 2000, enterprises deployed a large volume of networking equipment in anticipation of high network traffic growth.During this period, Extreme experienced a period of rapid revenue growth. Subsequent to 2000 the global economy entered a recessionary period and thedemand for information technology products declined as enterprises reduced spending on technology. In particular enterprises cut their IT budgets fornetworking equipment due to overcapacity as the anticipated increase in network growth in the years 2002 through early 2003 did not materialize. Webelieve that this phenomenon adversely affected demand for our products and made it more difficult to accurately forecast demand for network equipment. Expanded Focus on Service Offering Extreme’s service offering is primarily the provision of service contracts for extended warranty and maintenance agreements related to our networkingequipment. To a lesser extent, the service revenue includes professional services related to the design and installation of data networks and training. In fiscal2004, we focused our service sales efforts on increasing the number of service contracts sold on new equipment and in the area of securing renewals onexpiring contracts. Service revenue increased by 26.0% in fiscal 2004 compared to fiscal 2003 and represented 13.8% of total revenues in fiscal 2004compared to 10.6% in fiscal 2003. Cost of service revenue decreased by $5.3 million in fiscal 2004 to $35.5 million and gross margins improved to 26.8%from a negative 6.0% in fiscal 2003 due to efforts to improve and optimize our service supply chain. Results of Operations Throughout fiscal 2002, 2003 and 2004, the primary factor that has impacted our operations and financial performance has been weak demand fornetworking equipment resulting from the continuing weakness of the global and U.S. economies. Weak economic conditions persisted through most of fiscal2004, but beginning in the third quarter of fiscal 2004, we began to see early evidence of strengthening demand for our products. While it is too early todetermine if this slow improvement in demand will continue, we believe that industry demand may be stabilizing and may be showing signs of returning topositive growth. Although our operations and financial performance were directly and adversely impacted by the economic factors described above, and despite thedifficult economic challenges we faced during fiscal 2004, we were able to achieve the following results: •We stabilized net revenues in fiscal 2004 of $351.8 million, a decrease of 3.1% from fiscal 2003 revenues of $363.3. •We recorded service revenue of $48.6 million, an increase of 26.0% from fiscal 2003 service revenue of $38.5 million. •Total gross margin in fiscal 2004 expanded to 50.9% of net revenues from 41.4% in fiscal 2003. 24Table of Contents •We reduced our net loss in fiscal 2004 to $1.7 million. •Cash and cash equivalents, short-term investments and marketable securities increased by $23.5 million in fiscal 2004 to $425.7 million as of June27, 2004. Net Revenues The following table presents net product and service revenues for the fiscal years 2004, 2003 and 2002 (dollars in thousands): Year Ended June 27,2004 % of NetRevenues June 29,2003 % of NetRevenues June 30,2002 % of NetRevenues Net revenues: Product $303,293 86.2% $324,727 89.4% $407,394 92.3%Service 48,555 13.8% 38,549 10.6% 34,215 7.7% Total net revenues $351,848 100.0% $363,276 100.0% $441,609 100.0% Net revenues were $351.8 million in fiscal 2004, $363.3 million in fiscal 2003 and $441.6 million in fiscal 2002, representing a decrease of 3.1% infiscal 2004 from fiscal 2003 and a decrease of 17.7% in fiscal 2003 from fiscal 2002. The decrease in revenues in fiscal 2004 and fiscal 2003 is generally dueto weak demand for networking equipment resulting from the continuing weakness of the global and U.S. economies. Product revenue was $303.3 million in fiscal 2004, $324.7 million in fiscal 2003, and $407.4 million in fiscal 2002, representing a decrease of 6.6% infiscal 2004 from fiscal 2003 and a decrease of 20.3% in fiscal 2003 from fiscal 2002. The decrease in product revenue in fiscal 2004 from fiscal 2003 isprimarily due to a change in mix in product demand, with both total units and average selling price remaining relatively stable. The decrease in productrevenue in fiscal 2003 from fiscal 2002 was due primarily to a significant reduction in our business in Japan, along with a decline in units shipped and adecrease in average selling price. We experienced some erosion of average selling prices of our products in fiscal 2003 compared to fiscal 2002 due to anumber of factors, including competitive pricing pressures, promotional pricing and rapid technological change. Our average selling price will continue to besubject to such competitive pressure and can be expected to change rapidly. Service revenue was $48.6 million in fiscal 2004 representing an increase of 26.0% from fiscal 2003 service revenue of $38.5 million. The increase inservice revenue in fiscal 2004 from fiscal 2003 is the result of our focus on increasing the number of service contracts purchased by customers, changes in ourpolicies regarding service and increasing renewal rates. Service revenue in fiscal 2003 increased by 12.7% from fiscal 2002 service revenue of $34.2 million.This increase was primarily due to the expansion of our customer base purchasing service contracts. As a percentage of total net revenues, service revenue was13.8% in fiscal 2004, 10.6% in fiscal 2003 and 7.7% in fiscal 2002. The following table presents the total net revenues geographically for the fiscal years 2004, 2003 and 2002 (dollars in thousands): Year Ended June 27,2004 % of NetRevenues June 29,2003 % of NetRevenues June 30,2002 % of NetRevenues Net revenues: United States $136,622 38.8% $144,066 39.7% $146,345 33.1%Europe, Middle East and Africa 93,700 26.6% 90,303 24.9% 97,774 22.1%Japan 77,600 22.1% 82,916 22.8% 145,203 32.9%Other 43,926 12.5% 45,991 12.6% 52,287 11.9% $351,848 100.0% $363,276 100.0% $441,609 100.0% 25Table of ContentsRevenue outside of the United States accounted for 61.2%, 60.3% and 66.9% of net revenues in fiscal 2004, fiscal 2003 and fiscal 2002, respectively.Revenue outside the U.S. as a percentage of total net revenues in fiscal 2004 decreased by 0.9% compared to fiscal 2003 with revenue in Europe, the MiddleEast and Africa as a percentage of total net revenues increasing by 1.7%; revenue in Japan as a percentage of total net revenues decreasing by 0.7%; andrevenue in other international regions, primarily Asia Pacific, as a percentage of total net revenues remaining flat as a percent of the total. The decrease in netrevenues outside the United States in fiscal 2003 compared to fiscal 2002 was primarily due to a reduction of sales in Japan. We expect that export sales willcontinue to represent a significant portion of net revenues, although export sales will fluctuate as a percentage of net revenues. Substantially all salestransactions are currently denominated in United States dollars. We rely upon our two-tiered distribution channel for the majority of our revenues. Revenue through the distributor channel was 33% of total productrevenue in fiscal 2004 and 37% in fiscal 2003. The level of sales to any customer may vary from period to period; however, we expect that significantcustomer concentration will continue for the foreseeable future. No distributor or customer accounted for more than 10% of our net revenues in fiscal 2004.One customer, Tech Data Corporation, who is a distributor of our products, accounted for 11% and 15% of our net revenues in fiscal 2003 and fiscal 2002,respectively. Cost of Revenues and Gross Margin The following table presents the gross margin on product and service revenues and the gross margin percentage of net revenues for the fiscal years2004, 2003 and 2002 (dollars in thousands): Year Ended June 27,2004 % of NetRevenues June 29,2003 % of NetRevenues June 30,2002 % of NetRevenues Gross margin: Product $166,187 54.8% $152,658 47.0% * * Service 13,009 26.8% (2,303) -6.0% * * Total gross margin $179,196 50.9% $150,355 41.4% $183,970 41.7% *Cost of revenues and gross margin are presented in total for the year ended June 30, 2002 since Extreme Networks did not track cost of product andservice revenues separately in that year. Gross margin was $179.2 million in fiscal 2004, $150.4 million in fiscal 2003 and $184.0 million in fiscal 2002, representing an increase of 19.2% infiscal 2004 from fiscal 2003 and a decrease of 18.3% in fiscal 2003 from fiscal 2002. Gross margin as a percentage of net revenues was 50.9%, 41.4% and41.7% in fiscal 2004, fiscal 2003 and fiscal 2002, respectively. Cost of product revenue includes costs of raw materials, amounts paid to third-party contract manufacturers, costs related to warranty obligations,charges for excess and obsolete inventory, and internal costs associated with manufacturing overhead including management, manufacturing engineering,quality assurance, development of test plans, and document control. Product gross margin in fiscal 2004 was $166.2 million, representing 54.8% of productrevenues as compared to $152.7 million in fiscal 2003, or 47.0% of product revenue. The increase in product gross margin in fiscal 2004 is due to a reductionin per-unit product costs resulting from a consolidation of volume at a single manufacturer. In addition, the fiscal 2004 gross margin was favorably impactedby a reduction in manufacturing overhead, warranty expense, reductions in scrap, rework, and was negatively impacted by increases in excess inventoryexpenses. Cost of product revenue in all periods includes the cost of our manufacturing overhead. We outsource the majority of our manufacturing and supplychain management operations, and we conduct quality assurance, manufacturing engineering, document control and repairs at our facility in Santa Clara,California. Accordingly, a significant portion of our cost of revenue consists of payments to our primary contract manufacturer, Flextronics International, Ltd.located in San Jose, California and Guadalajara, Mexico. 26Table of ContentsThe total gross margin in fiscal 2003 of $150.4 million decreased by 18.3% from fiscal 2002 of $184.0 and was primarily due to the related decrease inrevenue. As a percentage of net revenues, gross margin was 41.4% in fiscal 2003 and 41.7% in fiscal 2002. Fiscal 2003 gross margin was adversely affectedby a higher than normal rate of warranty expense due to problems with various component parts within our products and our election, in some cases, toaddress those problems by replacing such products with new rather than refurbished replacements. Fiscal 2002 gross margin benefited by $4.8 millionrelating to products sold that were written off in fiscal 2001. In the first quarter of fiscal 2002, we recorded a charge of $9.0 million related to an equipment lease in cost of revenues. As part of our businessrelationship with MCMS, Inc. (“MCMS”), a former contract manufacturer, in September 2000, we entered into a $9.0 million operating equipment lease formanufacturing equipment with a third-party financing company; we, in turn, subleased the equipment to MCMS. Due to the liquidity problems at MCMS itfiled for protection under Chapter 11 on September 18, 2001. On January 8, 2002, MCMS completed an agreement to sell a majority of its assets to PlexusCorp. for $45.0 million. Our cost of service consists primarily of labor, overhead, repair and freight costs and the cost of spares used in providing support under customerservice contracts. Service gross margin was $13.0 million in fiscal 2004, representing 26.8% of service net revenue as compared to a negative gross margin of$2.3 million in fiscal 2003, a negative 6.0% of service net revenue. Service gross margin in fiscal 2003 was negatively impacted by a number of programsthat we implemented to improve service delivery productivity and to enhance customer satisfaction. These programs included expenses incurred to increaseservice revenue and reduce service infrastructure, including outsourcing certain service functions. The cost of service and gross margin in fiscal 2004 reflectthe benefits we achieved from these programs. As our service revenue represents more than 10% of total net revenues for fiscal 2004 and fiscal 2003, we have separately reported product and servicegross margin. The fiscal 2004 and fiscal 2003 service gross margin calculations include all service related expenses. Gross margin for fiscal 2002 is presentedin total since we do not have records that detail product and service cost of revenue in separate categories. Furthermore, in the past, some service relatedexpenses were included in operating expenses as part of the line item titled sales, marketing and service expense. The ERP system we implemented at thebeginning of fiscal 2003 enables us to record cost of product and service revenue in separate detail. We were able to identify the service expenses that hadpreviously been included in operating expenses and, therefore, our fiscal 2002 results reflect the reclassification of $23.1 million from operating expenses tocost of revenue. Such amounts represented 5.3% of previously reported operating expenses for fiscal 2002. Our product and service gross margins are variable and dependent on many factors, some of which are outside of our control. Some of the primaryfactors affecting gross margin include demand for our products, changes in our pricing policies and those of our competitors, and the mix of products sold.Our gross margin may be adversely affected by increases in material or labor costs, increases in warranty expense or the cost of providing services underextended service contracts, heightened price competition, obsolescence charges and higher inventory balances. In addition, our gross margin may fluctuatedue to the mix of distribution channels through which our products are sold, including the effects of our two-tier distribution model. Any significant declinein sales to our resellers, distributors or end-user customers, or the loss of any of our key resellers, distributors or end-user customers could have a materialadverse effect on our business, operating results and financial condition. In addition, an increase in distribution channels generally makes it more difficult toforecast the mix of products sold and the timing of orders from our customers. New product introductions may result in excess or obsolete inventories, whichmay also reduce our gross margin. Sales and Marketing Expenses Sales and marketing expenses consist of salaries, commissions and related expenses for personnel engaged in marketing and sales functions, as well astrade shows and promotional expenses. Sales and marketing expenses were $93.2 million in fiscal 2004, $102.5 million in fiscal 2003 and $117.9 million infiscal 2002, representing a 27Table of Contentsdecrease of 9.0% in fiscal 2004 from fiscal 2003 and a decrease of 13.1% in fiscal 2003 from fiscal 2002. The decrease in fiscal 2004 from fiscal 2003 wasprimarily due to a decrease in advertising and other promotional expenses of $4.2 million as a result of cost-cutting measures, a decrease in depreciationexpense of $1.7 million, a decrease in occupancy expenses of $1.0 million, a decrease in salaries and related personnel expenses of $1.2 million primarily dueto lower sales commissions and a decrease in travel expenses of $1.0 million. The decrease in fiscal 2003 from fiscal 2002 was primarily due to lower salescommissions and a reduction of 62 people in fiscal 2003 in our sales and marketing organization. As a percentage of net revenues, sales and marketingexpenses were 26.5% in fiscal 2004, 28.2% in fiscal 2003 and 26.7% in fiscal 2002. The rate of future spending changes in our sales and marketing expenses,if any, will depend on the pace of recovery in the market for networking products. Research and Development Expenses Research and development expenses consist principally of salaries and related personnel expenses, consultant fees and prototype expenses related tothe design, development, and testing of our products. Research and development expenses were $58.1 million in fiscal 2004, $58.0 million in fiscal 2003 and$61.5 million in fiscal 2002, remaining flat in fiscal 2004 from fiscal 2003 and representing a decrease of 5.7% in fiscal 2003 from fiscal 2002. Fiscal 2004includes amortization expense of $4.0 million related to the fair value of the warrant issued to Avaya as part of the Joint Development Agreement, offset inpart by decreased payroll and personnel expenses of $1.6 million, decreased engineering project expenses of $1.2 million and decreased depreciationexpense of $0.7 million. The fair value of the warrant allocated to the Joint Development Agreement with Avaya is $17.9 million and will be amortized overa three-year period beginning November 1, 2003 (see Note 13 of Notes to Consolidated Financial Statements). Amortization expense related to thisagreement is approximately $1.5 million per fiscal quarter; the amortization expense related to this agreement in fiscal 2004 represents eight months ofamortization. The decrease in fiscal 2003 compared to fiscal 2002 was a result of tightening our focus on our core product lines. As a percentage of total netrevenues, research and development expenses were 16.5% in fiscal 2004, 16.0% in fiscal 2003 and 13.9% in fiscal 2002. The increase in these percentages infiscal 2004 and fiscal 2003 was primarily the result of a decrease in our net revenues in fiscal 2004 and fiscal 2003. We expense all research and developmentexpenses as incurred. We believe that continued investment in research and development is critical to attaining our strategic objectives. General and Administrative Expenses General and administrative expenses consist primarily of salaries and related expenses for executive, finance and administrative personnel, professionalfees and other general corporate expenses. General and administrative expenses were $29.6 million in fiscal 2004, $25.7 million in fiscal 2003 and $26.9million in fiscal 2002, representing an increase of 15.0% in fiscal 2004 from fiscal 2003 and a decrease of 4.4% in fiscal 2003 from fiscal 2002. The increasein fiscal 2004 from fiscal 2003 was primarily due to increases in legal fees of $3.9 million relating to litigation and increases in other professional fees of $1.3million, offset by decreases in insurance expense of $0.8 million and decreases in payroll and personnel expenses of $0.5 million. The decrease in fiscal 2003from fiscal 2002 was primarily due to decreases in bad debt expense of $4.6 million and rent expense of $1.4 million offset by increases in professional feesof $3.3 million and salaries and benefits of $1.8 million. As a percentage of net revenues, general and administrative expenses were 8.4% in fiscal 2004, 7.1%in fiscal 2003 and 6.1% in fiscal 2002. The increase in the percentage in fiscal 2004 was primarily due to the increase in legal expense and the increase in thepercentage in fiscal 2003 was primarily the result of decreases in our net revenues in fiscal 2003. In June 2003, we implemented a reduction in force and otherexpense control measures to reduce expenses, including general and administrative expenses. The rate of any future spending increases in our general andadministrative expenses, if any, will depend on the pace of recovery in the market for networking products. Legal expenses related to intellectual propertylitigation are expected to continue and may also cause general and administrative expenses to increase. We increased expenses as a result of compliance withthe Sarbanes-Oxley Act of 2002, including Section 404 thereof, and expect to incur additional expenses in fiscal 2005 as we implement procedures to meetthe requirements of this act. 28Table of ContentsImpairment of Acquired Intangible Assets During fiscal 2003, we performed our annual evaluation of goodwill for impairment in accordance with Statement of Financial Accounting Standards(“SFAS”) No. 142 (“SFAS 142”), Goodwill and Other Intangible Assets. This evaluation indicated decreased expected future demand for the productsassociated with the goodwill and, therefore, we recorded an impairment charge of $1.0 million, representing the carrying value of goodwill at that time. Therewas no goodwill remaining as of June 27, 2004 or June 29, 2003. During the third quarter of fiscal 2002, we evaluated goodwill and purchased intangibleassets associated with recent acquisitions for impairment in accordance with SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and forLong-Lived Assets to be Disposed of. The assessment was performed as a result of weakening economic conditions and decreased current and expected futuredemand for certain categories of products in the markets in which we operate. As a result of the assessment, we recorded a charge to reduce goodwill andpurchased intangible assets of $89.8 million. Amortization of Deferred Stock Compensation Amortization of deferred stock compensation was $1.1 million in fiscal 2004, $0.7 million in fiscal 2003 and $10.2 million in fiscal 2002, representingan increase of $0.4 million in fiscal 2004 from fiscal 2003 and a decrease of $9.5 million in fiscal 2003 from fiscal 2002. Amortization of deferred stockcompensation is attributable to unvested stock options subject to forfeiture issued to employees that we assumed in conjunction with acquisitions duringfiscal 2001. Deferred stock compensation is amortized as charges to operations, using the graded method, over the vesting periods of the individual stockoptions, generally four years. Upon termination of an employee, the amount of expense recognized under the graded vesting method that is in excess of theamount actually earned is reversed. For fiscal 2004, fiscal 2003 and fiscal 2002, we reversed $0.4 million, $5.3 million and zero, respectively, of excesscompensation expense related to terminated employees. Amortization of Goodwill and Purchased Intangible Assets We recorded amortization of goodwill of $33.5 million and amortization of purchased intangible assets of $3.6 million in fiscal 2002 primarily relatedto acquisitions in fiscal 2000 and fiscal 2001. We adopted SFAS 142 as of July 1, 2002. SFAS 142 requires goodwill and certain other intangible assets to betested for impairment at least annually and written down only when impaired, rather than being amortized as previous accounting standards required.Accordingly, as of July 1, 2002, we stopped amortizing goodwill with a carrying value of $1.0 million. This amount was subsequently written off due toimpairment in fiscal 2003. Restructuring Charge During fiscal 2004, we recorded restructuring charges of $962 thousand in the quarter ended September 28, 2003 and $5.5 million in the quarter endedJune 27, 2004 related to excess facilities. The excess facilities charge represents an increase to the charge initially recognized during the third quarter of fiscal2002. The commercial real estate market has continued to deteriorate in fiscal 2004 and we have not been able to find suitable tenants to sublease thesefacilities necessitating an additional charge due to lower projected sublease receipts. As a result of the excess facilities charges recorded in fiscal 2004, rentexpense in fiscal 2005 is expected to remain approximately the same as the fiscal 2004 levels. During fiscal 2003, we recorded restructuring charges of $15.9 million. The restructuring charges included excess facilities charges of $9.6 million,severance charges of $4.4 million and asset impairments of $1.9 million. The excess facility charge originally recognized in the third quarter of fiscal 2002was increased due to lower projected sublease income caused by the deterioration of the commercial real estate market. Severance charges of $2.7 millionrelated to a reduction in total staff during the second quarter of fiscal 2003 of approximately 100 people, or 10% of the total workforce, across alldepartments. Severance charges of $1.7 million related to a reduction in total staff announced at the end of fiscal 2003 of approximately 70 people, or 8% ofthe total workforce, across all departments. The asset impairment charge relates to the write-off of leasehold improvements and office furniture related toexcess facilities. 29Table of ContentsDuring fiscal 2002, we implemented a restructuring plan to lower our overall cost structure. Restructuring charges of $73.6 million included a $39.0million charge related to the exit of two facility leases we entered into in June 2000, excess facilities charges of $25.4 million and asset impairments of $9.1million. The excess facilities charges of $25.4 million were the result of our decision to permanently reduce occupancy or vacate certain domestic andinternational facilities. The asset impairment charge represented the unamortized amount of the assets at the date a decision was made to discontinue use.These assets were not utilized subsequently or held for sale. They were either scrapped or abandoned. Property and Equipment Write-Off During fiscal 2003, we completed a property and equipment physical inventory in conjunction with the implementation of our new ERP system. Theproperty and equipment physical inventory resulted in the identification of $12.7 million of property and equipment whose fair value was determined to bezero because the assets were either no longer in service or were not identifiable. Therefore these assets were written off during the second quarter of fiscal2003. Interest Income Interest income was $8.6 million in fiscal 2004, $11.1 million in fiscal 2003 and $11.7 million in fiscal 2002, representing a decrease of $2.5 million infiscal 2004 from fiscal 2003 and a decrease of $0.6 million in fiscal 2003 from fiscal 2002. The decrease in fiscal 2004 from fiscal 2003 is attributed to lowerinterest rates offset by an increase in available investment balances due to increased cash flow from operations. The decrease in fiscal 2003 from fiscal 2002was due to lower interest rates. Interest Expense Interest expense was $7.0 million in fiscal 2004, $7.1 million in fiscal 2003 and $4.5 million in fiscal 2002, representing a decrease of $0.1 million infiscal 2004 from fiscal 2003, and an increase of $2.6 million in fiscal 2003 from fiscal 2002. In December 2001, we completed a private placement of $200.0million of convertible subordinated notes maturing in 2006. Interest is payable semi-annually at 3.5% per annum. The increase in fiscal 2003 from fiscal2002 was due to a full year of interest expense on these notes. Other Income (Expense), net Other income (expense) was income of $9.1 million in fiscal 2004, expense of $0.2 million in fiscal 2003 and expense of $11.1 million in fiscal 2002.Other income in fiscal 2004 was primarily comprised of cash settlements from vendors, net of related expenses, of $2.2 million recorded in the first fiscalquarter and $5.7 million recorded in the fourth fiscal quarter. These settlements related to disputes regarding quality issues pertaining to componentssupplied for use in our products. In addition, other income in the fourth quarter of fiscal 2004 includes a foreign consumption tax refund in the amount of$2.5 million. Other expense in fiscal 2004 includes approximately $1.4 million of amortization of costs associated with the convertible subordinated notes.Other expense in fiscal 2003 was primarily comprised of amortization of costs associated with the convertible subordinated notes of $1.2 million and a write-down of investments in privately-held companies of $0.2 million partially offset by realized gains on marketable securities of $1.6 million. Other expense infiscal 2002 was primarily comprised of write-downs of investments in privately-held companies that were accounted for under the cost method. Provision (Benefit) for Income Taxes The provision for income taxes of $3.2 million for fiscal 2004 was recorded for taxes due on income generated in certain states and foreign taxjurisdictions. Income tax benefits have been recorded on the fiscal 2004 pre-tax loss and we have provided a full valuation allowance against such taxbenefits. 