Table of Contents
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
| þ | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the fiscal year ended June 1, 2007
OR
| o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to
Commission file number: 0-12867
3COM CORPORATION
(Exact name of registrant as specified in its charter)
| Delaware | 94-2605794 | |
| (State or other jurisdiction of incorporation or organization) |
(I.R.S. Employer Identification No.) |
|
| 350 Campus Drive | ||
| Marlborough, Massachusetts | 01752 | |
| (Address of principal executive offices) | (Zip Code) |
(508) 323-1000
(Registrant’s telephone number, including area code)
(Registrant’s telephone number, including area code)
N/A
(Former name, former address and former fiscal year, if changed since last report)
(Former name, former address and former fiscal year, if changed since last report)
Securities registered pursuant to Section 12(b) of the Act:
| Title of each class | Name of each exchange on which registered | |
| Common Stock, $0.01 par value per share Preferred Stock Purchase Rights |
The NASDAQ Stock Market LLC The NASDAQ Stock Market LLC |
Securities registered pursuant to Section 12(g) of the Act: NONE
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of
the Securities Act.
Yes þ No o
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or
Section 15(d) of the Exchange Act.
Yes o No þ
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for
such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days.
Yes þ No o
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, to the best of registrant’s knowledge, in
definitive proxy or information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K. o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer,
or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in
Rule 12b-2 of the Exchange Act.
Large accelerated filer þ Accelerated filer o Non-accelerated filer o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the
Exchange Act).
Yes o No þ
As of December 1, 2006, the aggregate market value of the registrant’s common stock held by
non-affiliates of the registrant was $1,601,609,102 based on the closing sale price as reported on
the NASDAQ Global Select Market.
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of
the latest practicable date.
| Class | Outstanding at July 27, 2007 | |
| Common Stock, $0.01 par value per share | 399,502,446 shares |
DOCUMENTS INCORPORATED BY REFERENCE
| Document | Parts Into Which Incorporated | |
Proxy Statement for the Annual
Meeting of Shareholders to be held
September 26, 2007 (Proxy Statement)
|
Part III, to the extent stated herein |
3Com Corporation
Form 10-K Annual Report
For the Fiscal Year Ended June 1, 2007
Table of Contents
Form 10-K Annual Report
For the Fiscal Year Ended June 1, 2007
Table of Contents
1
Table of Contents
We use a 52 or 53 week fiscal year ending on the Friday nearest to May 31, with each fiscal quarter
ending on the Friday generally nearest August 31, November 30 and February 28. For presentation
purposes, the periods are shown as ending on August 31, November 30, February 28 and May 31, as
applicable.
We acquired majority (51 percent) ownership of Huawei-3Com Co., Ltd. (“H3C”), a China-based joint
venture, on January 27, 2006 and determined it was then appropriate to consolidate H3C’s results.
For convenience of close purposes we consolidated the results of H3C as of February 1, 2006. H3C
follows a calendar year basis of reporting and therefore results are consolidated on a two-month
time lag. In fiscal 2006, we recorded equity income for the period April 1, 2005 through January
31, 2006 and consolidated H3C’s results for the period February 1, 2006 through March 31, 2006.
Prior to 2006 we reported our equity in H3C’s net loss for H3C’s fiscal period from April 1, 2004
through March 31, 2005 and the date of formation (November 17, 2003) through March 31, 2004 in our
results of operations for fiscal 2005 and 2004.
We acquired the remaining 49 percent minority interest of H3C on March 29, 2007.
3Com, the 3Com logo, Digital Vaccine, NBX, IntelliJack, OfficeConnect, TippingPoint Technologies,
UnityOne, and H3C are registered trademarks of 3Com Corporation or its subsidiaries. TippingPoint
and VCX are trademarks of 3Com Corporation. Other product and brand names may be trademarks or
registered trademarks of their respective owners.
This Annual Report on Form 10-K contains forward-looking statements made pursuant to the safe
harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking
statements include, without limitation, statements regarding the following aspects of our business:
future growth of H3C, including strategy, growth, management of growth, dependence, expected
benefits, method of consolidation, tax rate, sales from China, adjustments to preliminary purchase
price allocation for 49 percent acquisition, and resources needed to comply with Sarbanes-Oxley and
manage operations; impact of SFAS No. 123(R) and other accounting regulations; expected annual
amortization expense; TippingPoint IPO; environment for enterprise networking equipment; challenges
relating to sales growth; supply of components; trend towards Gigabit products; research and
development focus; characteristics of IPS and certain H3C products; future sales of connectivity
products; re-assessment, development and execution of our “go-to-market” strategy; strategic
product and technology development plans; management of SCN segment to reach sustained
profitability; goal of profitability; dependence on China; ability to satisfy cash requirements for
at least the next twelve months; restructuring activities and expected charges to be incurred;
potential additional restructuring and cost reduction activities; expected sale of land; expected
cost savings from restructuring activities and integration; potential acquisitions and strategic
relationships; future contractual obligations; recovery of deferred tax assets; reserves; market
risk; outsourcing; competition and pricing pressures; and effect of litigation; and you can
identify these and other forward-looking statements by the use of words such as “may,” “can,”
“should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “intends,”
“continue,” or the negative of such terms, or other comparable terminology. Forward-looking
statements also include the assumptions underlying or relating to any forward-looking statements.
Actual results could differ materially from those anticipated in these forward-looking statements
as a result of various factors, including those set forth under Part I Item 1A Risk Factors. All
forward-looking statements included in this document are based on our assessment of information
available to us at the time this report is filed. We do not intend, and disclaim any obligation,
to update any forward-looking statements.
In this Form 10-K we refer to the People’s Republic of China as China or the PRC.
2
Table of Contents
PART I
ITEM 1. BUSINESS
GENERAL
We provide secure, converged networking solutions on a global scale to organizations of all sizes.
Our products and solutions enable customers to manage business-critical voice, video and data in a
secure, scalable, reliable and efficient network environment. We deliver networking products and
services for enterprises that view their networks as mission critical, and value cost-effective
superior performance. Our products form integrated solutions and function in multi-vendor
environments based upon open, not proprietary, platforms. Our products are sold on a worldwide
basis through a combination of value added partners and direct sales representatives.
We deliver products and solutions that support the increasingly complex and demanding application
environments in today’s businesses. We aspire to be one of the leading enterprise networking
companies by delivering innovative, secure, feature-rich products and solutions built on open
platform technology. We believe that our global presence, brand identity and intellectual property
portfolio provide a solid foundation for achieving our objectives.
On January 27, 2006, 3Com completed the purchase of an additional two percent ownership interest
in, and we assumed majority ownership of, H3C, our China-based subsidiary, from Huawei
Technologies, or Huawei. With the completion of that transaction, 3Com held a 51 percent majority
interest in and control of the joint venture and has consolidated its results from the transaction
closing date. Three years after formation of H3C, that started as a joint venture with Huawei, we
and Huawei each had the right to initiate a bid process to purchase the equity interest in H3C held
by the other. 3Com initiated the bidding process on November 15, 2006 to buy Huawei’s 49 percent
stake in H3C and our last bid of $882 million was accepted by Huawei on November 27, 2006. The
transaction closed on March 29, 2007, at which time the purchase price was paid in full.
When the joint venture was initially formed in 2003, we had three key objectives: first, to
establish a substantial presence in China, a rapidly growing large market; second, to create a
resource capable of building enterprise-class, cutting-edge switching and routing products faster
than we could deliver on our own; and third, to capitalize on a rapidly growing pool of engineering
talent. With the completion of our acquisition bringing us to 100 percent ownership of H3C we
intend to continue to deliver on the above objectives as well as to increasingly integrate the
businesses.
Since commencing the consolidation of H3C during our fourth fiscal quarter of 2006, 3Com has
reported two operating business segments: the Secure, Converged Networking (SCN) segment,
comprising our security, networking, and voice product offerings (other than H3C offerings in these
areas), and the H3C segment. See Note 19 to our Consolidated Financial Statements in Item 8 of
this Form 10-K for certain financial information relating to our segments.
In addition to our acquisition of incremental ownership in H3C, during the past year we undertook
several actions we believe will enhance our competitiveness, execution and financial performance
over the longer term. First, we continued to manage our expenses in an effort to achieve
profitability. These actions will be discussed in more detail later in this report. Second, we
focused on developing offerings that deliver on the needs of converged networking, and we began to
launch products and enter into partnership arrangements to support our open platform networking
strategy. More specifically, we have introduced multiple new products targeted at enterprises of
all sizes, including new convergence ready switch offerings and secure switches for the small and
medium enterprise, network based storage solutions for large enterprise, new security offerings
including network access control features and enhancements to our TippingPoint products.