30Table of ContentsThe provision for income taxes of $134.8 million for fiscal 2003 was attributable to $2.6 million for taxes due on income generated in foreign taxjurisdictions and a $132.2 million non-cash charge to income tax expense recorded in the fourth quarter of fiscal 2003, representing a full valuationallowance for our net deferred tax assets. We recorded this charge in accordance with SFAS No. 109, Accounting for Income Taxes (“SFAS 109”), whichplaces greater weight on previous cumulative losses than the outlook for future profitability when determining whether deferred tax assets can be realized.Based upon our most recent three-year history of losses and relying on other guidance specified in SFAS 109, we determined that it was appropriate toestablish a full valuation allowance against our deferred tax assets. This valuation allowance will be evaluated periodically and can be reversed partially ortotally if business results have sufficiently improved to support realization of our deferred tax assets. We recorded a tax benefit of $52.8 million for fiscal 2002. The benefit for fiscal 2002 results in an effective tax benefit rate of 22.3%, which consistsprimarily of federal and state income tax benefits offset by nondeductible goodwill. Critical Accounting Policies and Estimates Our significant accounting policies are more fully described in Note 2 of Notes to Consolidated Financial Statements included in Item 8 this annualreport on Form 10-K. The preparation of consolidated financial statements in accordance with generally accepted accounting principles requires managementto make estimates, assumptions and judgments that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilitiesat the date of the consolidated financial statements, and the reported amounts of revenue and expenses during the period reported. By their nature, theseestimates, assumptions and judgments are subject to an inherent degree of uncertainty. We base our estimates, assumptions and judgments on historicalexperience, market trends and other factors that are believed to be reasonable under the circumstances. Estimates, assumptions and judgments are reviewed onan ongoing basis and the effects of revisions are reflected in the consolidated financial statements in the period they are determined to be necessary. Actualresults may differ from these estimates under different assumptions or conditions. We believe the critical accounting policies stated below, among others,affect our more significant judgments and estimates used in the preparation of our consolidated financial statements. Revenue Recognition We derive the majority of our revenue from sales of our modular and stackable networking equipment, with the remaining revenue generated fromservice fees relating to the service contracts and training on our products. Our revenue recognition policy follows Securities Exchange Commission Staff(“SEC”) Accounting Bulletin No. 104, Revenue Recognition (“SAB 104”). We generally recognize product revenue from our Value-Added Resellers and end-user customers at the time of shipment, provided that persuasive evidence of an arrangement exists, delivery has occurred, the price of the product is fixed ordeterminable and collection of the sales proceeds is reasonably assured. In instances where the criteria for revenue recognition established by SAB 104 is notmet, revenue is deferred until all criteria have been met. Our total deferred product revenue was $3.0 million and $3.3 million as of June 27, 2004 and June29, 2003, respectively. Revenue from service obligations under service contracts is deferred and recognized on a straight-line basis. Our total deferredrevenue for services was $50.7 million and $45.0 million as of June 27, 2004 and June 29, 2003, respectively. Service contracts typically range from one tofive years. When sales arrangements contain multiple deliverables such as hardware, service contracts and other services, we determine whether the deliverablesrepresent separate units of accounting and then allocate revenue to each unit of accounting based on its relative fair value in accordance with EmergingIssues Task Force Issue No. 00-21, Revenue Arrangements with Multiple Deliverables (“EITF 00-21”). We recognize revenue for each unit of accountingwhen the revenue recognition criteria for each unit of accounting are met in accordance with SAB 104. The amount of product revenue recognized isimpacted by our judgments as to whether an arrangement includes multiple units of accounting and if so, whether vendor-specific objective evidence of fairvalue exists for those units of accounting. The ability to establish vendor specific objective evidence for any unit of accounting could affect the timing of therevenue recognition. 31Table of ContentsWe make certain sales to partners in two-tier distribution channels. The first tier consists of a limited number of independent distributors that sellprimarily to resellers and, on occasion, to end-user customers. We defer recognition of revenue on all sales to these distributors until the distributors sell theproduct, as evidenced by a monthly sales-out report that the distributors provide to us. We grant these distributors the right to return a portion of unsoldinventory to us for the purpose of stock rotation, provide them with credits for changes in selling prices, and allow them to participate in cooperativemarketing programs. We maintain estimated accruals and allowances for these exposures based upon our historical experience. If actual credits to distributorsfor inventory returns, changes in selling prices and cooperative marketing programs were to deviate significantly from our estimates, which are based oncontractual arrangements and historical experience, our future revenue could be adversely affected. The second tier of the distribution channel consists of a large number of third-party Value-Added Resellers that sell directly to end-users and aregenerally not granted return privileges, except for defective products during the warranty period. We reduce product revenue for certain price protectionrights that may occur under contractual arrangements we have with our customers. We provide an allowance for sales returns based on our historical returns, analysis of credit memo data and our return policies. The allowance forreturns reserve was $2.2 million and $3.6 million as of June 27, 2004 and June 29, 2003, respectively, for estimated future returns that were recorded as areduction of our accounts receivable. The allowance is charged to net revenues in the accompanying consolidated statements of operations. The allowancefor returns reserve charged to net revenues was $1.8 million in fiscal 2004, zero in fiscal 2003 and $8.7 million in fiscal 2002. If the historical data we use tocalculate the estimated sales returns and allowances does not properly reflect future levels of product returns, these estimates are revised, thus resulting in animpact on future net revenues. We estimate and adjust this allowance at each balance sheet date. Inventory Valuation Our inventory balance was $25.9 million as of June 27, 2004, compared with $18.7 million as of June 29, 2003. We value our inventory at lower ofcost or market. The networking industry is characterized by rapid technological change, frequent new product introductions, changes in customerrequirements and evolving industry standards. We perform a detailed assessment of inventory at each balance sheet date, which includes a review of, amongother factors, demand requirements, product lifecycle and product development plans and quality issues. Based on this analysis, we record adjustments, whenappropriate, to reflect inventory at net realizable value. Inventory write-downs charged to cost of product revenue were $1.3 million in fiscal 2004, $0.4million in fiscal 2003 and $2.8 million in fiscal 2002. Although we make every effort to ensure the accuracy of our forecasts of product demand, anysignificant unanticipated changes in demand or technological developments would significantly impact the value of our inventory and our reportedoperating results. In the future, if we find that our estimates are too optimistic and we determine that our inventory needs to be written down, we will berequired to recognize such costs in our cost of product revenue at the time of such determination. Conversely, if we find our estimates are too pessimistic andwe subsequently sell product that has previously been written down, our operating margin in that period will be favorably impacted. Accrued Warranty Networking products may contain undetected hardware or software errors when new products or new versions or updates of existing products arereleased to the marketplace. We have experienced such errors in connection with products and product upgrades. Our standard hardware warranty period istypically 12 months from the date of shipment to end-users and 14 months from the date of shipment to channel partners, which include resellers anddistributors, and 90 days for software. Upon shipment of products to our customers, including both end-users and channel partners, we estimate expenses forthe cost to repair or replace products that may be returned under warranty and accrue a liability for this amount. 32Table of ContentsOur accrued warranty balance was $8.3 million as of June 27, 2004, compared with $10.2 million as of June 29, 2003. The determination of ourwarranty requirements is based on our actual historical experience with the product or product family, estimates of repair and replacement costs and anyproduct warranty problems that are identified after shipment. We estimate and adjust this accrual at each balance sheet date in accordance with changes inthese factors. The cost of new warranties issued that was charged to cost of product revenue was $11.8 million in fiscal 2004, $15.5 million in fiscal 2003 and$10.3 million in fiscal 2002. While we believe that our warranty accrual is adequate and that the judgments applied in calculating this accrual areappropriate, the assumptions used are based on estimates and these estimated amounts could differ materially from our actual warranty expenses in the future.If actual expenses exceed those we have estimated, our future cost of product revenue would be adversely affected. Allowance for Doubtful Accounts Our accounts receivable balance, net of allowance for doubtful accounts, was $33.0 million and $26.8 million as of June 27, 2004 and June 29, 2003,respectively. The allowance for doubtful accounts as of June 27, 2004 was $1.4 million, compared with $2.3 million as of June 29, 2003. We continuallymonitor and evaluate the collectibility of our trade receivables based on a combination of factors. We record specific allowances for bad debts in general andadministrative expense when we become aware of a specific customer’s inability to meet its financial obligation to us, such as in the case of bankruptcyfilings or deterioration of financial position. Estimates are used in determining our allowances for all other customers based on factors such as current trendsin the length of time the receivables are past due and historical collection experience. We mitigate some collection risk by requiring most of our customers inthe Asia-Pacific region, excluding Japan, to pay cash in advance or secure letters of credit when placing an order with us. Our provision for doubtful accountswas a benefit of $0.2 million in fiscal 2004, a benefit of $0.8 million in fiscal 2003 and expense of $3.9 million in fiscal 2002. If a major customer’screditworthiness deteriorates, or if actual defaults are higher than our historical experience, or if other circumstances arise, our estimates of the recoverabilityof amounts due to us could be overstated, and additional allowances could be required. Deferred Tax Asset Valuation Allowance We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax bases of assetsand liabilities. Significant management judgment is required in determining our deferred tax assets and liabilities and any valuation allowance recordedagainst our net deferred tax assets. We make an assessment of the likelihood that our net deferred tax assets will be recovered from future taxable income, andto the extent that recovery is not believed to be likely, a valuation allowance is established. During fiscal 2003, we established a full valuation allowance forour net deferred tax assets in the amount of $163.1 million. In fiscal 2004, the valuation allowance increased by $6.8 million to $169.9 million. The valuation allowance was calculated in accordance with the provisions of SFAS 109, which requires an assessment of both negative and positiveevidence when measuring the need for a valuation allowance. In accordance with SFAS 109, evidence, such as operating results during the most recent three-year period, is given more weight than our expectations of future profitability, which are inherently uncertain. Our net losses in recent periods representedsufficient negative evidence to require a full valuation allowance against our net deferred tax assets under SFAS 109. This valuation allowance will beevaluated periodically and can be reversed partially or totally if business results have sufficiently improved to support realization of our deferred tax assets. Legal Contingencies We are currently involved in various claims and legal proceedings, including negotiations regarding potential licenses from third parties who havenotified us that they believe our products may infringe certain patents. Periodically, we review the status of each significant matter, whether litigation orlicensing negotiation, and assess our potential financial exposure. If the potential loss from any claim or legal proceeding is considered 33Table of Contentsprobable and the amount can be estimated, we accrue a liability for the estimated loss. Because of uncertainties related to these matters, accruals, if any, arebased only on the most current and dependable information available at any given time. As additional information becomes available, we may reassess thepotential liability from pending claims and litigation and the probability of claims being successfully asserted against us. As a result, we may revise ourestimates related to these pending claims and litigation. Such revisions in the estimates of the potential liabilities could have a material impact on ourconsolidated results of operations, financial position and cash flows in the future. For further detail, see Note 4 of Notes to Consolidated Financial Statementsfor a description of legal proceedings. Liquidity and Capital Resources Cash and cash equivalents, short-term investments and marketable securities were $425.7 million and $402.2 million at June 27, 2004 and at June 29,2003, respectively, representing an increase of $23.5 million. This increase was primarily due to cash provided by operating activities of $21.5 million andproceeds from issuance of common stock of $13.0 million, partially offset by capital expenditures of $6.3 million. We generated $21.5 million in cash from operations in fiscal 2004 despite a net loss of $1.7 million. The net loss included significant non-cash chargesincluding a restructuring charge of $6.5 million, depreciation of $20.1 million and amortization expense related to the warrant issued to Avaya of $5.0million. Accounts receivable increased to $33.0 million at June 27, 2004 from $26.8 million at June 29, 2003. Days sales outstanding in receivablesincreased to 33 days at June 27, 2004 from 28 days at June 29, 2003. The increase in accounts receivable and days sales outstanding were primarily due totiming of collections and reductions in allowance for doubtful accounts and sales returns reserves. Inventory levels increased to $25.9 million at June 27,2004 from $18.7 million at June 29, 2003. This increase was the result of an increase in inventory related to three new product introductions within the fiscalyear. Inventory management remains an area of focus as we balance the need to maintain strategic inventory levels to ensure competitive lead times andavoid stock-outs with the risk of inventory excess or obsolescence because of declining demand, rapidly changing technology and customer requirements.Deferred revenue increased to $53.7 million at June 27, 2004 from $48.3 million at June 29, 2003. This increase was due primarily to increased serviceobligations under service contracts. We have a revolving line of credit for $10.0 million with a major lending institution. As of June 27, 2004, there were no outstanding borrowings underthis facility. The line of credit contains a provision for the issuance of letters of credit not to exceed the unused balance of the line. At June 27, 2004, we hadletters of credit totaling $0.9 million. These letters of credit were primarily issued to satisfy requirements of certain of our customers for performance bonds.The line of credit requires us to maintain specified financial covenants related to tangible net worth and liquidity with which we were in compliance as ofJune 27, 2004. The line of credit expires on January 27, 2005. It is our intention to renew this line of credit when it expires. As part of our business relationship with MCMS, Inc., a former contract manufacturer, we entered into a $9.0 million operating equipment lease formanufacturing equipment in September 2000 with a third-party financing company; we, in turn, subleased the equipment to MCMS. The equipment leasewith the third-party financing company requires us to make monthly payments through September 2005 and to maintain specified financial covenants relatedto profitability and our cash to debt ratio with which we were in compliance as of June 27, 2004. The liability related to this lease is included in leaseliability on the consolidated balance sheets. In December 2001, we completed a private placement of $200.0 million of convertible subordinated notes. The notes mature on December 1, 2006.Interest is payable semi-annually at 3.5% per annum. The notes are convertible at the option of the holders into our common stock at an initial conversionprice of $20.96 per share, subject to adjustment. The notes are redeemable in cash at our option at an initial redemption price of 101.4% of the principalamount on or after December 2004 if not converted to common stock prior to the redemption date. Each holder of the notes has the right to cause us torepurchase all of such holder’s convertible notes at 100% of the principal amount plus accrued interest upon a change of control of ownership of ExtremeNetworks, as defined in the offering circular. Instead of paying the repurchase price in cash, we may, if we satisfy certain 34Table of Contentsconditions, elect to pay the repurchase price in common stock valued at 95% of the average of the closing prices of our common stock for the five tradingdays immediately preceding and including the third trading day prior to the repurchase date. The following summarizes our contractual obligations (including interest payments) at June 27, 2004, and the effect such obligations are expected tohave on our liquidity and cash flow in future periods (in thousands): Total Less Than1 Year 1 – 3 Years 3 – 5 Years More Than5 YearsContractual Obligations: Convertible subordinated notes $217,500 $7,000 $210,500 $— $— Non-cancelable inventory purchasecommitments 22,979 22,979 — — — Non-cancelable operating lease obligations 35,982 9,753 14,272 6,318 5,639 Total contractual cash obligations $276,461 $39,732 $224,772 $6,318 $5,639 We did not have any material commitments for capital expenditures or other non-cancelable purchase commitments as of June 27, 2004. We did nothave any off-balance sheet arrangements as of June 27, 2004. We require substantial capital to fund our business, particularly to finance inventories and accounts receivable and for capital expenditures. As a result,we could be required to raise substantial additional capital at any time. To the extent that we raise additional capital through the sale of equity or convertibledebt securities, the issuance of such securities could result in dilution to existing stockholders. If additional funds are raised through the issuance of debtsecurities, these securities may have rights, preferences and privileges senior to holders of common stock and the terms of such debt could impose restrictionson our operations. If we are unable to obtain such additional capital, we may be required to reduce the scope of our planned product development andmarketing efforts, which would have a material adverse affect our business, financial condition and operating results. We believe that our current cash and cash equivalents, short-term investments, marketable securities and cash available from credit facilities and futureoperations will enable us to meet our working capital requirements for at least the next 12 months. New Accounting Pronouncements Consolidation of Variable Interest Entities In January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities(“FIN 46”). FIN 46 requires that if an entity has a controlling financial interest in a variable interest entity, the assets, liabilities, and results of activities of thevariable interest entity should be included in the consolidated financial statements of the entity. For arrangements entered into after January 31, 2003, FIN 46was effective immediately. For arrangements entered into prior to February 1, 2003, FIN 46 was effective at the end of the period ending after December 15,2003. In December 2003, FIN 46 was revised to require application in financial statements of public entities that have interests in special-purpose entities forperiods ending after December 15, 2003. For all other types of variable interest entities, application was required for periods ending after March 15, 2004.The adoption of the provisions of FIN 46, as revised, in fiscal 2004 did not have a material impact on our results of operations or financial condition. Identification of Impaired Investments In March 2004, the FASB approved the consensus reached on EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and ItsApplication to Certain Investments (“EITF 03-1”). The objective EITF 03-1 is to provide guidance for identifying impaired investments. EITF 03-1 alsoprovides new disclosure requirements for 35Table of Contentsinvestments that are deemed to be temporarily impaired. The accounting provisions of EITF 03-1 are effective for all reporting periods beginning after June15, 2004, while the disclosure requirements are effective only for annual periods ending after June 15, 2004. We have evaluated the impact of the adoption ofEITF 03-1 and do not believe the impact will be significant to our overall results of operations or financial position. Risk Factors We Are Not Profitable and We Cannot Assure You That We Will Be Profitable in the Future Fiscal 2000 was the only year in which we have achieved profitability for the full year. We reported losses for fiscal 2004, fiscal 2003, and fiscal 2002.We anticipate continuing to incur significant sales and marketing, product development and general and administrative expenses and, as a result, we willcontinue to need to rationalize expense levels and increase revenue levels to achieve profitability in future fiscal quarters. A Number of Factors Could Cause Our Quarterly Financial Results to Be Worse Than Expected, Resulting in a Decline in Our Stock Price Our ability to control our operating expenses at a level that is consistent with anticipated revenue is significant to our financial results. A highpercentage of our expenses are fixed in the short term, so any delay in generating or recognizing revenue could cause our quarterly operating results to fallbelow the expectations of public market analysts or investors, which could cause the price of our stock to fall. Orders in our backlog at the beginning of each quarter do not equal expected revenue for that quarter and are generally cancelable at any time.Accordingly, we are dependent upon obtaining orders during a quarter and shipping those orders in the same quarter to achieve our revenue objectives. Inaddition, the timing of product releases and purchase orders, and product availability, often results in a majority of our product shipments being schedulednear the end of a quarter. Failure to ship these products by the end of a quarter may adversely affect our operating results. Our customer agreements generallyallow customers to delay scheduled delivery dates or to cancel orders within specified timeframes without significant charges to the customers. Furthermore,some of our customers require that we provide installation or inspection services that may delay the recognition of revenue for both products and services,and some of our customer agreements include acceptance provisions that prevent our ability to recognize revenue upon shipment. We may experience a delay in generating or recognizing revenue for a number of reasons and our quarterly revenue and operating results have variedsignificantly in the past and may vary significantly in the future due to a number of factors, including, but not limited to, the following: •changes in general and/or specific economic conditions in the networking industry; •seasonal fluctuations in demand for our products and services, particularly in Asia-Pacific and Europe; •linearity of quarterly sales have historically reflected a pattern in which a disproportionate percentage of such sales occur in the last month of thequarter; •reduced visibility into the implementation cycles for our products and our customers’ spending plans; •our ability to forecast demand for our products, which in the case of lower-than-expected sales, may result in excess or obsolete inventory inaddition to non-cancelable purchase commitments for component parts; •product returns or the cancellation or rescheduling of orders; •our ability to develop, introduce, ship and support new products and product enhancements and manage product transitions; •announcements and new product introductions by our competitors; •our ability to develop and support relationships with enterprise customers, service providers and other potential large customers; 36Table of Contents •our ability to achieve targeted cost reductions; •our ability to obtain sufficient supplies of sole- or limited-source components for our products on a timely basis; •increases in the prices of the components that we purchase; •decreases in the prices of the products that we sell; •our ability to achieve and maintain desired production volumes and quality levels for our products; •the mix of products sold and the mix of distribution channels through which products are sold; •downward adjustments resulting from other-than-temporary declines in the carrying value of long-lived assets; •costs associated with adjustments to the size of our operations; •costs relating to possible acquisitions and the integration of technologies or businesses; and •the effect of amortization of deferred compensation and purchased intangibles resulting from existing or new transactions. On July 12, 2004 we hired a new Senior Vice President of Worldwide Sales. While we believe we have strengthened our executive team and the overallorganization, a recent high level of attrition in our sales group could adversely affect our sales. In addition, the integration of new personnel into our salesorganization, including our new Senior Vice President, will take time and the impact of their addition to Extreme Networks may not be realized in the nearterm. Due to the foregoing factors, we believe that period-to-period comparisons of our operating results should not be relied upon as an indicator of ourfuture performance. Intense Competition in the Market for Networking Equipment Could Prevent Us from Increasing Revenue and Returning to Profitability The market for networking equipment is intensely competitive. Our principal competitors include Cisco Systems, Enterasys Networks, FoundryNetworks, Inc., Nortel Networks and 3Com Corporation. In addition, a number of private companies and foreign competitors have announced plans for newproducts, or have introduced products, that may compete with our own products. Some of our current and potential competitors have superior marketleverage, longer operating histories and substantially greater financial, technical, sales and marketing resources, in addition to wider name recognition andlarger installed customer bases. Foreign competitors may have competitive advantages due to significantly lower costs or strong ties to customers in theirhome countries. These competitors may have developed, or may in the future develop, new competing products based on technologies that compete with ourown products or render our products obsolete. Furthermore, a number of these competitors may merge or form strategic partnerships that enable them to offeror bring to market competitive products. Consolidation within our industry could lead to increased competition and could harm our operating results. The pricing policies of our competitors impact the overall demand for our products and services. Some of our competitors are capable of operating atsignificant losses for extended periods of time, increasing pricing pressure on our products and services. If we do not maintain competitive pricing, thedemand for our products and services, as well as our market share, may decline. From time to time, we may lower the prices of our products and services.When this happens, if we are unable to reduce our component costs or improve operating efficiencies, our revenues and margins are adversely affected. To remain competitive, we believe that we must, among other things, invest significant resources in developing new products, improve our currentproducts and maintain customer satisfaction. Such investment will increase our expenses and affect our profitability. In addition, if we fail to make thisinvestment, we may not be able to compete successfully with our competitors, which could have a material adverse effect on our revenue and futureprofitability. 37Table of ContentsWhen Our Products Contain Undetected Software or Hardware Errors, We Incur Significant Unexpected Expenses and Could Lose Sales Network products frequently contain undetected software or hardware errors when new products or new versions or updates of existing products arereleased to the marketplace. In the past, we have experienced such errors in connection with new products and product upgrades. We have experiencedcomponent problems that caused us to incur higher than expected warranty and service costs and expenses, and to take an accrual for anticipated expenses.Such expenses adversely affected our recent results. We have undertaken extensive efforts to address these issues; however until these programs arecompleted, these expenses are expected to exceed normal levels. In the future, we expect that, from time to time, such errors or component failures will befound in new or existing products after the commencement of commercial shipments. These problems have adversely affected our business and may have amaterial adverse effect on our business by causing us to incur significant warranty and repair costs, diverting the attention of our engineering personnel fromnew product development efforts, delaying the recognition of revenue and causing significant customer relations problems. Further, if products are notaccepted by customers due to such defects, and such returns exceed the amount we accrued for defect returns based on our historical experience, ouroperating results would be adversely affected. Our products must successfully interoperate with products from other vendors. As a result, when problems occur in a network, it may be difficult toidentify the sources of these problems. The occurrence of hardware and software errors, whether or not caused by our products, could result in the delay or lossof market acceptance of our products and any necessary revisions may cause us to incur significant expenses. The occurrence of any such problems wouldlikely have a material adverse effect on our business, operating results and financial condition. We Depend Upon International Sales for a Significant Portion of Our Revenue and Our Ability to Grow Our International Sales Depends onSuccessfully Expanding Our International Operations International sales constitute a significant portion of our net revenues. Our ability to grow will depend in part on the continued expansion ofinternational sales. Sales to customers outside of the United States accounted for approximately 61%, 60% and 67% of our net revenues, respectively, forfiscal 2004, fiscal 2003 and fiscal 2002. Our international sales primarily depend on the success of our resellers and distributors. The failure of these resellersand distributors to sell our products internationally would limit our ability to sustain and grow our revenue. There are a number of risks arising from ourinternational business, including: •longer accounts receivable collection cycles; •difficulties in managing operations across disparate geographic areas; •difficulties associated with enforcing agreements through foreign legal systems; •the payment of operating expenses in local currencies, which exposes us to risks of currency fluctuations; •higher credit risks requiring cash in advance or letters of credit; •difficulty in safeguarding intellectual property; •political and economic turbulence; •potential adverse tax consequences; and •unexpected changes in regulatory requirements, including compliance with U.S. and foreign export laws and regulations. In addition, conducting our business on a global basis subjects us to a number of frequently changing and complex trade protection measures andimport or export regulatory requirements. Our failure to comply with these measures and regulatory requirements may result in the imposition of financialpenalties and restrictions on our ability to conduct business in and with certain countries, which may harm our business and damage our reputation. Pursuantto regulations of the U.S. Department of Commerce providing for voluntary disclosure, in the fourth quarter of fiscal 2002 we disclosed information regardinga possible violation of certain export 38Table of Contentsregulations. Following such disclosures the Department of Commerce will determine whether to conduct an investigation. If an investigation is commenced,we believe that these matters will be resolved without a material adverse effect on our business, and we have implemented procedures to reduce the risk ofviolations in the future. Our international sales currently are U.S. dollar-denominated. Recently the U.S. dollar exchange rate has fallen against foreign currencies, in particularthe Euro. However, future increases in the value of the U.S. dollar relative to foreign currencies could make our products less competitive in internationalmarkets. In the future, we may elect to invoice some of our international customers in local currency which will expose us to fluctuations in exchange ratesbetween the U.S. dollar and the particular local currency. If we do so, we may decide to engage in hedging transactions to minimize the risk of suchfluctuations. We have entered into foreign exchange forward contracts to offset the impact of payment of operating expenses in local currencies to some of ouroperating foreign subsidiaries. However, if we are not successful in managing these hedging transactions, we could incur losses from hedging activities. We Expect the Average Selling Prices of Our Products to Decrease, Which May Reduce Gross Margin and/or Revenue The network equipment industry has traditionally experienced a rapid erosion of average selling prices due to a number of factors, includingcompetitive pricing pressures, promotional pricing and technological progress. In addition, companies have lowered their prices in order to liquidate excessinventory that has accumulated as a result of the current economic slowdown. We anticipate that the average selling prices of our products will decrease inthe future in response to competitive pricing pressures, excess inventories, increased sales discounts and new product introductions by us or our competitors,including, for example, competitive products manufactured with low-cost merchant silicon. We may experience substantial decreases in future operatingresults due to the erosion of our average selling prices. Competitive pressures are expected to increase as a result of the industry slowdown that began in thefirst half of 2001, coupled with the downturn in the broader economy. To maintain our gross margin, we must develop and introduce on a timely basis newproducts and product enhancements and continually reduce our product costs. Our failure to do so would likely cause our revenue and gross margins todecline, which could have a material adverse effect on our operating results and cause the price of our common stock to decline. Some of Our Customers May Not Have the Resources to Pay for Our Products as a Result of the Current Economic Environment At June 27, 2004, no customer accounted for more than 10% of our accounts receivable balance. Some of our customers are forecasting that theirrevenue for the foreseeable future will generally be lower than originally anticipated. Some of these customers are experiencing, or are likely to experience,serious cash flow problems and, as a result, may find it increasingly difficult to obtain financing, if financing is available at all. If our customers are notsuccessful in generating sufficient revenue or securing alternate financing arrangements, they may not be able to pay, or may delay payment of, the amountsthat they owe us. In particular, sales to the service provider market are especially volatile and continued declines or delays in sale orders from this market mayharm our financial condition. Furthermore, they may not order as many products from us as originally forecast, or cancel orders with us entirely. The inabilityof some of our potential customers to pay us for our products may adversely affect our cash flow, the timing of our revenue recognition and the amount ofrevenue, which may cause our stock price to decline. The Market in Which We Compete is Subject to Rapid Technological Progress and to Compete We Must Continually Introduce New Products thatAchieve Broad Market Acceptance The network equipment market is characterized by rapid technological progress, frequent new product introductions, changes in customer requirementsand evolving industry standards. If we do not regularly introduce new products in this dynamic environment, our product lines will become obsolete.Developments in routers and routing software could also significantly reduce demand for our products. Alternative technologies 39Table of Contentscould achieve widespread market acceptance and displace the Ethernet technology on which we have based our product architecture. We cannot assure youthat our technological approach will achieve broad market acceptance or that other technologies or devices will not supplant our own products andtechnology. When we announce new products or product enhancements that have the potential to replace or shorten the life cycle of our existing products,customers may defer or cancel orders for our existing products. These actions could have a material adverse effect on our operating results by unexpectedlydecreasing sales, increasing inventory levels of older products and exposing us to greater risk of product obsolescence. The market for switching products isevolving and we believe our ability to compete successfully in this market is dependent upon the continued compatibility and interoperability of ourproducts with products and architectures offered by other vendors. In particular, the networking industry has been characterized by the successive introduction of new technologies or standards that have dramaticallyreduced the price and increased the performance of switching equipment. To remain competitive, we need to introduce products in a timely manner thatincorporate, or are compatible with, these emerging technologies. We are particularly dependent upon the successful introduction of new products. Wecannot ensure that any new products we introduce will be commercially successful. We have experienced delays in releasing new products and productenhancements in the past that resulted in lower quarterly revenue than anticipated. We may experience similar delays in product development and releases inthe future, and any delay in product introduction could adversely affect our ability to compete, causing our operating results to be below our expectations orthe expectations of public market analysts or investors. Our Limited Ability to Protect Our Intellectual Property May Adversely Affect Our Ability to Compete We rely on a combination of patent, copyright, trademark and trade secret laws and restrictions on disclosure to protect our intellectual property rights.However, we cannot ensure that the actions we have taken will adequately protect our intellectual property rights or that other parties will not independentlydevelop similar or competing products that do not infringe on our patents. We generally enter into confidentiality or license agreements with our employees,consultants and corporate partners, and control access to and distribution of our software, documentation and other proprietary information. Despite ourefforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise misappropriate or use our products or technology, whichwould adversely affect our ability to compete. Claims of Infringement by Others May Increase and the Resolution of such Claims May Adversely Affect our Ability to Compete and Our OperatingResults Our industry is characterized by the existence of a large number of patents and frequent claims and related litigation regarding patent and otherintellectual property rights. Because of the existence of a large number of patents in the networking field, the secrecy of some pending patents and theissuance of new patents as a rapid pace, it is not possible to determine in advance if a product or component might infringe the patent rights of others.Because of the potential for courts awarding substantial damages and the lack of predictability of such awards, it is not uncommon for companies in our andsimilar industries to settle even potentially unmeritorious claims with very substantial amounts. We expect to increasingly be subject to infringement claimsasserted by third parties as the numbers of products and competitors in the market for network switches grow and product functionality overlaps. We are actively involved in disputes and licensing discussions with, and have received notices from, others regarding their claimed proprietary rights,and as the functionality and features of our products expands, these disputes and discussions could increase or become harder to resolve. The corporationswith whom we have or could have disputes or discussions include corporations with extensive patent portfolios and substantial financial assets who areactively engaged in programs to generate substantial revenues from their patent portfolios, and who are seeking or may seek significant payments or royaltiesfrom us and others in our industry. We cannot 40Table of Contentsensure that we will always be able successfully to defend ourselves against such claims or conclude licensing discussions on favorable terms. If we are foundto infringe the proprietary rights of others, or if we otherwise settle such claims or enter into licensing arrangement to resolve potential disputes, we could becompelled to pay damages, royalties or other payments and either obtain a license to those intellectual property rights or alter our products so that they nolonger infringe upon such proprietary rights. Any license could be very expensive to obtain or may not be available at all. Similarly, changing our productsor processes to avoid infringing the rights of others may be costly or impractical. Litigation resulting from claims that we are infringing the proprietary rightsof others has resulted and could in the future result in substantial costs and a diversion of resources, and could have a material adverse effect on our business,financial condition and results of operations. Due to the number of companies with extensive patent portfolios in our industry who are or may be activelyinvolved in licensing programs, we believe that even if we do not infringe any patents, we will incur significant expenses in the future due to disputes orlicensing negotiations, though the amounts can not be determined. We cannot assure you that any such expenses will not be material or otherwise adverselyaffect our operating results. We Are Engaged in Litigation Regarding Intellectual Property Rights, and an Adverse Outcome Could Harm Our Business and Require Us to IncurSignificant Costs We have received notice from several companies alleging that we may be infringing their patents. One of these companies, Lucent Technologies, Inc.,filed a claim against us alleging patent infringement, and we are in litigation as of the date of this filing. Following examination of this claim, we believe it iswithout merit and we have responded accordingly. Without regard to the merits of this or any other claim, if judgments by a court of law on this or any otherclaim received in the future were to be upheld, or if we were otherwise to agree to the settlement of such claims, the consequences to us may be severe andcould require us, among other actions to: •stop selling our products that incorporate the challenged intellectual property; •obtain a royalty bearing license to sell or use the relevant technology, which license may not be available on reasonable terms or available at all; •pay damages; or •redesign those products that use the disputed technology. If we are compelled to take any of the foregoing actions, our business could be severely harmed. Adjustments to the Size of Our Operations May Require Us to Incur Unanticipated Costs Prior to the quarter ended April 1, 2001, we experienced rapid growth and expansion that placed a significant strain on our resources. Subsequent tothat period, we have from time to time incurred unanticipated costs to downsize our operations to a level consistent with lower forecast sales. Even if wemanage the current period of instability effectively, as well as possible expansion in the future, we may make mistakes in restructuring or operating ourbusiness, such as inaccurate sales forecasting or incorrect material planning. Any of these mistakes may lead to unanticipated fluctuations in our operatingresults. We cannot assure you that we will be able to size our operations in accordance with fluctuations of our business in the future. We Must Continue to Develop and Increase the Productivity of Our Indirect Distribution Channels to Increase Net Revenues and Improve OurOperating Results Our distribution strategy focuses primarily on developing and increasing the productivity of our indirect distribution channels. If we fail to developand cultivate relationships with significant resellers, or if these resellers are not successful in their sales efforts, sales of our products may decrease and ouroperating results could suffer. Many of our resellers also sell products from other vendors that compete with our products. We cannot assure you that we willbe able to enter into additional reseller and/or distribution agreements or that we will be able to successfully manage our product sales channels. Our failureto do any of these could limit our 41Table of Contentsability to grow or sustain revenue. In addition, our operating results will likely fluctuate significantly depending on the timing and amount of orders from ourresellers. We cannot assure you that our resellers and/or distributors will continue to market or sell our products effectively or continue to devote theresources necessary to provide us with effective sales, marketing and technical support. Most of Our Revenue is Derived From Sales of Three Product Families, So We are Dependent on Widespread Market Acceptance of These Products We derive substantially all of our revenue from sales of our Summit, BlackDiamond and Alpine products and related services. We expect that revenuefrom these product families will account for a substantial portion of our revenue for the foreseeable future. Accordingly, widespread market acceptance of ourproduct families is vital to our future success. Factors that may affect the sales of our products, some of which are beyond our control, include: •the demand for switching products (Gigabit Ethernet and Layer 3 switching technologies in particular) in the enterprise and service providermarkets; •the performance, price and total cost of ownership of our products; •the availability and price of competing products and technologies; •our ability to match supply with demand for certain products; and •the success and development of our resellers, distributors and field sales channels. We may not be able to achieve widespread market acceptance of our product families, which could reduce our revenue. Future Performance will Depend on the Introduction and Acceptance of New Products Our future performance will also depend on the successful development, introduction, and market acceptance of new and enhanced products thataddress customer requirements in a timely and cost-effective manner. In particular, we are dependent upon the successful introduction of new products. In thepast, we have experienced delays in product development and such delays may occur in the future. We have recently announced a third-generation chipsetfor use in future products. The introduction of new and enhanced products may cause our customers to defer or cancel orders for existing products. Therefore,to the extent customers defer or cancel orders in the expectation of new product releases, any delay in the development or introduction of new products couldcause our operating results to suffer. The inability to achieve and maintain widespread levels of market acceptance for our current and future products maysignificantly impair our revenue growth. If a Key Reseller, Distributor, or Other Significant Customer Cancels or Delays a Large Purchase, Our Net Revenues May Decline and the Price of OurStock May Fall To date, a limited number of resellers, distributors and other customers have accounted for a significant portion of our revenue. While no distributor orcustomer has accounted for 10% or more of revenue in the current fiscal year, sales to Westcon Corp, Tech Data Corporation and Hitachi Cable Ltd., representa high percentage of our sales and these customers have individually accounted for 10% or more of revenue in prior periods. If any of our large customersstop or delay purchases, our revenue and profitability would be adversely affected. Our expense levels are based on our expectations as to future revenue and to a large extent are fixed in the short term, so a substantial reduction ordelay in sales of our products to a significant reseller, distributor or other customer could harm our business, operating results and financial condition.Although our largest customers may differ from period-to-period, we anticipate that our operating results for any given period will continue to depend to asignificant extent on large orders from a relatively small number of customers. 42Table of ContentsWhile our financial performance depends on large orders from a limited number of key resellers, distributors and other significant customers, we do nothave binding purchase commitments from any of them. For example: •our service providers and enterprise customers can stop purchasing, and our resellers and distributors can stop marketing, our products at any time; •our reseller agreements are non-exclusive and are for one-year terms, with no obligation upon the resellers to renew the agreements; and •our reseller, distributor and end-user customer agreements generally do not require minimum purchases. Under specified conditions, some third-party distributors are allowed to return products to us. We do not recognize revenue on sales to distributorsuntil the distributors sell the product to their customers. The Sales Cycle for Our Products is Long and We May Incur Substantial Non-Recoverable Expenses or Devote Significant Resources to Sales that DoNot Occur When Anticipated The use of indirect sales channels may contribute to the length and variability of our sales cycle. Our products represent a significant strategic decisionby a customer regarding its communications infrastructure. The decision by customers to purchase our products is often based on the results of a variety ofinternal procedures associated with the evaluation, testing, implementation and acceptance of new technologies. Accordingly, the product evaluation processfrequently results in a lengthy sales cycle, typically ranging from three months to longer than a year, and as a result, our ability to sell products is subject to anumber of significant risks, including: •the risk that budgetary constraints and internal acceptance reviews by customers will result in the loss of potential sales; •the risk of substantial variation in the length of the sales cycle from customer to customer, making decisions on the expenditure of resourcesdifficult to assess; •the risk that we may incur substantial sales and marketing expenses and expend significant management time in an attempt to initiate or increasethe sale of products to customers, but not succeed; •the risk that, if a sales forecast from a specific customer for a particular quarter is not achieved in that quarter, we may be unable to compensate forthe shortfall, which could harm our operating results; and •the risk that downward pricing pressures could occur during this lengthy sales cycle. We Purchase Several Key Components for Products From Single or Limited Sources and Could Lose Sales if These Suppliers Fail to Meet Our Needs We currently purchase several key components used in the manufacture of our products from single or limited sources and are dependent upon supplyfrom these sources to meet our needs. Certain components such as tantalum capacitors, static random access memory, or SRAM, dynamic random accessmemory, or DRAM, and printed circuit boards, have been in the past, and may in the future be, in short supply. We have encountered, and are likely in thefuture to encounter, shortages and delays in obtaining these or other components, and this could have a material adverse effect on our ability to meetcustomer orders. Our principal sole-source components include: •ASICs; •microprocessors; •programmable integrated circuits; •selected other integrated circuits; 43Table of Contents •custom power supplies; and •custom-tooled sheet metal. Our principal limited-source components include: •flash memories; •DRAMs and SRAMs; and •printed circuit boards. We use our forecast of expected demand to determine our material requirements. Lead times for materials and components we order vary significantly,and depend on factors such as the specific supplier, contract terms and demand for a component at a given time. If forecasts exceed orders, we may haveexcess and/or obsolete inventory on hand or under non-cancelable purchase commitments that could have a material adverse effect on our operating resultsand financial condition. If orders exceed forecasts, we may have inadequate supplies of certain materials and components, which could have a materialadverse effect on our operating results and financial condition. We do not have agreements fixing long-term prices or minimum volume requirements fromsuppliers. From time to time we have experienced shortages and allocations of certain components, resulting in delays in filling orders. Qualifying newsuppliers to compensate for such shortages may be time-consuming and costly, and may increase the likelihood of errors in design or production. In addition,during the development of our products, we have experienced delays in the prototyping of our chipsets, which in turn has led to delays in productintroductions. We cannot ensure that similar delays will not occur in the future. Furthermore, we cannot ensure that the performance of the components asincorporated in our products will meet the quality requirements of our customers. Our Dependence on One Contract Manufacturer for All of Our Manufacturing Requirements Could Harm Our Operating Results If the demand for our products grows, we will need to increase our material purchases, contract manufacturing capacity, and internal test and qualityfunctions. Any disruptions in product flow could limit our revenue, adversely affect our competitive position and reputation, and result in additional costs orcancellation of orders under agreements with our customers. We rely on an independent contractor to manufacture our products. The sole company we currently utilize for the manufacture of our products isFlextronics International, Ltd., located in San Jose, California and Guadalajara, Mexico. Our commitment with Flextronics is formalized through a one-yearcontract. We have experienced delays in product shipments from contract manufacturers in the past, which in turn delayed product shipments to ourcustomers. These or similar problems may arise in the future, such as products of inferior quality, insufficient quantity of products, or the interruption ordiscontinuance of operations of a manufacturer, any of which could have a material adverse effect on our business and operating results. We do not know whether we will effectively manage our contract manufacturer or that this manufacturer will meet our future requirements for timelydelivery of products of sufficient quality and quantity. We intend to introduce new products and product enhancements, which will require that we rapidlyachieve volume production by coordinating our efforts with those of our suppliers and contract manufacturer. The inability of our contract manufacturer toprovide us with adequate supplies of high-quality products may cause a delay in our ability to fulfill orders and may have a material adverse effect on ourbusiness, operating results and financial condition. Moreover, our current dependence on a single manufacturer makes us particularly vulnerable to theserisks. As part of our cost-reduction efforts, we will need to realize lower per unit product costs from our contract manufacturer by means of volumeefficiencies and the utilization of manufacturing sites in lower-cost geographies. However, we cannot be certain when or if such price reductions will occur.The failure to obtain such price reductions would adversely affect our gross margins and operating results. 