Third, we also announced our Open Services Networking (OSN) strategic initiative which is designed
to uniquely provide enterprises and service providers with open intelligent switches and routers,
to deliver converged voice, video and security services which are designed to reduce total cost of
acquisition and ownership. OSN is intended to allow customers the freedom to innovate with an open
“ecosystem” of open source, best of breed and 3Com technologies to enable the rapid development and
deployment of new networking solutions in a timeframe that is driven by the customer.
During the fiscal year ended June 1, 2007, we focused on continuing the profitable growth of our
H3C segment while reducing expenses in our SCN segment in a manner intended to limit the impact on
revenues. In our 2008 fiscal year we intend to focus on growth in each of our segments, while
maintaining our focus on controlling costs in our business.
3
Table of Contents
3Com was incorporated in California on June 4, 1979 and reincorporated in Delaware on June 12,
1997. Our corporate headquarters are located in Marlborough, Massachusetts. We have offices and
sales capabilities in 35 countries and 60 locations worldwide. Our Web site address is
www.3Com.com. We make available on our Web site, free of charge, our SEC filings (including our
Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, Section 16
filings on Forms 3, 4 and 5, and any amendments to those reports) as soon as reasonably practicable
after we electronically file with or furnish such material to the Securities and Exchange
Commission (SEC). The information contained on our Web site is not incorporated by reference in
this Annual Report on Form 10-K.
SECURED, CONVERGED NETWORKING “SCN” SEGMENT PRODUCTS AND SERVICES
Networking needs vary among customers and, therefore, we offer a broad line of products and
solutions. We strive to meet our customers’ needs by delivering scalable, feature-rich, high
performance, reliable, and secure standards-based networking solutions.
Our long-term technology-based strategy centers on enterprises and public sector organizations
migrating to secure IP-based infrastructures that deliver converged voice and data applications.
Our products and services can generally be classified in the following categories:
| § | Security; | ||
| § | IP Telephony; | ||
| § | Networking; and | ||
| § | Services. |
During fiscal 2007 we decided to discontinue our connectivity products through an “end-of-life”
program. The revenues from these products over the past three fiscal years were $15.4 million for
2007, $39.8 million for 2006 and $54.0 million for 2005. With the exception of certain revenue
sharing and royalty relationships associated with the technologies for these products we expect the
revenues from this business to be insignificant on a going-forward basis.
Each of our principal product categories and service offerings is described in greater detail
below.
Security
We have a comprehensive security portfolio that includes end-to-end solutions for core-to-edge
protection. Organizations can choose to implement overlaid or embedded security solutions that are
automatic and centrally manageable and which provide adaptive and dynamic protection.
Our security products include the following:
| § | Intrusion Prevention Systems; | ||
| § | Network Access Control; and | ||
| § | Firewalls. |
Intrusion Prevention Systems
Our TippingPoint™ line of intrusion prevention systems (IPS) are hardware-based products utilizing
high-speed network processors and Field Programmable Gate Arrays (FPGAs) that can operate at
multi-Gigabit speeds. Our hardware platform is complemented by a robust security-oriented
operating system and suite of vulnerability filters that can be dynamically updated. Our
TippingPoint IPS offers bandwidth management, peer-to-peer protection, and default “Recommended
Settings” to accurately block malicious traffic automatically upon installation without tuning.
The TippingPoint IPS provides application protection, performance protection and infrastructure
protection through total packet inspection, which means that our system reviews all data processed
through it for viruses and other malicious traffic. Application protection capabilities provide
fast, accurate, reliable protection from internal and external cyber attacks. Through its
infrastructure protection capabilities, the TippingPoint IPS protects IP telephony infrastructure,
routers, switches, DNS and other critical infrastructure from targeted attacks and traffic
anomalies. Our performance protection capabilities enable customers to throttle non-mission
critical applications that hijack valuable bandwidth and IT resources, thereby aligning network
resources and business-critical application performance.