44Table of ContentsIf We Do Not Adequately Manage and Evolve Our Financial Reporting and Managerial Systems and Processes, Our Ability to Manage and Grow OurBusiness May Be Harmed Our ability to successfully implement our business plan and comply with regulations requires an effective planning and management process. We needto continue improving our existing, and implement new, operational and financial systems, procedures and controls. Any delay in the implementation of, ordisruption in the transition to, new or enhanced systems, procedures or controls, could harm our ability to record and report financial and managementinformation on a timely and accurate basis, or to forecast future results. In addition, rules adopted by the Securities and Exchange Commission pursuant toSection 404 of the Sarbanes-Oxley Act of 2002 require annual review and evaluation of our internal control systems, and attestation of these systems by ourindependent auditors. We are currently undergoing a review of our internal control systems and procedures and considering improvements that will benecessary in order for us to comply with the requirements of Section 404 by the end of 2004. This process will require us to hire additional personnel andretain outside advisory services and will result in additional accounting and legal expenses, which we has and may continue to cause our operating expensesto increase. In addition, the evaluation and attestation processes required by Section 404 are new and untested, and we may encounter problems or delays incompleting the implementation of improvements and receiving a favorable review and attestation by our independent auditors. Future Changes in Financial Accounting Standards May Cause Adverse Unexpected Revenue Fluctuations and Affect Our Reported Results ofOperations A change in accounting policies can have a significant effect on our reported results and may even affect our reporting of transactions completedbefore the change is effective. New pronouncements and varying interpretations of pronouncements have occurred with frequency and may occur in thefuture. Changes to existing rules or the questioning of current practices may adversely affect our reported financial results or the way we conduct ourbusiness. In particular, if we are required to record stock option grants as compensation expense on our income statement, our profitability may be reducedsignificantly. The current methodology for expensing such stock options is based on, among other things, the historical volatility of the underlying stock.Our stock price has been historically volatile. Therefore, the adoption of an accounting standard requiring companies to expense stock options wouldnegatively impact our profitability and may adversely impact our stock price. In addition, the adoption of such a standard could limit our ability to continueto use stock options as an incentive and retention tool, which could, in turn, hurt our ability to recruit employees and retain existing employees. In addition, various accounting rules and regulations have been established over the recent past relating to revenue recognition. These regulationsfrequently require judgments in their application, and are subject to numerous subsequent clarifications and interpretations, some of which may requirechanges in the way we recognize revenue and may require restatement of prior period revenue and results. Our Business Substantially Depends Upon the Continued Growth of the Internet and Internet-Based Systems A substantial portion of our business and revenue depends on growth of the Internet and on the deployment of our products by customers that dependon the continued growth of the Internet. As a result of the recent economic slowdown and reduction in capital spending, which have particularly affectedtelecommunications service providers, spending on Internet infrastructure has declined, which has materially harmed our business. To the extent that therecent economic slowdown and reduction in capital spending continue to adversely affect spending on Internet infrastructure, we could continue toexperience material harm to our business, operating results, and financial condition. Because of the rapid introduction of new products, and changing customer requirements related to matters such as cost-effectiveness and security, webelieve that there could be certain performance problems with Internet communications in the future, which could receive a high degree of publicity andvisibility. As we are a 45Table of Contentslarge supplier of networking products, our business, operating results, and financial condition may be materially adversely affected, regardless of whether ornot these problems are due to the performance of our own products. Such an event could also result in a material adverse effect on the market price of ourcommon stock independent of direct effects on our business. Compliance with Changing Regulation of Corporate Governance and Public Disclosure May Result in Additional Expenses Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SECregulations and Nasdaq Stock Market rules, are creating uncertainty for companies such as ours. We are committed to maintaining high standards of corporategovernance and public disclosure. As a result, we are investing all reasonably necessary resources to comply with evolving standards, and this investmentmay result in increased general and administrative expenses and a diversion of management time and attention from revenue-generating activities tocompliance activities. We Have Been Named as a Defendant in a Shareholder Class Action Lawsuit Arising Out of Our Public Offerings of Securities in 1999 Beginning on July 6, 2001, purported securities fraud class action complaints were filed in the United States District Court for the Southern District ofNew York. The cases were consolidated and the litigation is now captioned as In re Extreme Networks, Inc. Initial Public Offering Securities Litigation, Civ.No. 01-6143 (SAS) (S.D.N.Y.), related to In re Initial Public Offering Securities Litigation, 21 MC 92 (SAS) (S.D.N.Y.). The operative amended complaint is brought purportedly on behalf of all persons who purchased Extreme Networks’ common stock from April 8, 1999through December 6, 2000. It names as defendants Extreme Networks; six of our present and former officers and/or directors, including our CEO (the“Extreme Networks Defendants”); and several investment banking firms that served as underwriters of our initial public offering and October 1999 secondaryoffering. Subsequently, plaintiffs and one of the individual defendants stipulated to a dismissal of that defendant without prejudice. The complaint allegesliability under Sections 11 and 15 of the Securities Act of 1933 and Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, on the grounds that theregistration statement for the offerings did not disclose that: (1) the underwriters had agreed to allow certain customers to purchase shares in the offerings inexchange for excess commissions paid to the underwriters; and (2) the underwriters had arranged for certain customers to purchase additional shares in theaftermarket at predetermined prices. The Securities Act allegations against the Extreme Networks Defendants are made as to the secondary offering only. Theamended complaint also alleges that false analyst reports were issued. No specific damages are claimed. Similar allegations were made in other lawsuits challenging over 300 other initial public offerings and follow-on offerings conducted in 1999 and2000. The cases were consolidated for pretrial purposes. On February 19, 2003, the Court ruled on all defendants’ motions to dismiss. The Court denied themotions to dismiss the claims in our case under the Securities Act of 1933. The Court denied the motion to dismiss the claim under Section 10(a) of theSecurities Exchange Act of 1934 against Extreme Networks and 184 other issuer defendants, on the basis that the complaints alleged that the respectiveissuers had acquired companies or conducted follow-on offerings after their initial public offerings. The Court denied the motion to dismiss the claims underSection 10(a) and 20(a) of the Securities Exchange Act of 1934 against the remaining Extreme Networks Defendants and 59 other individual defendants, onthe basis that the respective amended complaints alleged that the individuals sold stock. We have executed a settlement agreement presented to all issuer defendants. In this settlement, plaintiffs will dismiss and release all claims against theExtreme Network Defendants, in exchange for a contingent payment by the insurance companies collectively responsible for insuring the issuers in all of theIPO cases, and for the assignment or surrender of control of certain claims we may have against the underwriters. The Extreme 46Table of ContentsNetworks Defendants will not be required to make any cash payments in the settlement, unless the pro rata amount paid by the insurers in the settlementexceeds the amount of the insurance coverage, a circumstance which we do not believe will occur. The settlement will require approval of the Court, whichcannot be assured. If the settlement is not approved, we cannot assure you that we will prevail in the lawsuit. Failure to prevail could have a material adverseeffect on our consolidated financial position, results of operations and cash flows in the future. In addition, we may become subject to other types of litigation in the future. Litigation is often expensive and diverts management’s attention andresources, which could materially and adversely affect our business. Our Headquarters and Some Significant Supporting Businesses Are Located in Northern California and Other Areas Subject to Natural Disasters ThatCould Disrupt Our Operations and Harm Our Business Our corporate headquarters are located in Silicon Valley in Northern California. Historically, this region has been vulnerable to natural disasters andother risks, such as earthquakes, fires and floods, which at times have disrupted the local economy and posed physical risks to our property. We have acontract manufacturer located in Northern California and in Mexico where similar natural disasters and other risks may disrupt the local economy and posephysical risks to our property and the property of our contract manufacturer. In addition, terrorist acts or acts of war targeted at the United States, and specifically Silicon Valley, could cause damage or disruption to us, ouremployees, facilities, partners, suppliers, distributors and resellers, and customers, which could have a material adverse effect on our operations and financialresults. We currently do not have redundant, multiple site capacity in the event of a natural disaster or catastrophic event. In the event of such an occurrence,our business would suffer. If We Lose Key Personnel or are Unable to Hire Additional Qualified Personnel as Necessary, We May Not Be Able to Successfully Manage OurBusiness or Achieve Our Goals Our success depends to a significant degree upon the continued contributions of our key management, engineering, sales and marketing, service andoperations personnel, many of whom would be difficult to replace. We do not have employment contracts with these individuals nor do we carry lifeinsurance on any of our key personnel. We believe our future success will also depend in large part upon our ability to attract and retain highly skilled managerial, engineering, sales andmarketing, service, finance and operations personnel. The market for these personnel is competitive, especially in the San Francisco Bay Area, and we havehad difficulty in hiring employees, particularly engineers, in the timeframe we desire. In addition, retention has become more difficult for us and other publictechnology companies as a result of the stock market decline, which caused the price of many of our employees’ stock options to be above the current marketprice of our stock and we have recently experienced a high level of attrition, particularly in our sales personnel, including our senior vice president ofWorldwide Sales and others. There can be no assurance that we will be successful in attracting and retaining our key personnel. The loss of the services of anyof our key personnel, the inability to attract or retain qualified personnel in the future or delays in hiring desired personnel, particularly engineers and salespersonnel, could make it difficult for us to manage our business and meet key objectives, such as new product introductions. In addition, companies in thenetworking industry whose employees accept positions with competitors frequently claim that competitors have engaged in unfair hiring practices. We havefrom time to time been involved in claims like this with other companies and, although to date they have not resulted in material litigation, we do not knowwhether we will be involved in additional claims in the future as we seek to hire and retain qualified personnel or that such claims will not result in materiallitigation. We could incur substantial costs in litigating any such claims, regardless of the merits. 47Table of ContentsFailure of Our Products to Comply With Evolving Industry Standards and Complex Government Regulations May Cause Our Products to Not BeWidely Accepted, Which May Prevent Us From Growing Our Net Revenues or Achieving Profitability The market for network equipment products is characterized by the need to support industry standards as different standards emerge, evolve andachieve acceptance. We will not be competitive unless we continually introduce new products and product enhancements that meet these emergingstandards. In the past, we have introduced new products that were not compatible with certain technological standards, and in the future we may not be ableto effectively address the compatibility and interoperability issues that arise as a result of technological changes and evolving industry standards. Ourproducts must comply with various United States federal government regulations and standards defined by agencies such as the Federal CommunicationsCommission, in addition to standards established by governmental authorities in various foreign countries and recommendations of the InternationalTelecommunication Union. If we do not comply with existing or evolving industry standards or if we fail to obtain timely domestic or foreign regulatoryapprovals or certificates we will not be able to sell our products where these standards or regulations apply, which may prevent us from sustaining our netrevenue or achieving profitability. Failure to Successfully Expand Our Sales and Support Teams or Educate Them In Regard to Technologies and Our Product Families May Harm OurOperating Results The sale of our products and services requires a concerted effort that is frequently targeted at several levels within a prospective customer’sorganization. We may not be able to increase net revenues unless we expand our sales and support teams in order to address all of the customer requirementsnecessary to sell our products. We cannot assure you that we will be able to successfully integrate employees into our company or to educate current and future employees in regardto rapidly evolving technologies and our product families. A failure to do so may hurt our revenue growth and operating results. We May Engage in Future Acquisitions that Dilute the Ownership Interests of Our Stockholders, Cause Us to Incur Debt and Assume ContingentLiabilities As part of our business strategy, we review acquisition and strategic investment prospects that we believe would complement our current productofferings, augment our market coverage or enhance our technical capabilities, or otherwise offer growth opportunities. From time to time we reviewinvestments in new businesses and we expect to make investments in, and to acquire, businesses, products, or technologies in the future. In the event of anyfuture acquisitions, we could: •issue equity securities which would dilute current stockholders’ percentage ownership; •incur substantial debt; •assume contingent liabilities; or •expend significant cash. These actions could have a material adverse effect on our operating results or the price of our common stock. Moreover, even if we do obtain benefitsin the form of increased sales and earnings, there may be a lag between the time when the expenses associated with an acquisition are incurred and the timewhen we recognize such benefits. This is particularly relevant in cases where it is necessary to integrate new types of technology into our existing portfolioand new types of products may be targeted for potential customers with which we do not have pre-existing relationships. Acquisitions and investmentactivities also entail numerous risks, including: •difficulties in the assimilation of acquired operations, technologies and/or products; •unanticipated costs associated with the acquisition or investment transaction; •the diversion of management’s attention from other business concerns; 48Table of Contents •adverse effects on existing business relationships with suppliers and customers; •risks associated with entering markets in which we have no or limited prior experience; •the potential loss of key employees of acquired organizations; and •substantial charges for the amortization of certain purchased intangible assets, deferred stock compensation or similar items. We cannot ensure that we will be able to successfully integrate any businesses, products, technologies, or personnel that we might acquire in the future,and our failure to do so could have a material adverse effect on our business, operating results and financial condition. We May Need Additional Capital to Fund Our Future Operations and, If It Is Not Available When Needed, We May Need to Reduce Our PlannedDevelopment and Marketing Efforts, Which May Reduce Our Net Revenues and Prevent Us From Achieving Profitability We believe that our existing working capital and cash available from credit facilities and future operations, will enable us to meet our working capitalrequirements for at least the next 12 months. However, if cash from future operations is insufficient, or if cash is used for acquisitions or other currentlyunanticipated uses, we may need additional capital. The development and marketing of new products and the expansion of reseller and distribution channelsand associated support personnel requires a significant commitment of resources. In addition, if the markets for our products develop more slowly thananticipated, or if we fail to establish significant market share and achieve sufficient net revenues, we may continue to consume significant amounts of capital.As a result, we could be required to raise additional capital. To the extent that we raise additional capital through the sale of equity or convertible debtsecurities, the issuance of such securities could result in dilution of the shares held by existing stockholders. If additional funds are raised through theissuance of debt securities, such securities may provide the holders certain rights, preferences, and privileges senior to those of common stockholders, and theterms of such debt could impose restrictions on our operations. We cannot assure you that additional capital, if required, will be available on acceptableterms, or at all. If we are unable to obtain sufficient amounts of additional capital, we may be required to reduce the scope of our planned productdevelopment and marketing efforts, which could harm our business, financial condition and operating results. We Have Substantial Debt Obligations In connection with the sale of convertible subordinated notes in December 2001, we incurred $200 million of indebtedness. We will require substantialamounts of cash to fund scheduled payments of interest on the convertible notes, payment of the principal amount of the convertible notes, future capitalexpenditures, payments on our leases and any increased working capital requirements. If we are unable to meet our cash requirements out of cash flow fromoperations, there can be no assurance that we will be able to obtain alternative financing. The degree to which we are financially leveraged could materiallyand adversely affect our ability to obtain financing for working capital, acquisitions or other purposes and could make us more vulnerable to industrydownturns and competitive pressures. In the absence of such financing, our ability to respond to changing business and economic conditions, to make futureacquisitions, to absorb adverse operating results or to fund capital expenditures or increased working capital requirements would be significantly reduced.Our ability to meet our debt service obligations will be dependent upon our future performance, which will be subject to financial, business and other factorsaffecting our operations, some of which are beyond our control. If we do not generate sufficient cash flow from operations to repay the notes at maturity, wecould attempt to refinance the notes; however, no assurance can be given that such a refinancing would be available on terms acceptable to us, if at all. Anyfailure by us to satisfy our obligations with respect to the notes at maturity (with respect to payments of principal) or prior thereto (with respect to paymentsof interest or required repurchases) would constitute a default under the indenture and could cause a default under agreements governing our otherindebtedness. 49Table of ContentsWe Have Entered into Long-Term Lease Agreements for Several Facilities that are Currently Vacant and May be Difficult to Sublease due to CurrentReal Estate Market Conditions We have certain long-term real estate lease commitments carrying future obligations for non-cancelable lease payments. Reductions in our workforceand the restructuring of operations since fiscal 2002 have resulted in the need to consolidate certain of these leased facilities, located primarily in NorthernCalifornia, for which we recorded excess facilities charges of approximately $6.5 million in fiscal 2004, $9.6 million in fiscal 2003 and $25.4 million infiscal 2002. For more information, see Note 12 of Notes to Consolidated Financial Statements. We continue to attempt to sublease certain of these facilitiesand have estimated the amount of sublease income to offset the carrying costs of these facilities when establishing our excess facilities charges. However, wemay not be able to sublease these facilities at the times or on the terms we anticipated when we took the excess facilities charge and therefore if the marketdoes not improve, we may incur additional charges in the future. In addition, we may incur additional charges for excess facilities as a result of additionalreductions in our workforce or future restructuring of operations. We will continue to be responsible for all carrying costs of these facilities until such time aswe can sublease these facilities or terminate the applicable leases based on the contractual terms of the lease agreements, and these costs may have an adverseeffect on our business, operating results and financial condition. Our Stock Price Has Been Volatile In the Past and Our Stock Price and the Price of the Notes May Significantly Fluctuate in the Future In the past, our common stock price has fluctuated significantly. This could continue as we or our competitors announce new products, our results orthose of our customers or competition fluctuate, conditions in the networking or semiconductor industry change, or when investors, change their sentimenttoward stocks in the networking technology sector. In addition, fluctuations in our stock price and our price-to-earnings multiple may make our stock attractive to momentum, hedge or day-tradinginvestors who often shift funds into and out of stock rapidly, exacerbating price fluctuations in either direction, particularly when viewed on a quarterlybasis. Securities We Issue to Fund Our Operations Could Dilute Your Ownership We may decide to raise additional funds through public or private debt or equity financing to fund our operations. If we raise funds by issuing equitysecurities, the percentage ownership of current stockholders will be reduced and the new equity securities may have rights prior to those of our commonstock, including the common stock issuable upon conversion of the notes. We may not obtain sufficient financing on terms that are favorable to you or us.We may delay, limit or eliminate some or all of our proposed operations if adequate funds are not available. Provisions in Our Charter Documents and Delaware Law and Our Adoption of a Stockholder Rights Plan May Delay or Prevent Acquisition Of Us,Which Could Decrease the Value of Our Common Stock and the Notes Our certificate of incorporation and bylaws and Delaware law contain provisions that could make it more difficult for a third party to acquire us withoutthe consent of our board of directors. Delaware law also imposes some restrictions on mergers and other business combinations between us and any holder of15% or more of our outstanding common stock. In addition, our board of directors has the right to issue preferred stock without stockholder approval, whichcould be used to dilute the stock ownership of a potential hostile acquirer. Although we believe these provisions of our certificate of incorporation andbylaws and Delaware law and our stockholder rights plan, which is described below, will provide for an opportunity to receive a higher bid by requiringpotential acquirers to negotiate with our board of directors, these provisions apply even if the offer may be considered beneficial by some of our stockholders. 