4
Table of Contents
The switch-like performance characteristics of the TippingPoint IPS allow it to be placed at the
core, in-line at the perimeter, on internal network segments, and at remote site locations with
minimal or no adverse network impact. Additionally, our IPS solutions are deployed and managed
using a scalable, tiered Security Management System (SMS). Using SMS, customers implement and
manage coherent, enterprise-wide security policies based on rules and thresholds set within the
SMS. The SMS offers a rich reporting system, allowing customized reports to be generated and
distributed automatically on a scheduled basis. Support for multiple user profiles allows a range
of users, such as administrators and executives, access to this management system.
We provide a real-time update service, called Digital Vaccine® service, which automatically and
rapidly delivers vulnerability filters against the latest threats. To facilitate the creation of
Digital Vaccine filters, our Threat Management Center monitors and collects security intelligence
from customers and security agencies around the world. Based on this intelligence, we perform
investigations of new software vulnerabilities and create antidotes that are delivered directly to
our products.
Network Access Control
We offer Network Access Control (NAC) features which enable enterprises to enforce device and user
policies to ensure endpoint compliance, through our TippingPoint NAC Enforcer offering. We are
developing additional products for NAC functionality as well as investigating the integration of
this technology into other network offerings.
Firewalls
We offer a range of firewall solutions including embedded, standalone and application or
situation-specific offerings. Our firewall solutions are designed to protect networks by
preventing unauthorized network access, blocking attacks and encrypting traffic traveling across
the Internet.
Our firewall solutions include the following:
| § | Integrated switch firewalls; | ||
| § | Secure network interface cards; | ||
| § | Secure switches and routers; and | ||
| § | SMB VPN firewall devices with Content Filter Services. |
Internet Protocol (IP) Telephony
Voice communications are a mission critical function for businesses of all kinds and sizes around
the world. IP is ubiquitous today both within an enterprise and outside of it, providing the
ability for software applications and computers to communicate in an efficient manner. We offer a
broad portfolio of IP telephony products that work together to deliver business-focused
applications, including: next-generation dial tone, IP messaging, IP presence, IP conferencing, IP
mobility and IP customer contact center services. Our secure, Session Initiation Protocol
(SIP)-driven platform and applications are designed to meet the performance expectations of today’s
business environments: cost effectiveness, increased user productivity and strengthened customer
interactions. These products include the following:
| § | IP Telephony Platforms | ||
| § | Convergence Application Suite | ||
| § | IP Phones |
IP Telephony Platforms
Our IP telephony platforms deliver converged voice and data services to enterprises with
distributed or single-location networks. Our NBX® platform was initially introduced in 1998,
making it the first-to-market IP-Private Branch Exchange (PBX) system. NBX platforms provide the
benefits of industry-standard, SIP-based call control along with a robust set of built-in
applications to small to medium size businesses. Our VCX™ platform, introduced in April 2003,
delivers the benefits of SIP-based carrier-class “survivability” and next-generation network
applications to enterprises with up to thousands of users. Designed for enterprise campus,
multi-site and multinational networks, VCX platforms include modular software components that are
highly scalable – performing call control, signaling, application creation and media control.
5
Table of Contents
Convergence Application Suite
Our Convergence Application Suite includes real-time, efficiency-generating applications that share
a common infrastructure for call control, authentication, privacy, location and presence. These
applications are designed to help enterprises lower cost, improve productivity, and strengthen
customer interactions. Our Convergence Application Suite includes the following components:
| § | IP Telephony Module. Scalable and flexibly-deployed NBX and VCX solutions delivering proven reliability and cost-effective capabilities for organizations of all sizes. | ||
| § | IP Messaging Module. Messaging with server software for centralized voice mail, fax mail, and e-mail services. | ||
| § | IP Presence Module. Software for improving collaboration and communications. | ||
| § | IP Conferencing Module. Audio, video, and data sharing to cost-effectively enhance collaboration. | ||
| § | IP Mobility Module. 802.11 wireless phone and remote telecommuting options designed to address the increasing needs of a mobile workforce. | ||
| § | IP Contact Center Module. Complete multi-media customer interaction management application. | ||
| § | IP Convergence Client. Provides convenient personal portal to a variety of interpersonal communications functions including telephony, audio & video conferencing, messaging, presence, document sharing and instant messaging. | ||
| § | IP Telecommuting Module. Delivers the benefits of 3Com Converged applications to users connecting to enterprise network from remote locations. |
IP Phones
The advanced features and high-fidelity of our IP Phones are designed to help enterprises function
more productively and meet customer needs more competitively. Our IP Phones are compatible with
our NBX and VCX IP Telephony platforms. In addition to customary features, our phones include
advanced functionality such as power over ethernet, or PoE, interactive display, intuitive user
interface and browser-based administration.