50Table of ContentsOur board of directors adopted a stockholder rights plan, pursuant to which we declared and paid a dividend of one right for each share of commonstock held by stockholders of record as of May 14, 2001. Under the plan, each right will entitle stockholders to purchase a fractional share of our preferredstock for $150.00. Each such fractional share of the new preferred stock has terms designed to make it substantially the economic equivalent of one share ofcommon stock. Initially the rights will not be exercisable and will trade with our common stock. Generally, the rights may become exercisable if a person orgroup acquires beneficial ownership of 15% or more of our common stock or commences a tender or exchange offer upon consummation of which suchperson or group would beneficially own 15% or more of our common stock. When the rights become exercisable, our board of directors has the right toauthorize the issuance of one share of our common stock in exchange for each right that is then exercisable. 51Table of Contents Item 7A. Quantitative and Qualitative Disclosures About Market Risk Interest Rate Sensitivity The primary objective of our investment activities is to preserve principal while at the same time maximize the income we receive from our investmentswithout significantly increasing risk. Some of the securities that we have invested in may be subject to market risk. This means that a change in prevailinginterest rates may cause the principal amount of the investment to fluctuate. For example, if we hold a security that was issued with a fixed interest rate at thethen-prevailing rate and the prevailing interest rate later rises, the principal amount of our investment will probably decline. To minimize this risk, wemaintain our portfolio of cash equivalents and short-term investments in a variety of securities, including commercial paper, other non-government debtsecurities and money market funds. In general, money market funds are not subject to market risk because the interest paid on such funds fluctuates with theprevailing interest rate. The following table presents the amounts of our cash equivalents, short-term investments, marketable securities and long-term debtthat are subject to market risk by range of expected maturity and weighted-average interest rates as of June 27, 2004 and June 29, 2003. This table does notinclude money market funds because those funds are not subject to market risk. Maturing in Threemonthsor less Threemonths toone year Greaterthan oneyear Total Fair Value (In thousands)June 27, 2004: Included in cash and cash equivalents $470 $470 $470Weighted average interest rate 0.97% Included in short-term investments $71,355 $90,723 $162,078 $162,078Weighted average interest rate 1.96% 2.71% Included in marketable securities $204,430 $204,430 $204,430Weighted average interest rate 2.32% Long-term debt $200,000 $200,000 $181,900Weighted average interest rate 3.50% Maturing in Threemonthsor less Threemonths toone year Greaterthan oneyear Total Fair Value (In thousands)June 29, 2003: Included in cash and cash equivalents $9,203 $9,203 $9,203Weighted average interest rate 0.99% Included in short-term investments $98,445 $20,832 $119,277 $119,277Weighted average interest rate 1.28% 2.77% Included in marketable securities $238,540 $238,540 $238,540Weighted average interest rate 2.59% Long-term debt $200,000 $200,000 $180,056Weighted average interest rate 3.50% Exchange Rate Sensitivity Currently, substantially all of our sales and the majority of our expenses are denominated in United States dollars and as a result, we have experiencedno significant foreign exchange gains and losses to date. While we have conducted some transactions in foreign currencies during the year ended June 27,2004 and expect to continue to do so, we do not anticipate that foreign exchange gains or losses will be significant, in part because of our foreign exchangerisk management process discussed below. 52Table of ContentsForeign Exchange Forward Contracts We enter into foreign exchange forward contracts to hedge foreign currency forecasted transactions related to certain operating expenses, denominatedin Japanese Yen, the Euro, the Swedish Krona and the British Pound. These derivatives are designated as cash flow hedges under SFAS No. 133, Accountingfor Derivative Instruments and Hedging Activities, as amended and interpreted (“SFAS 133”). At June 27, 2004, these forward foreign currency contracts hada notional principal amount of $5.2 million (fair value of $100). These contracts have maturities of less than 60 days. Additionally, we enter into foreign exchange forward contracts to mitigate the effect of gains and losses generated by the remeasurement of certainassets and liabilities denominated in Japanese Yen, the Euro, the Swedish Krona and the British Pound. These derivatives are not designated as hedges underSFAS 133. At June 27, 2004, we held foreign currency forward contracts with a notional principal amount of $2.6 million (fair value of $115,000). Thesecontracts have maturities of less than 45 days. Changes in the fair value of these foreign exchange forward contracts are offset largely by remeasurement ofthe underlying assets and liabilities. We do not enter into foreign exchange forward contracts for speculative or trading purposes. Foreign currency transaction gains and losses fromoperations, including the impact of hedging, were a loss of $0.5 million in fiscal 2004, a gain of $0.4 million in fiscal 2003 and a loss of $0.3 million in fiscal2002. Investments in Equity Securities We have historically made investments in several privately held companies. These nonmarketable investments are accounted for under the costmethod, as ownership is less than 20 percent and we do not have the ability to exercise significant influence over the operating, financing and investingactivities of the investee companies. These investments are inherently risky as the market for the technologies or products they have under development aretypically in the early stages and may never materialize. It is possible that we could lose our entire initial investment in these companies. As a part ofmanagement’s process of regularly reviewing these investments for impairment, we recorded write-downs of $0.2 million and $9.7 million on certaininvestments, which were determined to be other than temporarily impaired in fiscal 2003 and fiscal 2002, respectively. At June 27, 2004, the carrying valueof our remaining investments was zero. 53Table of ContentsItem 8. Financial Statements and Supplementary Data INDEX TO CONSOLIDATED FINANCIAL STATEMENTS OF EXTREME NETWORKS, INC. Page(s)Consolidated Balance Sheets 55Consolidated Statements of Operations 56Consolidated Statements of Cash Flows 57Consolidated Statements of Stockholders’ Equity 58Notes to Consolidated Financial Statements 59Report of Ernst & Young LLP, Independent Registered Public Accounting Firm 82Quarterly Financial Data (unaudited) 83 54Table of ContentsEXTREME NETWORKS, INC. CONSOLIDATED BALANCE SHEETS(In thousands, except par value and share amounts) June 27,2004 June 29,2003 ASSETS Current assets: Cash and cash equivalents $59,164 $44,340 Short-term investments 162,078 119,277 Accounts receivable, net of allowance for doubtful accounts of $1,378 ($2,331 in fiscal 2003) 32,998 26,794 Inventories 25,889 18,710 Deferred income taxes 886 609 Prepaid expenses and other current assets 7,165 16,269 Total current assets 288,180 225,999 Property and equipment, net 59,767 73,767 Marketable securities 204,430 238,540 Other assets 26,896 11,951 Total assets $579,273 $550,257 LIABILITIES AND STOCKHOLDERS’ EQUITY Current liabilities: Accounts payable $18,995 $19,020 Accrued compensation and benefits 15,827 14,665 Restructuring liabilities 6,085 6,812 Lease liability 2,355 4,396 Accrued warranty 8,297 10,200 Deferred revenue 53,674 48,298 Other accrued liabilities 22,921 25,317 Total current liabilities 128,154 128,708 Restructuring liabilities, less current portion 20,478 21,358 Deferred income taxes 762 673 Long-term deposit 321 282 Convertible subordinated notes 200,000 200,000 Commitments and contingencies (Note 4) Stockholders’ equity: Convertible preferred stock, $.001 par value, issuable in series; 2,000,000 shares authorized; none issued — — Common stock, $.001 par value; 750,000,000 shares authorized; 120,423,000 issued and outstanding(116,568,000 in fiscal 2003) and capital in excess of par value 687,216 652,091 Deferred stock compensation (69) (1,708)Accumulated other comprehensive income (loss) (2,388) 2,306 Accumulated deficit (455,201) (453,453) Total stockholders’ equity 229,558 199,236 Total liabilities and stockholders’ equity $579,273 $550,257 See accompanying notes to consolidated financial statements. 55Table of ContentsEXTREME NETWORKS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS(In thousands, except per share amounts) Year Ended June 27,2004 June 29,2003 June 30,2002 Net revenues: Product $303,293 $324,727 $407,394 Service 48,555 38,549 34,215 Total net revenues 351,848 363,276 441,609 Cost of revenues: Product 137,106 172,069 * Service 35,546 40,852 * Total cost of revenues 172,652 212,921 257,639 Gross margin: Product 166,187 152,658 * Service 13,009 (2,303) * Total gross margin 179,196 150,355 183,970 Operating expenses: Sales and marketing 93,220 102,472 117,855 Research and development 58,105 58,004 61,490 General and administrative 29,604 25,733 26,922 Impairment of acquired intangible assets — 1,021 89,752 Amortization of deferred stock compensation 1,061 723 10,184 Amortization of goodwill — — 33,546 Amortization of purchased intangible assets — — 3,642 Restructuring charge 6,487 15,939 73,570 Property and equipment write-off — 12,678 — Total operating expenses 188,477 216,570 416,961 Operating loss (9,281) (66,215) (232,991)Interest income 8,584 11,069 11,748 Interest expense (6,982) (7,058) (4,509)Other income (expense), net 9,107 (190) (11,050) Income (loss) before income taxes 1,428 (62,394) (236,802)Provision for (benefit from) income taxes 3,176 134,786 (52,840) Net loss $(1,748) $(197,180) $(183,962) Net loss per share — basic and diluted $(0.01) $(1.71) $(1.63)Shares used in per share calculation — basic and diluted 118,348 115,186 112,925 *Cost of revenue and gross margin are presented in total for the year ended June 30, 2002 since Extreme Networks did not track product and service cost ofrevenue separately in that year. See accompanying notes to consolidated financial statements. 56Table of ContentsEXTREME NETWORKS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS(In thousands) Year Ended June 27,2004 June 29,2003 June 30,2002 Cash flows from operating activities: Net loss $(1,748) $(197,180) $(183,962)Adjustments to reconcile net loss to net cash provided by operating activities: Depreciation 20,141 25,929 31,382 Amortization of goodwill — — 33,546 Amortization of purchased intangible assets — — 3,642 Impairment of acquired intangible assets — 1,021 89,752 Provision for doubtful accounts (200) — 3,913 Provision for excess and obsolete inventory 1,252 300 7,596 Deferred income taxes (188) 133,563 (56,771)Tax benefits from employee stock transactions — — 1,055 Amortization of warrant 5,044 — — Restructuring charge 6,487 15,939 73,095 Property and equipment write-off — 12,678 — Amortization of deferred stock compensation 1,061 723 10,184 Equity share of affiliate losses and write-down of investments — 250 9,657 Compensation expense for options granted to consultants — — 631 Changes in operating assets and liabilities; excluding impact of acquisitions: Accounts receivable (6,004) 24,550 7,954 Inventories (8,431) 5,617 28,306 Prepaid expenses and other current assets, and Other assets 11,814 (2,818) (4,760)Accounts payable (25) (10,195) (6,675)Accrued compensation and benefits 1,162 (135) (1,227)Restructuring liabilities (7,972) (6,579) (3,278)Lease liability (2,041) (3,667) (1,863)Accrued warranty (1,903) 1,145 6,098 Deferred revenue 5,376 7,526 15,235 Other accrued liabilities (2,396) 1,404 (43,047)Long-term deposit 39 10 6 Net cash provided by operating activities 21,468 10,081 20,469 Cash flows from investing activities: Capital expenditures (6,263) (14,716) (82,819)Purchases of investments (306,365) (582,910) (390,911)Proceeds from sales and maturities of investments 292,980 553,775 247,546 Payments for acquisitions, net of cash acquired, and other investments — — (14,920) Net cash used in investing activities (19,648) (43,851) (241,104) Cash flows from financing activities: Proceeds from issuance of common stock, net of repurchases 13,004 6,280 11,206 Proceeds from issuance of convertible subordinated notes, net — — 193,537 Net cash provided by financing activities 13,004 6,280 204,743 Net increase (decrease) in cash and cash equivalents 14,824 (27,490) (15,892)Cash and cash equivalents at beginning of year 44,340 71,830 87,722 Cash and cash equivalents at end of year $59,164 $44,340 $71,830 Supplemental disclosure of cash flow information: Interest paid $7,060 $7,058 $3,848 Cash paid for income taxes $2,612 $3,696 $3,598 See accompanying notes to consolidated financial statements. 57Table of ContentsEXTREME NETWORKS, INC. CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY(in thousands) Common Stock andcapital in excess ofpar value DeferredStockCompensation AccumulatedOtherComprehensiveIncome (Loss) AccumulatedDeficit TotalStockholders’Equity Shares Amount Balances at July 1, 2001 113,416 $640,655 $(20,351) $769 $(72,311) $548,762 Components of comprehensive loss: Net loss — — — — (183,962) (183,962)Change in unrealized gain on investments — — — 1,091 — 1,091 Change in unrealized loss on derivatives — — — (113) — (113)Foreign currency translation adjustment — — — 104 — 104 Total comprehensive loss (182,880) Exercise of options to purchase common stock, net of repurchases 901 3,421 — — — 3,421 Issuance of common stock under employee stock purchase plan 713 7,785 — — — 7,785 Tax benefit from employee stock transactions — 1,055 — — — 1,055 Stock compensation for options granted to consultants — 631 — — — 631 Amortization of deferred stock compensation — — 10,184 — — 10,184 Balances at June 30, 2002 115,030 653,547 (10,167) 1,851 (256,273) 388,958 Components of comprehensive loss: Net loss — — — — (197,180) (197,180)Change in unrealized gain on investments, net of tax expense of$1,407 — — — 448 — 448 Change in unrealized gain on derivatives — — — 114 — 114 Foreign currency translation adjustment — — — (107) — (107) Total comprehensive loss (196,725) Exercise of options to purchase common stock, net of repurchases 230 783 — — — 783 Issuance of common stock under employee stock purchase plan 1,308 5,497 — — — 5,497 Forfeiture of stock options — (7,736) 7,736 — — — Amortization of deferred stock compensation — — 723 — — 723 Balances at June 29, 2003 116,568 652,091 (1,708) 2,306 (453,453) 199,236 Components of comprehensive loss: Net loss — — — — (1,748) (1,748)Change in unrealized gain on investments, net of tax expense of$410 — — — (5,160) — (5,160)Change in unrealized gain on derivatives — — — (1) — (1)Foreign currency translation adjustment — — — 467 — 467 Total comprehensive loss (6,442) Exercise of options to purchase common stock, net of repurchases 1,455 7,452 — — — 7,452 Issuance of common stock under employee stock purchase plan 1,541 5,543 — — — 5,543 Issuance of warrant to Avaya — 22,699 — — — 22,699 Exercise of warrant by Avaya 859 9 — — — 9 Forfeiture of stock options — (578) 578 — — — Amortization of deferred stock compensation — — 1,061 — — 1,061 Balances at June 27, 2004 120,423 $687,216 $(69) $(2,388) $(455,201) $229,558 See accompanying notes to consolidated financial statements. 58Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Description of Business Extreme Networks, Inc. (“Extreme Networks” or the “Company”) is a leading provider of network infrastructure equipment and markets its productsprimarily to business, governmental, health care and educational customers with a focus on large corporate enterprises and metropolitan service providers ona global basis. We conduct our sales and marketing activities on a worldwide basis through a two-tier distribution channel utilizing distributors, resellers andour field sales organization. Extreme Networks was incorporated in California in 1996 and reincorporated in Delaware in 1999. 2. Basis of Presentation and Summary of Significant Accounting Policies Fiscal Year Our fiscal year is a 52/53-week fiscal accounting year that closes on the Sunday closest to June 30th every year. Fiscal 2004, fiscal 2003 and fiscal 2002were 52-week fiscal years. All references herein to “fiscal 2004” or “2004” represent the fiscal year ended June 27, 2004. Principles of Consolidation The consolidated financial statements include the accounts of Extreme Networks and its wholly-owned subsidiaries. All inter-company accounts andtransactions have been eliminated. Investments in which management intends to maintain more than a temporary 20% to 50% interest, or otherwise has theability to exercise significant influence, are accounted for under the equity method. Investments in which management has less than a 20% interest and doesnot have the ability to exercise significant influence are carried at the lower of cost or estimated realizable value. Assets and liabilities of foreign operations are translated to United States dollars at current rates of exchange, and revenues and expenses are translatedusing average rates. Foreign currency transaction losses from operations, including the impact of hedging, were $0.5 million in fiscal 2004. Foreign currencytransaction gains from operations, including the impact of hedging, were $0.4 million in fiscal 2003. Foreign currency transaction losses from operations,including the impact of hedging, were $0.3 million in fiscal 2002. Gains and losses from foreign currency translation are included as a separate component ofother comprehensive income (loss). Accounting Estimates The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United Statesrequires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Estimates areused for, but are not limited to, the accounting for the allowances for doubtful accounts and returns reserves, inventory valuation, depreciation andamortization, impairment of purchased intangible assets and minority investments, warranty accruals, restructuring liabilities and income taxes. Actual resultscould differ materially from these estimates. Reclassifications We have reclassified $1.1 million of restructuring liabilities from current to long-term as of June 29, 2003 in order to conform to the fiscal 2004presentation. This reclassification has not impacted previously reported revenues, operating loss or net loss. During fiscal 2003, revenue from servicearrangements increased to greater than 10% of total net revenues, requiring us to separately report product and service revenues. In order to separately statecost of revenues related to product and service revenues, we reclassified $23.1 million of service expenses that had previously been included in operatingexpenses for fiscal 2002. 59Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) Revenue Recognition We derive the majority of our revenue from sales of our modular and stackable networking equipment, with the remaining revenue generated fromservice fees relating to the service contracts and training on our products. Our revenue recognition policy follows SEC Staff Accounting Bulletin No. 104,Revenue Recognition (“SAB 104”). We generally recognize product revenue from our Value-Added Resellers and end-users at the time of shipment, providedthat persuasive evidence of an arrangement exists, delivery has occurred, the price of the product is fixed or determinable and collection of the sales proceedsis reasonably assured. Revenue from service obligations under service contracts is deferred and recognized on a straight-line basis. Service contracts typicallyrange from one to five years. When sales arrangements contain multiple deliverables such as hardware, service contracts and other services, we determinewhether the deliverables represent separate units of accounting and then allocate revenue to each unit of accounting based on its relative fair value inaccordance with Emerging Issues Task Force (“EITF”) Issue No. 00-21, Revenue Arrangements with Multiple Deliverables (“EITF 00-21”). We recognizerevenue for each unit of accounting when the revenue recognition criteria for each unit of accounting are met in accordance with SAB 104. EITF 00-21addresses certain aspects of accounting by a vendor for arrangements under which the vendor will perform multiple revenue generating activities and iseffective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. We adopted EITF 00-21 prospectively and the adoption ofEITF 00-21 did not have a material impact on our results of operations or financial position. Shipping costs are included in cost of product revenues. We make certain sales to partners in two-tier distribution channels. The first tier consists of a limited number of independent distributors that sellprimarily to resellers and, on occasion, to end-user customers. We defer recognition of revenue on all sales to these distributors until the distributors sell theproduct, as evidenced by a monthly sales-out report that the distributors provide to us. We grant these distributors the right to return a portion of unsoldinventory to us for the purpose of stock rotation, provide them with credits for changes in selling prices, and allow them to participate in cooperativemarketing programs. Cooperative advertising expenses are recorded as marketing expenses to the extent that an advertising benefit separate from the revenuetransaction can be identified and the cash paid does not exceed the fair value of that advertising benefit received. The second tier of the distribution channelconsists of a large number of third-party resellers that sell directly to end-users and are not granted return privileges, except for defective products during thewarranty period. We reduce product revenue for certain price protection rights that may occur under contractual arrangements we have with our customers. Cash Equivalents, Short-Term Investments and Marketable Securities Highly liquid investment securities with insignificant interest rate risk and with original maturities of three months or less at date of purchase areclassified as cash equivalents. Investment securities with original maturities greater than three months and remaining maturities of less than one year areclassified as short-term investments. Investment securities with remaining maturities greater than one year are classified as marketable securities. Ourinvestments are primarily comprised of United States, state and municipal government obligations and corporate securities. To date, all marketable securities have been classified as available-for-sale and are carried at fair value, with unrealized gains and losses reported net-of-tax as a separate component of stockholders’ equity. Realized gains and losses on available-for-sale securities are recorded in interest income. Declines invalue on available-for-sale securities judged to be other than temporary are recorded in other income (expense), net. Marketable securities are presumed to beimpaired if the fair value is less than the cost basis continuously for six months, absent compelling evidence to the contrary. The cost of securities sold isbased on specific identification. Premiums and 60Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) discounts are amortized over the period from acquisition to maturity and are included in investment income, along with interest and dividends. We have made minority investments in privately held companies. Our interest in these companies was significantly less than 20% and, as such, we didnot have the ability to exercise significant influence. We monitor our minority investments for other than temporary impairment and make appropriatereductions in carrying values when necessary. We recorded write-downs of $0.2 million, and $9.7 million during fiscal 2003 and fiscal 2002, respectively,related to impairments of our privately held investments. The carrying value of investments in privately held companies was zero as of June 27, 2004 andJune 29, 2003. Fair Value of Financial Instruments The carrying amounts and estimated fair values of our financial instruments were as follows (in thousands): June 27, 2004 June 29, 2003 Carrying amount Fair value Carrying amount Fair value Financial assets: Cash and cash equivalents $59,164 $59,164 $44,340 $44,340 Short-term investments $162,078 $162,078 $119,277 $119,277 Marketable securities $204,430 $204,430 $238,540 $238,540 Financial liabilities: Convertible subordinated notes $200,000 $181,900 $200,000 $180,056 Forward foreign currency contracts $(115) $(115) $(121) $(121) The fair values of short-term investments and marketable securities are determined using quoted market prices for those securities or similar financialinstruments. The fair value of the convertible subordinated notes due December 1, 2006 is estimated using quoted market prices. Concentrations We may be subject to concentration of credit risk as a result of certain financial instruments consisting principally of marketable investments andaccounts receivable. We have placed our investments with high-credit quality issuers. We will not invest an amount exceeding 10% of our combined cash,cash equivalents, short-term investments and marketable securities in the securities of any one obligor or maker, except for obligations of the United Statesgovernment, obligations of United States government agencies and money market accounts. We perform ongoing credit evaluations of our customers and generally do not require collateral in exchange for credit. We mitigate some collectionrisk by requiring most of our customers in the Asia-Pacific region, excluding Japan, to pay cash in advance or secure letters of credit when placing an orderwith us. No distributor or customer accounted for more than 10% of our net revenues in fiscal 2004. One distributor of our products, Tech Data Corporation,accounted for 11% and 15% of our net revenues in fiscal 2003 and fiscal 2002, respectively. No customer accounted for more than 10% of our accountsreceivable balance at June 27, 2004 and one customer, Siemens Aktiengesellschaft, accounted for 11% of our accounts receivable balance as of June 29,2003. One supplier currently manufacturers all of our application specific integrated circuits, or ASICs, used in all of our hardware products. Any interruptionor delay in the supply of any of these or other single source components, or the inability to procure these components from alternate sources at acceptableprices and within a reasonable timeframe, would have a material adverse effect on our ability to meet customer orders which would negatively impact ourbusiness, operating results and financial condition. In addition, qualifying additional suppliers can be time-consuming and expensive, and may increase thelikelihood of design or production related 61Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) errors. We attempt to mitigate these risks by working closely with our ASIC supplier regarding production planning and timing of new product introductions. We currently derive substantially all of our revenue from sales of our Summit, BlackDiamond and Alpine products. We expect that revenue from theseproducts will account for a substantial portion of our revenue for the foreseeable future. Accordingly, widespread market acceptance of these products iscritical to our future success. Allowance for Doubtful Accounts We continually monitor and evaluate the collectibility of our trade receivables based on a combination of factors. We record specific allowances forbad debts in general and administrative expense when we become aware of a specific customer’s inability to meet its financial obligation to us, such as in thecase of bankruptcy filings or deterioration of financial position. Estimates are used in determining our allowances for all other customers based on factorssuch as current trends in the length of time the receivables are past due and historical collection experience. We mitigate some collection risk by requiringmost of our customers in the Asia-Pacific region, excluding Japan, to pay cash in advance or secure letters of credit when placing an order with us. Inventories Inventories consist of raw materials and finished goods and are stated at the lower of cost or market, on a first-in, first-out basis. We write down ourinventories based on estimated excess and obsolete inventories determined primarily by future demand forecasts. Inventories consist of (in thousands): June 27, 2004 June 29, 2003Raw materials $695 $100Finished goods 25,194 18,610 Total $25,889 $18,710 Sales to Distributors We defer recognition of revenue on all sales to distributors until the distributor successfully resells the product, typically to an authorized Value-Added Reseller. Distributors regularly provide us with reporting of their sales-out for this purpose. Until it is sold, inventory held by distributors is includedin our reported finished goods inventory and was $5.1 million and $3.9 million at June 27, 2004 and June 29, 2003, respectively. The accounts receivableowed us by distributors, net of the deferred revenue from sales to distributors, is recorded in other current assets, as reflected in the following table (inthousands): June 27, 2004 June 29, 2003 Accounts receivable, net of allowance for doubtful accounts of $724 (zero infiscal 2003) $20,350 $20,881 Deferred revenue (20,151) (15,799) Other current assets $199 $5,082 Property and Equipment, Net Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization is computed using thestraight-line method over the estimated useful lives of the assets, with the exception of land, which is not depreciated. Estimated useful lives of 25 years areused for buildings. Estimated useful lives of three to four years are used for computer equipment and software. Estimated useful lives of three years are usedfor office equipment, furniture and fixtures. Depreciation and amortization of leasehold 62Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) improvements is computed using the lesser of the remaining lease terms or three years. Property and equipment consist of the following (in thousands): June 27, 2004 June 29, 2003 Computer equipment $50,454 $45,330 Land 20,600 20,600 Buildings 17,400 17,400 Software 29,795 28,928 Office equipment, furniture and fixtures 4,115 4,374 Leasehold improvements 6,109 5,650 128,473 122,282 Less accumulated depreciation and amortization (68,706) (48,515) Property and equipment, net $59,767 $73,767 Goodwill and Other Long-Lived Assets Statement of Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Other Intangible Assets (“SFAS 142”), requires goodwill to be tested forimpairment on an annual basis and between annual tests in certain circumstances, and written down when impaired, rather than being amortized as previousstandards required. Furthermore, SFAS 142 requires purchased intangible assets other than goodwill to be amortized over their useful lives unless these livesare determined to be indefinite. We adopted this statement July 1, 2002. In accordance with SFAS 142, we ceased amortizing goodwill as of July 1, 2002. In accordance with the transition provisions of SFAS 142, we completed the first step of the transitional goodwill impairment test at July 1, 2002. Theresults of that test indicated that goodwill was not impaired and that a cumulative impairment loss did not have to be recognized. In accordance with SFAS 142, we performed the annual impairment review of our goodwill at the end of fiscal 2003. During this evaluation, we notedindicators that the carrying value of our goodwill might not be recoverable due to the prolonged economic downturn affecting our operations and revenueforecasts. Under the first step of the SFAS 142 analysis, the fair value was determined based on the income approach, which estimates the fair value based on thefuture discounted cash flows. Based on the first step analysis, we determined that the carrying amount of our goodwill was in excess of its fair value. As such,we were required to perform the second step analysis since it failed the first step test, to determine the amount of the impairment loss. We completed thesecond step analysis in connection with the impairment review for fiscal 2003 and recorded an impairment charge for the remaining $1.0 million of goodwill. The following table presents the impact of SFAS 142 on net loss and net loss per share had the standard been in effect in fiscal 2002 (in thousands,except per-share amounts): Year EndedJune 30, 2002 Net loss – as reported $(183,962)Adjustments: Amortization of goodwill 33,546 Income tax effect (11,741) Net adjustments 21,805 Net loss – adjusted $(162,157) Net loss per share – basic and diluted – as reported $(1.63) Net loss per share – basic and diluted – adjusted $(1.44) 63Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) During the third quarter of fiscal 2002, we evaluated goodwill and purchased intangible assets associated with recent acquisitions for impairment inaccordance with SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of. The assessment wasperformed as a result of weakening economic conditions and decreased current and expected future demand for certain categories of products in the marketsin which we operate. As a result of the assessment, we recorded a charge to reduce goodwill and purchased intangible assets of $89.8 million. Long-lived assets, including purchased intangible assets other than goodwill, are reviewed for impairment whenever events or changes incircumstances indicate that the carrying amount of such assets may not be recoverable. Determination of recoverability is based on an estimate ofundiscounted future cash flows resulting from the use of the asset and its eventual disposition. Measurement of an impairment loss for long-lived assets thatmanagement expects to hold and use is based on the fair value of the asset. Long-lived assets to be disposed of are reported at the lower of carrying amount orfair value less costs to sell. At June 27, 2004, there were no purchased intangible assets recorded in our consolidated balance sheets. Guarantees and Product Warranties Financial Accounting Standards Board (“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 recognize aliability for the fair value of the obligation it assumes under that guarantee. We have determined that the requirements of FIN 45 apply to our standardproduct warranty and to indemnification obligations contained in commercial agreements, including customary intellectual property indemnification for ourproducts contained in agreements with our resellers and end-users, to a guarantee of a lease obligation of one of our former contract manufacturers and toletters of credit issued under our line of credit. The following table summarizes the activity related to our product warranty liability during fiscal 2004, fiscal 2003 and fiscal 2002: Year Ended June 27, 2004 June 29, 2003 June 30, 2002 Balance beginning of period $10,200 $9,055 $2,957 New warranties issued 11,791 15,496 10,319 Warranty expenditures (13,694) (14,351) (4,221) Balance end of period $8,297 $10,200 $9,055 Our standard hardware warranty period is typically 12 months from the date of shipment to end-users and 14 months from the date of shipment tochannel partners, which include resellers and distributors. Upon shipment of products to our customers, including both end-users and channel partners, weestimate expenses for the cost to repair or replace products that may be returned under warranty and accrue a liability in cost of product revenue for thisamount. The determination of our warranty requirements is based on actual historical experience with the product or product family, estimates of repair andreplacement costs and any product warranty problems that are identified after shipment. We estimate and adjust these accruals at each balance sheet date inaccordance with changes in these factors. There have been no changes in these estimates for fiscal 2004, fiscal 2003 or fiscal 2002. In the normal course of business to facilitate sales of our products, we indemnify our resellers and end-user customers with respect to certain matters.We have agreed to hold the customer harmless against losses arising from a breach of intellectual property infringement or other claims made against certainparties. These agreements may limit the time within which an indemnification claim can be made and the amount of the claim. 64Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) It is not possible to estimate the maximum potential amount under these indemnification agreements due to the limited history of prior indemnificationclaims and the unique facts and circumstances involved in each particular agreement. Historically, payments made by us under these agreements have nothad a material impact on our operating results or financial position. Deferred Support Revenue We offer renewable support arrangements, including extended warranty contracts, to our customers that range generally from one to five years. Thechange in our deferred support revenue balance in relation to these arrangements was as follows (in thousands): Year Ended June 27, 2004 June 29, 2003 Balance beginning of period $44,220 $32,334 New support arrangements 49,918 43,012 Recognition of support revenue (43,960) (31,126) Balance end of period $50,178 $44,220 Other Accrued Liabilities The following are the components of other accrued liabilities (in thousands): June 27, 2004 June 29, 2003Accrued income taxes $1,672 $1,197Accrued indirect taxes 3,675 2,333Accrued interest on subordinated debt 583 661Other accrued liabilities 16,991 21,126 Total $22,921 $25,317 Stock-Based Compensation We have elected to follow APB Opinion No. 25, Accounting for Stock Issued to Employees, in accounting for our employee stock options because, asdiscussed below, the alternative fair value accounting provided for under SFAS No. 123, Accounting for Stock-Based Compensation, (“SFAS 123”) requiresthe use of option valuation models that were not developed for use in valuing employee stock options. Under APB No. 25, because the exercise price of ouremployee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized in our financialstatements. Pro forma information regarding net income and earnings per share is required by SFAS 123. This information is required to be determined as if we hadaccounted for our employee stock options and shares issued under the 1999 Purchase Plan under the fair value method of that statement. The fair value ofoptions granted in fiscal 2004, fiscal 2003 and fiscal 2002 was estimated at the date of grant using a Black-Scholes option pricing model with the followingweighted average assumptions: Stock Option Plan Employee Stock Purchase Plan Year Ended Year Ended June 27,2004 June 29,2003 June 30,2002 June 27,2004 June 29,2003 June 30,2002 Expected life 3.0 yrs 3.4 yrs 2.9 yrs 0.6 yrs 0.6 yrs 0.5 yrs Risk-free interest rate 2.3% 2.3% 3.7% 1.3% 1.1% 2.1%Volatility 77% 97% 111% 58% 86% 111%Dividend yield 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 65Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and arefully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected stock price volatility.Because our employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective inputassumptions can materially affect the fair value estimate, in the opinion of management, the existing models do not necessarily provide a reliable singlemeasure of the fair value of employee stock options. The weighted-average estimated per share fair value of options granted in fiscal 2004, fiscal 2003 andfiscal 2002 was $3.56, $3.41 and $7.95, respectively. The weighted-average estimated per share fair value of shares granted under the 1999 Purchase Plan infiscal 2004, fiscal 2003 and fiscal 2002 was $2.17, $1.92 and $5.55, respectively. Pro forma information regarding net income (loss) and earnings (loss) pershare is required by SFAS 123. This information is required to be determined as if we had accounted for shares issued under all of our employee stock optionsand shares issued under the 1999 Purchase Plan under the fair value method of that statement. For purposes of pro forma disclosures, the estimated fair valueof the options is amortized to expense over the options’ vesting periods. The following pro forma information sets forth our net loss and net loss per shareassuming that we had used the SFAS 123 fair value method in accounting for employee stock options and purchases (in thousands, except per shareamounts): Year Ended June 27, 2004 June 29, 2003 June 30, 2002 Net loss — as reported $(1,748) $(197,180) $(183,962)Add: APB 25 stock-based compensation expense, as reported 1,061 470 6,620 Less: Stock-based employee compensation expense determined under fairvalue based method, net of tax (29,197) (24,347) (41,320) Pro forma net loss $(29,884) $(221,057) $(218,662) Basic and diluted net loss per share: As reported $(0.01) $(1.71) $(1.63) Pro forma $(0.25) $(1.92) $(1.94) Stock compensation expense for options granted to nonemployees has been determined in accordance with SFAS 123 and EITF 96-18, Accounting forEquity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with, Selling Goods or Services, as the fair value of theconsideration received or the fair value of the equity instruments issued, whichever is more reliably measured. The fair value of options granted tononemployees is remeasured as the underlying options vest. Derivatives We use derivative financial instruments to manage exposures to foreign currency. Our objective for holding derivatives is to use the most effectivemethods to minimize the impact of these exposures. We do not enter into derivatives for speculative or trading purposes. All derivatives, whether designatedin hedging relationships or not, are required to be recorded on the balance sheet at fair value. The accounting for changes in the fair value of a derivativedepends on the intended use of the derivative and the resulting designation. For a derivative designated as a cash flow hedge, the effective portion of thederivative’s gain or loss is initially reported as a component of accumulated other comprehensive income and, upon occurrence of the forecasted transaction,is subsequently reclassified into the consolidated statement of operations line item to which the hedged transaction relates. The ineffective portion of thegain or loss is reported in other expense immediately. For a derivative not designated as a cash flow hedge, the gain or loss is recognized in other expense inthe period of change together with the offsetting gain or loss on the hedged item attributed to the risk being hedged. 66Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) Advertising Cooperative advertising obligations with customers are accrued and the costs expensed at the time the related revenue is recognized. All otheradvertising costs are expensed as incurred. Cooperative advertising expenses are recorded as marketing expenses to the extent that an advertising benefitseparate from the revenue transaction can be identified and the cash paid does not exceed the fair value of that advertising benefit received. Advertisingexpenses were $1.4 million, $3.8 million and $6.0 million for fiscal 2004, fiscal 2003 and fiscal 2002, respectively. Recently Issued Accounting Standards Consolidation of Variable Interest Entities In January 2003, the FASB issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities (“FIN 46”). FIN 46 requires that if an entityhas a controlling financial interest in a variable interest entity, the assets, liabilities and results of activities of the variable interest entity (“VIE”) should beincluded in the consolidated financial statements of the entity. For arrangements entered into after January 31, 2003, FIN 46 was effective immediately. Forarrangements entered into prior to February 1, 2003, FIN 46 was effective at the end of the period ending after December 15, 2003. In December 2003, FIN 46was revised to require application in financial statements of public entities that have interests in special-purpose entities for periods ending after December15, 2003. For all other types of variable interest entities, application was required for periods ending after March 15, 2004. The adoption of FIN 46, asrevised, in fiscal 2004 did not have a material impact on our results of operations or financial condition. Identification of Impaired Investments In March 2004, the FASB approved the consensus reached on EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and ItsApplication to Certain Investments (“EITF 03-1”). The objective EITF 03-1 is to provide guidance for identifying impaired investments. EITF 03-1 alsoprovides new disclosure requirements for investments that are deemed to be temporarily impaired. The accounting provisions of EITF 03-1 are effective forall reporting periods beginning after June 15, 2004, while the disclosure requirements are effective only for annual periods ending after June 15, 2004. Wehave evaluated the impact of the adoption of EITF 03-1 and we do not believe the impact will be significant to our overall results of operations or financialposition. 67Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) 3. Available-for-Sale Securities The following is a summary of available-for-sale securities (in thousands): AmortizedCost FairValue UnrealizedHoldingGains UnrealizedHoldingLosses June 27, 2004: Money market funds $470 $470 $— $— Foreign debt securities 9,124 9,129 45 (40)U.S. corporate debt securities 222,416 221,420 507 (1503)U.S. government agencies 74,715 73,824 14 (905)U.S. municipal bonds 40,371 40,339 33 (65)Market auction preferreds 21,796 21,796 — — $368,892 $366,978 $599 $(2,513) Classified as: Cash equivalents $470 $470 $— $— Short-term investments 161,654 162,078 525 (101)Marketable securities 206,768 204,430 74 (2,412) $368,892 $366,978 $599 $(2,513) June 29, 2003: Money market funds $9,203 $9,203 $— $— Foreign debt securities 3,201 3,322 121 — U.S. corporate debt securities 193,268 196,402 3,249 (115)U.S. government agencies 54,465 54,716 295 (44)U.S. municipal bonds 96,219 96,369 170 (20)Market auction preferreds 7,008 7,008 — — $363,364 $367,020 $3,835 $(179) Classified as: Cash equivalents $9,203 $9,203 $— $— Short-term investments 119,022 119,277 255 — Marketable securities 235,139 238,540 3,580 (179) $363,364 $367,020 $3,835 $(179) The amortized cost and estimated fair value of available-for-sale investments in debt securities at June 27, 2004, by contractual maturity, were asfollows (in thousands): AmortizedCost FairValueDue in 1 year or less $161,654 $162,078Due in 1-2 years 116,155 115,123Due in 2-5 years 90,613 89,307 Total investments in available for sale debt securities $368,422 $366,508 68Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) 4. Commitments, Contingencies and Leases Line of Credit We have a revolving line of credit for $10.0 million with a major lending institution. Borrowings under this line of credit bear interest at the bank’sprime rate. As of June 27, 2004, there were no outstanding borrowings under this line of credit. The line of credit contains a provision for the issuance ofletters of credit not to exceed the unused balance of the line. As of June 27, 2004, we had letters of credit totaling $0.9 million. These letters of credit wereprimarily issued to satisfy requirements of certain of our customers for performance bonds. The line of credit requires us to maintain specified financialcovenants related to tangible net worth and liquidity with which we were in compliance as of June 27, 2004. The line of credit expires on January 27, 2005. Leases As part of our business relationship with MCMS, Inc. (“MCMS”), a former contract manufacturer, we entered into a $9.0 million operating equipmentlease for manufacturing equipment in September 2000 with a third-party financing company; we, in turn, subleased the equipment to MCMS. The equipmentlease with the third-party financing company requires us to make monthly payments through September 2005 and to maintain specified financial covenantswith which we were in compliance as of June 27, 2004. During the first quarter of fiscal 2002, due to the liquidity problems at MCMS and its voluntary filingfor protection under Chapter 11, we recorded a charge of $9.0 million related to this lease. The liability, net of payments, related to this lease is included inlease liability on the consolidated balance sheets. We lease office space for our various United States and international sales offices. We sublease certain of our leased facilities to third party tenants.Future annual minimum lease payments under all noncancelable operating leases and future rental income under all noncancelable subleases having initialor remaining lease terms in excess of one year at June 27, 2004 were as follows (in thousands): Future LeasePayments Future RentalIncomeFiscal 2005 $9,753 $930Fiscal 2006 7,767 57Fiscal 2007 6,505 — Fiscal 2008 3,598 — Fiscal 2009 2,720 Thereafter 5,639 — Total minimum payments $35,982 $987 Rent expense was approximately $5.4 million, $6.3 million and $10.4 million for fiscal 2004, fiscal 2003 and fiscal 2002, respectively, net of subleaseincome of $0.3 million, $0.1 million and $2.0 million in the respective periods. Purchase Commitments We currently have arrangements with one contract manufacturer and other suppliers for the manufacture of our products. Our arrangements allow themto procure long lead-time component inventory on our behalf based upon a rolling production forecast provided by us. We are obligated to the purchase oflong lead-time component inventory that our contract manufacturer procures in accordance with the forecast, unless we give notice of order cancellationoutside of applicable component lead-times. As of June 27, 2004, we had non-cancelable commitments to purchase approximately $23.0 million of suchinventory during the first quarter of fiscal 2005. 69Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) Legal Proceedings On May 27, 2003, Lucent Technologies, Inc. (“Lucent”) filed suit against Extreme Networks and Foundry Networks, Inc. (“Foundry”) in the UnitedStates District Court for the District of Delaware, Civil Action No. 03-508. The complaint alleges willful infringement of U.S. Patent Nos. 4,769,810,4,769,811, 4,914,650, 4,922,486 and 5,245,607 and seeks a judgment: (a) determining that we have willfully infringed each of the five patents; (b)determining that Foundry has willfully infringed four of the five patents; (c) permanently enjoining us from infringement, inducement of infringement andcontributory infringement of each of the five patents; (d) permanently enjoining Foundry from infringement, inducement of infringement and contributoryinfringement of four of the five patents; and (e) awarding Lucent unspecified amounts of trebled damages, together with expenses, costs and attorneys’ fees. We intend vigorously to defend against Lucent’s allegations. We answered Lucent’s complaint on July 16, 2003, denying infringement and assertingvarious affirmative defenses and counterclaims that seek judgment: (a) that Lucent’s complaint be dismissed and Lucent be denied all requested relief; (b)declaring that we do not infringe, induce infringement or contribute to the infringement of any valid and enforceable claim of the five patents, (c) that each ofthe five patents be declared invalid; (d) finding the case exceptional within the definition of 35 U.S.C. § 285; and (e) that Lucent pay our attorneys’ fees andcosts. The court has served the cases against Extreme Networks and Foundry. Discovery is proceeding. A claim construction hearing has been set forNovember 17, 2004. A pre-trial conference is set for January 14, 2005. No trial date has been set. Beginning on July 6, 2001, purported securities fraud class action complaints were filed in the United States District Court for the Southern District ofNew York. The cases were consolidated and the litigation is now captioned as In re Extreme Networks, Inc. Initial Public Offering Securities Litigation, Civ.No. 01-6143 (SAS) (S.D.N.Y.), related to In re Initial Public Offering Securities Litigation, 21 MC 92 (SAS) (S.D.N.Y.). The operative amended complaint is brought purportedly on behalf of all persons who purchased Extreme Networks’ common stock from April 8, 1999through December 6, 2000. It names as defendants Extreme Networks; six of our present and former officers and/or directors, including our CEO (the“Extreme Networks Defendants”); and several investment banking firms that served as underwriters of our initial public offering and October 1999 secondaryoffering. Subsequently, plaintiffs and one of the individual defendants stipulated to a dismissal of that defendant without prejudice. The complaint allegesliability under Sections 11 and 15 of the Securities Act of 1933 and Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, on the grounds that theregistration statement for the offerings did not disclose that: (1) the underwriters had agreed to allow certain customers to purchase shares in the offerings inexchange for excess commissions paid to the underwriters; and (2) the underwriters had arranged for certain customers to purchase additional shares in theaftermarket at predetermined prices. The Securities Act allegations against the Extreme Networks Defendants are made as to the secondary offering only. Theamended complaint also alleges that false analyst reports were issued. No specific damages are claimed. Similar allegations were made in other lawsuits challenging over 300 other initial public offerings and follow-on offerings conducted in 1999 and2000. The cases were consolidated for pretrial purposes. On February 19, 2003, the Court ruled on all defendants’ motions to dismiss. The Court denied themotions to dismiss the claims in our case under the Securities Act of 1933. The Court denied the motion to dismiss the claim under Section 10(a) of theSecurities Exchange Act of 1934 against Extreme Networks and 184 other issuer defendants, on the basis that the complaints alleged that the respectiveissuers had acquired companies or conducted follow-on offerings after their initial public offerings. The Court denied the motion to dismiss the claims under 70Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) Section 10(a) and 20(a) of the Securities Exchange Act of 1934 against the remaining Extreme Networks Defendants and 59 other individual defendants, onthe basis that the respective amended complaints alleged that the individuals sold stock. We have executed a settlement agreement presented to all issuer defendants. In this settlement, plaintiffs will dismiss and release all claims against theExtreme Network Defendants, in exchange for a contingent payment by the insurance companies collectively responsible for insuring the issuers in all of theIPO cases, and for the assignment or surrender of control of certain claims we may have against the underwriters. The Extreme Networks Defendants will notbe required to make any cash payments in the settlement, unless the pro rata amount paid by the insurers in the settlement exceeds the amount of theinsurance coverage, a circumstance which we do not believe will occur. The settlement will require approval of the Court, which cannot be assured. If thesettlement is not approved, we cannot assure you that we will prevail in the lawsuit. Failure to prevail could have a material adverse effect on ourconsolidated financial position, results of operations and cash flows in the future. We are subject to other legal proceedings, claims and litigation arising in the ordinary course of business. While the outcome of these matters,including the specific matters discussed above, is currently not determinable, the ultimate costs to resolve these matters could have a material adverse effecton our consolidated financial position, results of operations or cash flows. 5. Convertible Subordinated Notes In December 2001, we completed a private placement of $200.0 million of convertible subordinated notes. The notes mature on December 1, 2006.Interest is payable semi-annually at 3.5% per annum. The notes are convertible at the option of the holders into our common stock at an initial conversionprice of $20.96 per share, subject to adjustment. In lieu of issuing common shares, the notes are redeemable in cash at the option of Extreme Networks at aninitial redemption price of 101.4% of the principal amount on or after December 2004 if not converted to common stock prior to the redemption date. Wehave reserved 9,544,260 shares of common stock for the conversion of these notes. Offering costs of $6.5 million are included in other assets and areamortized using the interest method. Each holder of the notes has the right to cause us to repurchase all of such holder’s convertible notes at 100% of theprincipal amount plus accrued interest upon a change of control of ownership of Extreme Networks, as defined in the notes. 6. Stockholders’ Equity Preferred Stock In April 2001, in connection with our Stockholders’ Rights Agreement, we authorized the issuance of preferred stock. The preferred stock may beissued from time to time in one or more series. The board of directors is authorized to provide for the rights, preferences and privileges of the shares of eachseries and any qualifications, limitations or restrictions on these shares. As of June 27, 2004, no shares of preferred stock were outstanding. Warrants On October 30, 2003, Extreme Networks and Avaya Inc. entered into a strategic alliance to jointly develop and market converged communicationssolutions, by executing a Joint Development Agreement, and a distribution agreement under which Avaya is entitled to resell Extreme Networks products.Extreme issued to Avaya a warrant with a ten-year expiration period to purchase up to 2.6 million shares of Extreme Networks common stock at a price of$0.01 per share, with Avaya having the right to exercise the warrant with respect to one third of such shares 90 days after the date of the agreements, and theremaining shares become exercisable based upon the completion of certain milestones by Avaya. Even if the milestones are not completed, however, 71Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) the warrant will become fully exercisable for all shares 90 days prior to the expiration of the warrant. Avaya exercised the warrant with respect to one third ofthe shares subject to the warrant on March 17, 2004 and, accordingly, approximately 859,000 shares of our common stock were issued to Avaya on that date. Deferred Stock Compensation During fiscal 2001, we recorded deferred stock-based compensation expense of $24.4 million associated with unvested stock options subject toforfeiture issued to employees assumed in acquisitions. These amounts are being amortized as charges to operations, using the graded method, over thevesting periods of the individual stock options, generally four years. Upon termination of an employee, the amount of expense recognized under the gradedvesting method that is in excess of the amount actually earned is reversed. For the year ended June 29, 2003, we reversed $5.3 million of excesscompensation expense (including $2.8 million related to forfeitures that occurred in prior years but which, due to oversight, were not accounted for until thefourth quarter of fiscal 2003) related to terminated employees. We do not believe the $2.8 million amount recorded in the fourth quarter of fiscal 2003 wasmaterial to the periods in which it should have been recorded. We recorded amortization of deferred stock compensation expense, net of reversals, of $1.1million, $0.7 million and $10.2 million for fiscal 2004, 2003 and 2002, respectively. At June 27, 2004, Extreme had a total of approximately $0.1 millionremaining to be amortized over the corresponding vesting period of each respective stock option. Stockholders’ Rights Agreement In April 2001, the board of directors approved a Stockholders’ Rights Agreement (“Rights Agreement”), declaring a dividend of one preferred sharepurchase right for each outstanding share of common stock, par value $0.001 per share, of Extreme Networks common stock. The Rights Agreement isintended to protect stockholders’ rights in the event of an unsolicited takeover attempt. It is not intended to prevent a takeover of Extreme Networks on termsthat are favorable and fair to all stockholders and will not interfere with a merger approved by the board of directors. In the event the rights becomeexercisable, each right entitles stockholders to buy, at an exercise price of $150 per right owned, a unit equal to a portion of a new share of Extreme NetworksSeries A preferred stock. The rights will be exercisable only if a person or a group acquires or announces a tender or exchange offer to acquire 15% or more ofour common stock. The rights, which expire in April 2011, are redeemable for $0.001 per right at the approval of the board of directors. Stock Option Exchange Program On March 25, 2003, we filed a Tender Offer Statement on Schedule TO with the Securities and Exchange Commission related to a voluntary stockoption exchange program for our employees. Our executive officers, directors and sales executives who report directly to the Vice President, Worldwide Saleswere not eligible to participate in this program. Under the program, eligible employees were given the opportunity to voluntarily cancel unexercised vestedand unvested stock options previously granted to them that had an exercise price greater than $12.00. For each option for five shares tendered forcancellation, a new option for three shares was granted to employees who elected to participate in the option exchange program. In order to receive new stockoptions, an employee must have been employed by us or by one of our subsidiaries on October 23, 2003 when the replacement options were granted.Participants who elected to exchange any options were required to exchange all eligible options and were also required to exchange any other optionsgranted to him or her in the previous six months. The replacement stock options vested 25% on October 23, 2003 and the remaining 75% of the replacementstock options vest monthly over 24 to 36 months based on the employee’s hire date. Options for approximately 11.0 million shares of common stock held by570 employees were eligible for exchange under the program. Options for approximately 9.3 million shares of common stock held by 435 employees wereaccepted for exchange under this program and, accordingly, were canceled on April 22, 2003. Replacement options for approximately 5.1 million shares ofcommons stock were issued on October 23, 2003 at an exercise price of 72Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) $7.07 per share, which was the fair market value of our common stock on October 23, 2003. The stock option exchange program did not result in any stockcompensation expense or variable accounting for replacement awards. Comprehensive Income (Loss) The activity of other comprehensive income (loss) was as follows (in thousands): Year Ended June 27, 2004 June 29, 2003 June 30, 2002 Unrealized gain on investments: Change in net unrealized gain on investments $(5,127) $755 $1,292 Less: Net gain (loss) on investments realized and includedin net loss 33 307 201 Net unrealized gain on investments (5,160) 448 1,091 Unrealized gain (loss) on derivatives (1) 114 (113)Foreign currency translation adjustments 467 (107) 104 Other comprehensive income (loss) $(4,694) $455 $1,082 The following are the components of accumulated other comprehensive income (loss), net of tax (in thousands): June 27, 2004 June 29, 2003Accumulated unrealized gain (loss) on investments, net of tax of $997 in fiscal 2004 and$1,407 in fiscal 2003 $(2,911) $2,249Accumulated unrealized gain on derivatives — 1Accumulated foreign currency translation adjustments 523 56 Accumulated other comprehensive income (loss) $(2,388) $2,306 7. Employee Benefit Plans 1999 Employee Stock Purchase Plan In January 1999, the board of directors approved the adoption of Extreme Network’s 1999 Employee Stock Purchase Plan (the “Purchase Plan”). A totalof 7,000,000 shares of common stock have been reserved for issuance under the Purchase Plan. The Purchase Plan permits eligible employees to acquireshares of our common stock through periodic payroll deductions of up to 15% of total compensation. No more than 625 shares may be purchased on anypurchase date per employee. Each offering period has a maximum duration of 12 months. The price at which the common stock may be purchased is 85% ofthe lesser of the fair market value of our common stock on the first day of the applicable offering period or on the last day of the respective purchase period.Through June 27, 2004, 4,350,833 shares had been purchased under the Purchase Plan. Amended 1996 Stock Option Plan In January 1999, the board of directors approved an amendment to the 1996 Stock Option Plan (the “1996 Plan”) to (i) increase the share reserve by10,000,000 shares, (ii) to remove certain provisions which are required to be in option plans maintained by California privately-held companies and (iii) torename the 1996 Plan as the “Amended 1996 Stock Option Plan.” Under the 1996 Plan, which was originally adopted in September 1996, options may be granted for common stock, pursuant to actions by the board ofdirectors, to eligible participants. A total of 56,387,867 shares have been reserved under the 1996 Plan. Options granted are exercisable as determined by theboard of directors. Options vest 73Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) over a period of time as determined by the board of directors, generally four years. The term of the 1996 Plan is ten years. As of June 27, 2004, 17,568,952shares were available for future grant under the 1996 Plan. 2000 Stock Option Plan In March 2000, the board of directors adopted the 2000 Nonstatutory Stock Option Plan (the “2000 Plan”). Options may be granted for common stock,pursuant to actions by the board of directors, to eligible participants. Generally, only non-officer employees are eligible to participate in this stock plan,except that options may be granted to officers under this plan in connection with written offers of employment. A total of 4,000,000 shares have beenreserved under the 2000 Plan. Options vest over a period of time as determined by the board of directors, generally four years. The term of the 2000 Plan is tenyears. As of June 27, 2004, 2,947,052 shares were available for future grant under the 2000 Plan. 2001 Stock Option Plan In May 2001, the board of directors adopted the 2001 Nonstatutory Stock Option Plan (the “2001 Plan”). Options may be granted for common stock,pursuant to actions by the board of directors, to eligible participants. Generally, only non-officer employees are eligible to participate in this stock plan,except that options may be granted to officers under this plan in connection with written offers of employment. A total of 4,000,000 shares have beenreserved under the 2001 Plan. Options vest over a period of time as determined by the board of directors, generally four years. The term of the 2001 Plan is tenyears. As of June 27, 2004, 1,321,059 shares were available for future grant under the 2001 Plan. During fiscal 2004 and fiscal 2003, we granted restricted stock awards under the 2001 Plan for 31,750 and 85,000 shares of common stock,respectively, to a number of employees. The shares were placed in an escrow account and will be released to the recipients as the shares vest over periods ofup to twenty-three months. If a participant terminates employment prior to the vesting dates, the unvested shares will be canceled and returned to the 2001Plan. We recognize compensation expense on the awards based on an intrinsic value calculation as the shares vest. During fiscal 2004, 50,813 shares ofcommon stock vested under these awards at market values ranging from $5.53 to $7.43 and we recognized approximately $345,000 in research anddevelopment expense and approximately $12,000 in sales and marketing expense based on the market value of the shares on the vesting dates. The following table summarizes stock option activity under all plans: Number ofShares Weighted-AverageExercise PricePer ShareOptions outstanding at July 1, 2001 24,977,373 $27.69Granted 13,029,329 $12.00Exercised (900,779) $3.80Canceled (9,283,219) $40.03 Options outstanding at June 30, 2002 27,822,704 $17.00Granted 4,655,195 $5.37Exercised (229,701) $4.02Canceled (20,340,656) $20.24 Options outstanding at June 29, 2003 11,907,542 $7.18Granted 13,899,622 $7.25Exercised (1,518,076) $4.78Canceled (2,837,767) $8.31 Options outstanding at June 27, 2004 21,451,321 $7.25 74Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) During fiscal 2001, approximately 724,077 shares of our common stock were reserved for issuance under stock option plans that we assumed inconnection with acquisitions. Options to purchase approximately 11,009 shares of common stock have been exercised under these assumed stock optionplans as of June 27, 2004 but are subject to repurchase until vested. The following table summarizes significant ranges of outstanding and exercisable options at June 27, 2004: Options Outstanding Options ExercisableRange ofExercisePrices NumberOutstanding Weighted-AverageRemainingContractual Life Weighted-AverageExercisePrice NumberExercisable Weighted-AverageExercisePrice (In years) $ 0.01 – 4.08 3,244,832 6.32 $2.95 2,046,863 $2.62$ 4.25 – 6.42 2,823,149 8.49 $5.30 916,952 $5.54$ 6.73 – 7.07 6,968,484 9.32 $7.06 2,409,118 $7.07$ 7.14 – 8.05 3,060,131 8.97 $7.76 835,736 $7.62$ 8.07 – 9.40 3,174,429 9.22 $8.36 787,388 $8.53$ 9.56 – 56.00 2,180,296 7.44 $14.41 1,644,339 $15.34 $ 0.01 – 56.00 21,451,321 8.50 $7.25 8,640,396 $7.61 Options to purchase 5,326,577 shares were exercisable at June 29, 2003 with a weighted-average exercise price of $7.49. 401(k) Plan We provide a tax-qualified employee savings and retirement plan, commonly known as a 401(k) plan (the “Plan”), which covers our eligibleemployees. Pursuant to the Plan, employees may elect to reduce their current compensation up to the lesser of 80% or the statutorily prescribed limit of$13,000 for calendar year 2004. Effective January 1, 2004, employees age 50 or over may elect to contribute an additional $3,000. The amount of thereduction is contributed to the Plan on a pre-tax basis. We provide for discretionary matching contributions as determined by the board of directors for each calendar year. As of September 2000, the board ofdirectors set the match at $0.25 for every dollar contributed by the employee up to the first 4% of pay. The same level of match was continued during the2001, 2002 and 2003 calendar years. All matching contributions vest immediately effective September 2000. In addition, the Plan provides for discretionarycontributions as determined by the board of directors each year. Our matching contributions to the Plan totaled $504,557, $484,010 and $503,051 for fiscal2004, fiscal 2003 and 2002, respectively. No discretionary contributions were made in fiscal 2004, fiscal 2003 or fiscal 2002. 75Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) 8. Income Taxes The provision for (benefit from) income taxes for fiscal 2004, fiscal 2003 and fiscal 2002 consisted of the following (in thousands): Year Ended June 27, 2004 June 29, 2003 June 30, 2002 Current: Federal $— $— $— State 50 — 200 Foreign 2,923 2,631 2,876 Total current 2,973 2,631 3,076 Deferred: Federal 372 109,517 (46,585)State 37 23,167 (9,719)Foreign (206) (529) 388 Total deferred 203 132,155 (55,916) Provision for (benefit from) income taxes $3,176 $134,786 $(52,840) Pretax income from foreign operations was $6.7 million, $2.5 million and $8.9 million in fiscal 2004, fiscal 2003 and fiscal 2002, respectively. The difference between the provision (benefit) for income taxes and the amount computed by applying the federal statutory income tax rate (35percent) to income (loss) before taxes is explained below (in thousands): Year Ended June 27, 2004 June 29, 2003 June 30, 2002 Tax at federal statutory rate (benefit) $500 $(21,838) $(82,881)State income tax, net of federal benefit 57 15,059 (6,196)Unbenefited foreign taxes 1,070 2,102 — Unbenefited net operating losses — 21,322 — Tax credits — — (1,079)Valuation allowance 1,749 117,626 — Foreign earnings taxed at other than US rates/unbenefited foreign loss (702) — 232 Nondeductible goodwill — 357 35,958 Deferred compensation 371 — — Other 131 158 1,126 Provision for (benefit from) income taxes $3,176 $134,786 $(52,840) 76Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) Significant components of our deferred tax assets are as follows (in thousands): June 27, 2004 June 29, 2003 Deferred tax assets: Net operating loss carryforwards $80,707 $68,706 Tax credit carryforwards 14,715 13,926 Depreciation 21,801 16,135 Deferred revenue 7,881 8,711 Warrant amortization 16,199 21,408 Inventory allowances 2,500 3,173 Other reserves and accruals 17,048 19,521 Other 10,184 13,549 Total deferred tax assets 171,035 165,129 Valuation allowance (169,886) (163,127) Total net deferred tax assets 1,149 2,002 Deferred tax liabilities — acquisition related intangibles and other (1,025) (2,066) Net deferred tax assets (liabilities) $124 $(64) In fiscal 2004, our valuation allowance increased by $6.8 million to provide a valuation allowance against all of our federal and state deferred taxassets. The valuation allowance is determined in accordance with the provisions of Statement of Financial Accounting Standards No. 109, Accounting forIncome Taxes, (“SFAS 109”) which requires an assessment of both negative and positive evidence when measuring the need for a valuation allowance. Ourlosses in recent periods represented sufficient negative evidence to require a valuation allowance under SFAS 109. This valuation allowance will beevaluated periodically and can be reversed partially or totally if business results have sufficiently improved to support realization of our deferred tax assets. As of June 27, 2004, approximately $3.5 million of the valuation allowance for deferred taxes was attributable to the tax benefits of stock optiondeductions which will be credited to equity when realized. As of June 27, 2004, we had net operating loss carryforwards for federal and state tax purposes of $227.5 million and $14.2 million, respectively. Wealso had federal and state tax credit carryforwards of $9.1 million and $8.7 million, respectively. Unused net operating loss and tax credit carryforwards willexpire at various dates beginning in the years 2005 and 2007, respectively. Utilization of the net operating losses and tax credits may be subject to a substantial annual limitation due to the ownership change limitationsprovided by the Internal Revenue Code of 1986, as amended, and similar state provisions. The annual limitation may result in the expiration of net operatinglosses and tax credits before utilization. 9. Disclosure about Segments of an Enterprise and Geographic Areas Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly bythe chief operating decision makers with respect to the allocation of resources and performance. We operate in one segment, the development and marketing of network infrastructure equipment. We conduct business globally and are managedgeographically. Revenue is attributed to a geographical area based on the location of the customers. 77Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) Information regarding geographic areas is as follows (in thousands): Year Ended June 27, 2004 June 29, 2003 June 30, 2002Net revenues: United States $136,622 $144,066 $146,345Europe, Middle East and Africa 93,700 90,303 97,774Japan 77,600 82,916 145,203Other 43,926 45,991 52,287 $351,848 $363,276 $441,609 Substantially all of our assets were attributable to United States operations at June 27, 2004 and June 29, 2003. 10. Net Loss Per Share Basic earnings (loss) per share is calculated by dividing net income (loss) by the weighted average number of common shares outstanding during theperiod, less shares subject to repurchase, and excludes any dilutive effects of options, warrants and convertible subordinated notes. Dilutive earnings pershare is calculated by dividing net income by the weighted average number of common shares used in the basic earnings (loss) per share calculation plus thedilutive effect of shares subject to repurchase, options, warrants and convertible subordinated notes. Diluted net loss per share was the same as basic net lossper share in fiscal 2004, 2003 and fiscal 2002 because we had net losses in those periods. The following table presents the calculation of basic and diluted netloss per share (in thousands, except per share data): Year Ended June 27, 2004 June 29, 2003 June 30, 2002 Net loss $(1,748) $(197,180) $(183,962) Weighted-average shares of common stock outstanding 118,450 115,742 114,321 Less: Weighted-average shares subject to repurchase (102) (556) (1,396) Weighted-average shares used in per share calculation — basic and diluted 118,348 115,186 112,925 Net loss per share — basic and diluted $(0.01) $(1.71) $(1.63) The following table sets forth potential shares of common stock that are not included in the diluted net loss per share calculation above because to doso would be antidilutive for the periods (in thousands): Year Ended June 27, 2004 June 29, 2003 June 30, 2002Stock options outstanding 2,177 1,567 3,206Warrants outstanding 1,493 — 2,250Unvested common stock subject to repurchase 102 556 1,396Convertible subordinated notes 9,542 9,542 5,566 Total potential shares of common stock excluded from thecomputation of earnings per share 13,314 11,665 12,418 78Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) 11. Foreign Currency Hedging SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS 133”) as amended and interpreted requires that all derivatives berecorded on the balance sheet at fair value. Changes in the fair value of derivatives that do not qualify, or are not effective as hedges must be recognizedcurrently in earnings. Accordingly, we record the forward contracts used to manage foreign exchange exposures in prepaid expenses and other current assetson the consolidated balance sheets at fair value. Foreign Exchange Exposure Management - We denominate global sales in US dollars. International sales subsidiaries generate operating expenses inforeign currencies. In the first quarter of fiscal 2002, we initiated a program of hedging forecasted and actual foreign currency risk with forward contracts toeliminate, reduce or transfer selected foreign currency risks that can be confidently identified and quantified. Hedges of anticipated transactions aredesignated and documented at inception as cash flow hedges and are evaluated for effectiveness at least quarterly. As the critical terms of the forward contractand the underlying are matched at inception, forward contract effectiveness is calculated by comparing the cumulative change in the contract (on a forward toforward basis) to the change in fair value of the anticipated expense, with the effective portion of the hedge recorded in accumulated other comprehensiveincome (“OCI”). Values accumulated in OCI are subsequently reclassified into the consolidated statement of operations line item to which the hedgedtransaction relates in the period the anticipated expense is recognized in income. Any ineffectiveness is recognized immediately in other expense. Noineffectiveness was recognized in other expense in fiscal 2004, fiscal 2003 or fiscal 2002. Forward contracts used to hedge the remeasurement of non-functional currency monetary assets and liabilities are recognized in other expensecurrently to mitigate reported foreign exchange gains and losses. 12. Restructuring Charges, Property and Equipment Write-Off and Provision for Excess and Obsolete Inventory Restructuring Charges During fiscal 2004, we recorded restructuring charges of $6.5 million related to excess facilities. The excess facilities charge represents an increase tothe charge initially recognized during the third quarter of fiscal 2002 as discussed below. The commercial real estate market has continued to deteriorate infiscal 2004 and we have not been able to find suitable tenants to sublease these facilities. The lower projected sublease income has necessitated an increase inreserves that takes into consideration the unfavorable difference between lease obligation payments and projected sublease receipts. The actual cost coulddiffer from this estimate, and additional facilities charges could be incurred if we are unsuccessful in negotiating reasonable termination fees on certainfacilities, if facility operating lease rental rates continue to decrease in these markets, if it takes longer than expected to find a suitable tenant to subleasethese facilities or if other estimates and assumptions change. During fiscal 2003, we recorded restructuring charges of $15.9 million. The restructuring charges included excess facilities charges of $9.6 million,severance charges of $4.4 million and asset impairments of $1.9 million. The excess facilities charge represents an increase to the charge recognized duringfiscal 2002 for the domestic and international facilities discussed below. Severance charges of $2.7 million related to a reduction in total staff during thesecond quarter of fiscal 2003 of approximately 100 people, or 10% of the total workforce, across all departments. Severance charges of $1.7 million related toa reduction in total staff announced at the end of the fiscal year of approximately 70 people, or 8% of the total workforce, across all departments. The assetimpairment charge relates to the write-off of leasehold improvements and office furniture related to excess facilities. During fiscal 2002, we implemented a restructuring plan to lower our overall cost structure. Restructuring charges of $73.6 million included a $39.0million charge related to the exit of two facility leases we entered into in June 2000, excess facilities charges of $25.4 million and asset impairments of $9.1million. 79Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) In June 2000, we entered into two operating lease agreements for approximately 16 acres of land and the accompanying 275,000 square feet ofbuildings to house our primary facility in Santa Clara, California (the “Property”). The two lease agreements required the purchase of the Property for $80.0million at the end of the lease term and provided the option to purchase the Property at any time during the lease term. In fiscal 2002, we exercised the optionto purchase the Property and title to the Property was transferred to us. The charge of $39.0 million represented the difference between the purchase price andthe appraised value of the land and buildings at the time of exercise of the option to purchase the Property. The excess facility charges of $25.4 million in fiscal 2002 are the result of our decision to permanently reduce occupancy or vacate certain domesticand international facilities. The estimated facilities costs were based on comparable rates for leases in the respective markets or estimated termination fees atthat time. We anticipate that we will continue to make cash outlays to meet lease obligations for these facilities in accordance with their terms, unlessestimates and assumptions change or we are able to negotiate acceptable lease terminations prior to the anticipated termination dates for the applicableleases. The asset impairment charge of $ 9.1 million represented the unamortized amount of the assets at the date a decision was made to discontinue use.These assets were not utilized subsequently or held for sale. They were either scrapped or abandoned. Restructuring liabilities consist of (in thousands): Purchaseof LeasedProperties ExcessFacilities AssetImpairments Severance Total Charge in third quarter of fiscal 2002 $39,000 $25,432 $9,138 $— $73,570 Write-offs — — (9,138) — (9,138)Cash payments (39,000) (2,011) — — (41,011) Balance at June 30, 2002 — 23,421 — — 23,421 Charge in second quarter of fiscal 2003 — 9,576 1,893 2,718 14,187 Charge in fourth quarter of fiscal 2003 — — — 1,752 1,752 Write-offs — — (1,893) — (1,893)Cash payments — (6,579) — (2,718) (9,297) Balance at June 29, 2003 — 26,418 — 1,752 28,170 Charge in first quarter of fiscal 2004 — 876 122 (36) 962 Charge in fourth quarter of fiscal 2004 — 5,622 — (97) 5,525 Write-offs — — (122) — (122)Cash payments — (6,353) — (1,619) (7,972) Balance at June 27, 2004 — 26,563 — — 26,563 Less: current portion — 6,085 — — 6,085 Restructuring liabilities at June 27, 2004, lesscurrent portion $— $20,478 $— $— $20,478 Property and Equipment Write-off During the second quarter of fiscal 2003, we completed a property and equipment physical inventory in conjunction with the implementation of ournew ERP system. The property and equipment physical inventory resulted in the identification of $12.7 million of property and equipment whose fair valuewas determined to be zero because the assets were either no longer in service or were not identifiable. Therefore these assets were written off during thesecond quarter of fiscal 2003. 80Table of ContentsEXTREME NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) Provision for Excess and Obsolete Inventory As a result of the rapid change in the market for networking products, we recorded $5.0 million and $39.2 million in charges for excess and obsoleteinventory and non-cancelable purchase commitments in fiscal 2002 and fiscal 2001, respectively. The following is a summary of the additional excessinventory allowance from the third quarter of fiscal 2001 to June 27, 2004 (in thousands) Excess InventoryAllowance Excess InventoryBenefitInitial additional excess inventory and non-cancelable purchase commitmentscharge in the third quarter of fiscal 2001 $39,205 $— Additional excess inventory charge in the first quarter of fiscal 2002 5,000 — 44,205 Usage: Inventory scrapped (22,509) — Sale of inventory (5,154) 4,776Inventory utilized (893) — Settlement of purchase commitments (15,649) — (44,205) $4,776 Remaining excess inventory as of June 27, 2004 $— 13. Alliance with Avaya On October 30, 2003, Extreme Networks and Avaya Inc. entered into a strategic alliance to jointly develop and market converged communicationssolutions, by executing a Joint Development Agreement, and a distribution agreement under which Avaya is entitled to resell Extreme Networks products.Extreme issued to Avaya a warrant with a ten-year expiration period to purchase up to 2.6 million shares of Extreme Networks common stock at a price of$0.01 per share, with Avaya having the right to exercise the warrant with respect to one third of such shares 90 days after the date of the agreements, and theremaining shares become exercisable based upon the completion of certain milestones by Avaya. Even if the milestones are not completed, however, thewarrant will become fully exercisable for all shares 90 days prior to the expiration of the warrant. Avaya exercised the warrant with respect to one third of theshares subject to the warrant on March 17, 2004 and, accordingly, approximately 859,000 shares of our common stock were issued to Avaya on that date. Extreme Networks engaged an independent valuation firm to estimate the fair value of the warrant and to assist with the allocation of the fair value tothe two agreements entered into. The independent valuation firm estimated the fair value of the warrant at $22.7 million which has been allocated $17.9million to the Joint Development Agreement and $4.8 million to the distribution agreement based on the assumptions by management related to theprojected revenue and expenses for the respective agreements. The values assigned to the respective agreements are being amortized over a three-year period as the agreements span a three-year period. Managementbelieves that it would not be prudent to assume there would be any benefit beyond the three-year period due to the nature of the industry it operates in. Theamortization of the warrant cost related to the Joint Development Agreement charged as research and development expense was $4.0 million in fiscal 2004.The amortization related to the distribution agreement included as contra-revenue in product net revenue was $1.1 million in fiscal 2004. 81Table of ContentsReport of Ernst & Young LLP, Independent Registered Public Accounting Firm The Board of Directors and Stockholders Extreme Networks, Inc. We have audited the accompanying consolidated balance sheets of Extreme Networks, Inc. as of June 27, 2004 and June 29, 2003, and the relatedconsolidated statements of operations, stockholders’ equity and cash flows for each of the three years in the period ended June 27, 2004. Our audits alsoincluded the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standardsrequire that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit alsoincludes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statementpresentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of ExtremeNetworks, Inc. at June 27, 2004 and June 29, 2003, and the consolidated results of its operations and its cash flows for each of the three years in the periodended June 27, 2004, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, whenconsidered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein. As discussed in Note 2 to the consolidated financial statements, in 2003, Extreme Networks, Inc. changed its method of accounting for goodwill andother intangible assets in accordance with guidance provided in Statement of Financial Accounting Standards No. 142, “Goodwill and Other IntangibleAssets.” /s/ Ernst & Young LLP Palo Alto, CaliforniaJuly 15, 2004 82Table of ContentsQUARTERLY FINANCIAL DATA(In thousands, except share and per share amounts)(unaudited) June 27,2004 (1) Mar. 28,2004 (2) Dec. 28,2003 (3) Sept. 28,2003 (4) Net revenue $92,158 $88,874 $83,445 $87,371 Gross margin $48,378 $45,473 $40,442 $44,903 Provision for (benefit from) income taxes $2,027 $339 $(110) $920 Net income (loss) $2,349 $(1,106) $(5,606) $2,615 Net income (loss) per share — basic $0.02 $(0.01) $(0.05) $0.02 Net income (loss) per share — diluted $0.02 $(0.01) $(0.05) $0.02 June 29,2003 (5) Mar. 30,2003 (6) Dec. 29,2002 (7) Sept. 29,2002 (8) Net revenue $87,278 $85,213 $90,216 $100,569 Gross margin $32,676 $33,920 $40,470 $43,289 Provision for (benefit from) income taxes $154,081 $(4,105) $(13,173) $(2,017)Net loss $(167,090) $(7,062) $(18,995) $(4,033)Basic and diluted net loss per share $(1.44) $(0.06) $(0.17) $(0.04)(1)Net income and net income per share include amortization of deferred stock compensation of $0.1 million, restructuring charges for excess facilities of$5.5 million, cash settlement from vendors, net of related expenses, of $5.7 million and a refund of foreign consumption tax of $2.5 million.(2)Net loss and net loss per share include amortization of deferred stock compensation of $0.2 million.(3)Net loss and net loss per share include amortization of deferred stock compensation of $0.2 million.(4)Net income and net income per share include amortization of deferred stock compensation of $0.6 million, restructuring charges for excess facilities of$1.0 million, and settlement of litigation, net of related expenses, of $2.2 million.(5)Net loss and net loss per share include a benefit related to amortization of deferred stock compensation of $2.6 million, impairment of acquiredintangible assets of $1.0 million and a $132.2 million charge included in our tax provision reflecting our provision of a full valuation allowanceagainst deferred tax assets.(6)Net loss and net loss per share include amortization of deferred stock compensation of $1.0 million.(7)Net loss and net loss per share include amortization of deferred stock compensation of $1.0 million, restructuring charges of $14.2 million and propertyand equipment write-off of $12.7 million.(8)Net loss and net loss per share include amortization of deferred stock compensation of $1.3 million. Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure Not applicable. Item 9A. Controls and Procedures Under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, we evaluated theeffectiveness of our disclosure controls and procedures, as such term is defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, asamended. Based on this evaluation, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures wereeffective as of the end of the period covered by this annual report in providing reasonable assurance that information required to be disclosed by ExtremeNetworks in reports that it files under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities andExchange Commission rules and forms. As required by Section 404 of the Sarbanes Oxley Act of 2002, we continue to test and evaluate our internal control procedures to determine whetherour controls are designed and operating effectively. The requirements of 83Table of ContentsSection 404 have caused most public companies to substantially increase the documentation of internal controls and to implement additional controls. As aresult of our testing and evaluation performed to date, we have noted that improvements could be made in the design or operation of our internal controlstructure. We believe adequate compensating controls exist in these areas; however, we are developing plans to implement improvements or additionalcontrol procedures. We have disclosed these matters to the audit committee of our board of directors and to our independent auditors. There were nosignificant changes to our internal controls during our most recent quarter that have materially affected, or are reasonably likely to materially affect, ourinternal controls over financial reporting. Item 9B. Other Information Not applicable. PART III Certain information required by Part III is incorporated by reference from Extreme’s definitive Proxy Statement to be filed with the Securities andExchange Commission in connection with the solicitation of proxies for Extreme’s 2004 Annual Meeting of Stockholders (the “Proxy Statement”). Item 10. Directors and Executive Officers of the Registrant The information required by this section is incorporated by reference from the information in the section entitled “Proposal 1—Election of Directors”in the Proxy Statement. The required information concerning executive officers of Extreme is contained in the section entitled “Executive Officers of theRegistrant” in Part I of this Form 10-K. Item 405 of Regulation S-K calls for disclosure of any known late filing or failure by an insider to file a report required by Section 16 of the ExchangeAct. This disclosure is contained in the section entitled “Section 16(a) Beneficial Ownership Reporting Compliance” in the Proxy Statement and isincorporated herein by reference. Information with respect to Item 406 of Regulation S-K is incorporated by reference to the information contained in the section captioned “Code ofEthics” in the Proxy Statement. Item 11. Executive Compensation The information required by this section is incorporated by reference from the information in the sections entitled “Directors’ Compensation”,“Executive Compensation”, “Report of the Compensation Committee on Executive Compensation” and “Stock Price Performance Graph” in the ProxyStatement. Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters The information required by this section is incorporated by reference from the information in the section entitled “Security Ownership of CertainBeneficial Owners and Management” in the Proxy Statement. Item 13. Certain Relationships and Related Transactions The information required by this section is incorporated by reference from the information in the section titled “Certain Relationships and RelatedTransactions” in the Proxy Statement. Item 14. Principal Accountant Fees and Services The information required by this section is incorporated by reference from the information in the section titled “Principal Accountant Fees andServices” in the Proxy Statement. 84Table of Contents PART IV Item 15. Exhibits and Financial Statement Schedules (a) The following documents are filed as a part of this Form 10-K: (1) Financial Statements: Reference is made to the Index to Consolidated Financial Statements of Extreme Networks, Inc. under Item 8 in Part II of this Form 10-K. (2) Financial Statement Schedules: The following financial statement schedule of Extreme Networks, Inc. for the fiscal years ended June 27, 2004, June 29, 2003, and June 30, 2002 isfiled as part of this Report and should be read in conjunction with the Consolidated Financial Statements of Extreme Networks, Inc. PageSchedule II — Valuation and Qualifying Accounts 87 All other schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto. (3) Exhibits: The exhibits listed below are required by Item 601 of Regulation S-K. Each management contract or compensatory plan or arrangement required to befiled as an exhibit to this Form 10-K has been identified. ExhibitNumber Description of Document INCORPORATED BY REFERENCE FiledHerewith Form Filing Date Number 2.1 Form of Agreement and Plan of Merger between Extreme Networks, a Californiacorporation, and Extreme Networks, Inc., a Delaware corporation. S – 1/A 03/11/99 2.1 3.1 Certificate of Incorporation of Extreme Networks, Inc., a Delaware Corporation. S – 1 02/05/99 3.1 3.2 Form of Certificate of Amendment of Certificate of Incorporation of ExtremeNetworks, Inc., a Delaware Corporation. S – 1 02/05/99 3.2 3.4 Amended and Restated Bylaws of Extreme Networks, Inc. 8 – K/A 06/07/01 3.4 3.5 Restated Certificate of Incorporation of Extreme Networks, Inc. 10 – K 09/26/01 3.5 3.6 Certificate of Amendment of Restated Certificate of Incorporation of ExtremeNetworks, Inc. 10 – K 09/26/01 3.6 3.7 Certificate of Designation, Preferences and Rights of the Terms of the Series APreferred Stock. 10 – K 09/26/01 3.7 4.1 Second Amended and Restated Rights Agreement dated January 12, 1998between Extreme Network and certain stockholders. S – 1 02/05/99 4.1 85Table of ContentsExhibitNumber Description of Document INCORPORATED BY REFERENCE FiledHerewith Form Filing Date Number 4.2 Rights Agreement dated April 27, 2001 between Extreme Networks, Inc. andMellon Investor Services LLC. 8 – K/A 06/07/01 4.2 4.3 Indenture, dated December 5, 2001 between Extreme Networks, Inc. and StateStreet Bank and Trust Company of California, N.A. S – 3 02/26/02 4.3 4.4 Registration Rights Agreement dated December 5, 2001 between ExtremeNetworks, Inc. and Goldman Sachs & Co., as representative. S – 3 02/26/02 4.4 4.5 Warrant to Purchase Common Stock issued to Avaya, Inc. S – 3 01/28/04 4.1 10.1 Form of Indemnification Agreement for directors and officers. S – 1 02/05/99 10.1 10.2* Amended 1996 Stock Option Plan and forms of agreements thereunder. S – 1 02/05/99 10.2 10.3* 1999 Employee Stock Purchase Plan. S – 1 02/05/99 10.3 10.4* 2000 Nonstatutory Stock Option Plan. 10 – K 09/24/00 10.7 10.5 Exhibit 10.14 Lease agreement dated July 28, 2000 between San TomasProperties LLC, a Delaware limited liability company, as Landlord, andExtreme Networks, Inc, a Delaware Corporation, as Tenant. 10 – Q 11/14/00 10.14 10.6 Purchase Agreement dated November 29, 2001 between Extreme Networks,Inc. and Goldman Sachs & Co., as representative. S – 3 02/26/02 10.15 10.7 2001 Nonstatutory Stock Option Plan. ScheduleTO 10/31/01 (d)(9) 12.1 Statement re: Computation of Ratios. X21.1 Subsidiaries of Registrant. X23.1 Consent of Ernst and Young LLP, Independent Registered PublicAccounting Firm. X24.1 Power of Attorney (see page 88 of this Form 10-K). X31.1 Section 302 Certification of Chief Executive Officer. X31.2 Section 302 Certification of Chief Financial Officer. X32.1 Section 906 Certification of Chief Executive Officer. X32.2 Section 906 Certification of Chief Financial Officer. X*Indicates management contract or compensatory plan or arrangement. 86Table of ContentsSCHEDULE II VALUATION AND QUALIFYING ACCOUNTSYEARS ENDED JUNE 27, 2004, JUNE 29, 2003, AND JUNE 30, 2002(In thousands) Description Balance atbeginning ofperiod Charged tocosts andexpenses Reversals tocosts andexpenses Charged tootheraccounts (Deductions) Balance atend ofperiodYear Ended June 30, 2002: Allowance for doubtful accounts $1,942 $3,913 $— $— $(3,119) $2,736Allowance for returns reserve $8,051 $8,687 $— $— $(7,776) $8,962Inventory valuation $24,911 $7,596 $(4,776) $— $(9,664) $18,067Year Ended June 29, 2003: Allowance for doubtful accounts $2,736 $— $(823) $— $418* $2,331Allowance for returns reserve $8,962 $— $— $— $(5,358) $3,604Inventory valuation $18,067 $402 $— $— $(10,140) $8,329Allowance for net deferred tax assets $— $163,127 $— $— $— $163,127Year Ended June 27, 2004: Allowance for doubtful accounts $2,331 $— $(200) $(724) $(29) $1,378Allowance for returns reserve $3,604 $1,818 $— $— $(3,196) $2,226Allowance for distributor doubtful accounts $— $— $— $724 $— $724Inventory valuation $8,329 $1,252 $— $— $(3,216) $6,365Allowance for net deferred tax assets $163,127 $6,759 $— $— $— $169,886*The amount for the year ended June 29, 2003 is an increase due to the fact that we had net recoveries of amounts that were previously written-off in excessof current year write-offs. 87Table of Contents SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed onits behalf by the undersigned, thereunto duly authorized, on September 3, 2004. EXTREME NETWORKS, INC.(Registrant)By: /s/ WILLIAM R. SLAKEY William R. Slakey Senior Vice President Chief Financial OfficerSeptember 3, 2004 POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Gordon L. Stitt and WilliamR. Slakey, and each of them, his or her true and lawful attorneys-in-fact, each with full power of substitution, for him or her in any and all capacities, to signany amendments to this report on Form 10-K and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities andExchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact or their substitute or substitutes may do or cause to be done byvirtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of theRegistrant and in the capacities and on the date indicated: /s/ GORDON L. STITT /s/ PROMOD HAQUE Gordon L. StittPresident, Chief Executive OfficerChairman of the BoardSeptember 3, 2004 Promod HaqueDirectorSeptember 3, 2004/s/ WILLIAM R. SLAKEY /s/ BOB L. COREY William R. SlakeySenior Vice President & Chief Financial Officer(Principal Financial and Accounting Officer)September 3, 2004 Bob L. CoreyDirectorSeptember 3, 2004/s/ CHARLES CARINALLI /s/ HARRY SILVERGLIDE Charles CarinalliDirectorSeptember 3, 2004 Harry SilverglideDirectorSeptember 3, 2004/s/ KENNETH LEVY Kenneth LevyDirectorSeptember 3, 2004 88Table of ContentsEXHIBIT INDEX INCORPORATED BY REFERENCE FiledHerewithExhibitNumber Description of Document Form Filing Date Number 2.1 Form of Agreement and Plan of Merger between Extreme Networks, aCalifornia corporation, and Extreme Networks, Inc., a Delaware corporation. S – 1/A 03/11/99 2.1 3.1 Certificate of Incorporation of Extreme Networks, Inc., a DelawareCorporation. S – 1 02/05/99 3.1 3.2 Form of Certificate of Amendment of Certificate of Incorporation of ExtremeNetworks, Inc., a Delaware Corporation. S – 1 02/05/99 3.2 3.4 Amended and Restated Bylaws of Extreme Networks, Inc. 8 – K/A 06/07/01 3.4 3.5 Restated Certificate of Incorporation of Extreme Networks, Inc. 10 – K 09/26/01 3.5 3.6 Certificate of Amendment of Restated Certificate of Incorporation ofExtreme Networks, Inc. 10 – K 09/26/01 3.6 3.7 Certificate of Designation, Preferences and Rights of the Terms of the SeriesA Preferred Stock. 10 – K 09/26/01 3.7 4.1 Second Amended and Restated Rights Agreement dated January 12, 1998between Extreme Network and certain stockholders. S – 1 02/05/99 4.1 4.2 Rights Agreement dated April 27, 2001 between Extreme Networks, Inc. andMellon Investor Services LLC. 8 – K/A 06/07/01 4.2 4.3 Indenture, dated December 5, 2001 between Extreme Networks, Inc. andState Street Bank and Trust Company of California, N.A. S – 3 02/26/02 4.3 4.4 Registration Rights Agreement dated December 5, 2001 between ExtremeNetworks, Inc. and Goldman Sachs & Co., as representative S – 3 02/26/02 4.4 4.5 Warrant to Purchase Common Stock issued to Avaya, Inc. S – 3 01/28/04 4.1 10.1 Form of Indemnification Agreement for directors and officers. S – 1 02/05/99 10.1 10.2* Amended 1996 Stock Option Plan and forms of agreements thereunder. S – 1 02/05/99 10.2 10.3* 1999 Employee Stock Purchase Plan. S – 1 02/05/99 10.3 10.4* 2000 Nonstatutory Stock Option Plan. 10 – K 09/24/00 10.7 10.5 Exhibit 10.14 Lease agreement dated July 28, 2000 between San TomasProperties LLC, a Delaware limited liability company, as Landlord, andExtreme Networks, Inc, a Delaware Corporation, as Tenant. 10 – Q 11/14/00 10.14 89Table of Contents INCORPORATED BY REFERENCE FiledHerewithExhibitNumber Description of Document Form Filing Date Number 10.6 Purchase Agreement dated November 29, 2001 between Extreme Networks, Inc.and Goldman Sachs & Co., as representative. S – 3 02/26/02 10.15 10.7 2001 Nonstatutory Stock Option Plan. ScheduleTO 10/31/01 (d)(9) 12.1 Statement re: Computation of Ratios. X21.1 Subsidiaries of Registrant. X23.1 Consent of Ernst and Young LLP, Independent Registered Public AccountingFirm. X24.1 Power of Attorney (see page 88 of this Form 10-K). X31.1 Section 302 Certification of Chief Executive Officer. X31.2 Section 302 Certification of Chief Financial Officer. X32.1 Section 906 Certification of Chief Executive Officer. X32.2 Section 906 Certification of Chief Financial Officer. X*Indicates management contract or compensatory plan or arrangement. 90EXHIBIT 12.1 Statement re: Computation of Ratios (in thousands, except ratio of earnings) June 27, 2004 June 29, 2003 June 30, 2002 Income (loss) from continuing operations before taxes $1,428 $(62,394) $(236,802)Fixed charges from continuing operations: Interest expense and amortization of debt discount on all indebtedness 8,354 8,191 5,064 Interest included in rent 2,400 2,700 4,066 Total fixed charges from continuing operations 10,754 10,891 9,130 Income (loss) before taxes and fixed charges $12,182 $(51,503) $(227,672) Deficiency of earnings (as defined) to fixed charges — $(62,394) $(236,802) Ratio of earnings to fixed charges (1) 1.13 — — (1)For purposes of computing the ratio of earnings to fixed charges, earnings consist of loss before provision for income taxes plus fixed charges. Fixedcharges consist of interest charges and that portion of rental expense that we believe to be representative of interest. Earnings were inadequate to coverfixed charges in fiscal 2003 and fiscal 2002.EXHIBIT 21.1 SUBSIDIARIES OF REGISTRANT NAME LOCATIONExtreme Networks International Cayman IslandsExtreme Networks Japan K.K. JapanExtreme Networks Hong Kong Limited Hong KongExtreme Networks IHC, Inc. DelawareExtreme Networks UK Limited United KingdomExtreme Networks B.V. The NetherlandsExtreme Networks GmbH GermanyExtreme Networks Sarl FranceExtreme Networks Srl ItalyExtreme Networks Canada, Inc. CanadaExtreme Networks Korea, Ltd. KoreaIHC Networks AB SwedenExtreme Networks Australia PTE, Ltd. AustraliaExtreme Networks EMEA DubaiExtreme Networks Argentina, SRL ArgentinaExtreme Networks Brasil, Ltda. BrazilExtreme Networks Mexico, Ltda. MexicoExtreme Networks Chile, Ltda. ChileExtreme Networks Singapore PTE, Ltd. SingaporeExtreme Networks China Ltd. ChinaExtreme Networks Spain, SL SpainExtreme Networks Switzerland GmbH SwitzerlandExhibit 23.1 CONSENT OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM We consent to the incorporation by reference in the following Registration Statements of our report dated July 15, 2004, with respect to the consolidatedfinancial statements and schedule of Extreme Networks, Inc. included in the Annual Report (Form 10-K) for the year ended June 27, 2004: Form Number Registration Statement Number DescriptionForm S-8 333-112831 Extreme Networks, Inc. Amended 1996 Stock Option Plan and 1999 EmployeeStock Purchase PlanForm S-3 333-112281 Common Stock Issuable on Exercise of WarrantForm S-8 333-105767 Extreme Networks, Inc. Amended 1996 Stock Option PlanForm S-8 333-76798 Extreme Networks, Inc. Amended 1996 Stock Option PlanForm S-8 333-65636 Extreme Networks, Inc. 2001 Nonstatutory Stock Option PlanForm S-8 333-58634 Extreme Networks, Inc. Individual Option Agreements Granted Under theWebstacks, Inc. 2000 Stock Option Plan and Assumed by Extreme Networks,Inc.Form S-8 333-55644 Extreme Networks, Inc. Individual Option Agreements Granted Under theOptranet, Inc. 2000 Option Plan and Assumed by Extreme Networks, Inc.Form S-8 333-54278 Extreme Networks, Inc. Amended 1996 Stock Option Plan, 1999 EmployeeStock Purchase Plan and 2000 Nonstatutory Stock Option Plan /s/ Ernst & Young LLP Palo Alto, CaliforniaAugust 30, 2004EXHIBIT 31.1 I, Gordon L. Stitt, certify that: 1.I have reviewed this annual report on Form 10-K of Extreme Networks, Inc.; 2.Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by thisreport; 3.Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4.The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined inExchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a)Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under oursupervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us byothers within those entities, particularly during the period in which this report is being prepared; (b)Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about theeffectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c)Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s mostrecent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonablylikely to materially affect, the registrant’s internal control over financial reporting; and 5.The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to theregistrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent function): (a)All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which arereasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and (b)Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internalcontrol over financial reporting. Dated: September 3, 2004 /s/ GORDON L. STITT Gordon L. Stitt Chief Executive OfficerEXHIBIT 31.2 I, William R. Slakey, certify that: 1.I have reviewed this annual report on Form 10-K of Extreme Networks, Inc.; 2.Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by thisreport; 3.Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4.The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined inExchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: (a)Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under oursupervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us byothers within those entities, particularly during the period in which this report is being prepared; (b)Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about theeffectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (c)Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s mostrecent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonablylikely to materially affect, the registrant’s internal control over financial reporting; and 5.The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to theregistrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent function): (a)All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which arereasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and (b)Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internalcontrol over financial reporting. Dated: September 3, 2004 /s/ WILLIAM R. SLAKEY William R. Slakey Chief Financial OfficerEXHIBIT 32.1 CERTIFICATION OF GORDON L. STITT AS CHIEF EXECUTIVE OFFICER, PURSUANT TO18 U.S.C. SECTION 1350,AS ADOPTED PURSUANT TOSECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of Extreme Networks, Inc. (the “Company”) on Form 10-K for the period ended June 27, 2004, as filed with theSecurities and Exchange Commission on the date hereof (the “Report”), I, Gordon L. Stitt, Chief Executive Officer of the Company, certify, pursuant to 18U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1)The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m or 78o(d)); and (2)The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ GORDON L. STITTGordon L. StittChief Executive OfficerSeptember 3, 2004EXHIBIT 32.2 CERTIFICATION OF WILLIAM R. SLAKEY AS CHIEF FINANCIAL OFFICER, PURSUANT TO18 U.S.C. SECTION 1350,AS ADOPTED PURSUANT TOSECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of Extreme Networks, Inc. (the “Company”) on Form 10-K for the period ended June 27, 2004, as filed with theSecurities and Exchange Commission on the date hereof (the “Report”), I, William R. Slakey, Chief Financial Officer of the Company, certify, pursuant to 18U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (3)The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m or 78o(d)); and (4)The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ WILLIAM R. SLAKEYWilliam R. SlakeyChief Financial OfficerSeptember 3, 2004

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