Our line of phones consists of the following products:
| § | 3108 Wireless Phone; | ||
| § | 3106/3107 Cordless Phones; | ||
| § | 3105 Attendant Console; | ||
| § | 3103 Manager Phone; | ||
| § | 3102 Business Phone; | ||
| § | 3101 Basic Phone and with Speaker | ||
| § | 3100 Entry Phone. |
Networking
In order to meet the business and technology needs of our customers, our networking infrastructure
products focus on the requirements for a secure, converged network: availability, performance,
scalability and ease-of-use. We focus on reducing complexity by making management and
configuration of secure, converged voice and data networking much easier, and we continue to
innovate around a standards-based, open architecture that supports multi-vendor environments.
We deliver our networking infrastructure capabilities in the following categories of data
networking infrastructure products and solutions, each of which is described in greater detail
below:
| § | Local Area Network (LAN) Switches; | ||
| § | Routers and Gateways; | ||
| § | Mobility and Wireless LAN; and | ||
| § | Network and Security Management. |
6
Table of Contents
LAN Switches
Switches are multi-port devices, located in the network core and at the network edge, that join
multiple computers and peripheral devices and serve as the foundation for transporting voice, video
and data over a network. We offer a number of fixed-configuration and modular chassis switches
that we believe provide the performance and flexibility required by our customers.
Our switching products represent a broad offering, including full-featured modular, stackable and
stand-alone switches ranging from 10 Megabits per second (Mbps) to near Terabit per second
performance. Our switches are available as managed units, which are typically found in enterprise
environments and unmanaged, standalone units, typically used by small and medium-sized
organizations. We design our enterprise-class switches to share a common operating system and user
interface that work together to lower the cost of ownership and management. We offer a number of
switching products, which we generally classify in the following families:
| § | Core Switching. We offer modular chassis core networking solutions in our Switch 8800 series and Switch 7750 series of products. They are highly resilient, secure and convergence-ready, with Layer 2 and Layer 3 IPv4 and IPv6 Gigabit Ethernet and 10-Gigabit connectivity. The 7750 series can also be used in conjunction with the 8800 as either an aggregation or edge switch capable of delivering PoE, as well as Quarantine Protection, a feature of our TippingPoint Security Management System. | ||
| § | Gigabit Ethernet Switching. Our Switch 5500G, 4500G, 4200G families of products address the growing requirements for Gigabit speeds at the edge of the network as well as features such as PoE, security and Quarantine Protection. These stackable switches are offered in configurations to provide customers with both 24- and 48-port models and built-in 10-Gigabit expansion slot capability. | ||
| § | Fast Ethernet Switching. We offer a full range of fixed-configuration switches that deliver performance and flexibility to the edge of the network. These include enterprise-class offerings such as the Switch 5500 family, Switch 4500 and Switch 4200 families of products, as well as our OfficeConnect® and Baseline series. Several of these switches are available in managed and unmanaged configurations, offer line speeds of 10/100/1000 Mbps and incorporate PoE technology allowing power from the wiring closet to be supplied to any compliant device, including IP phones, wireless LAN access points and IntelliJack® products. |
Routers and Gateways
Our enterprise routers, in combination with our other networking infrastructure products, provide a
means of transporting converged voice and data traffic across an IP Wide Area Network (WAN) while
preserving the Quality of Service (QoS) required for mission critical applications.
Our enterprise routers, all of which support a variety of WAN connection speeds, are offered in the
following three families of products:
| § | Router 6000 Products. The Router 6000 series of products bring enterprise-class WAN routing features, redundancy and performance to the regional offices of large enterprise customers and to the headquarters of medium-sized businesses. | ||
| § | Router 5000 Products. The Router 5000 series of modular products are designed to connect corporate sites, from small branch to large regional offices. | ||
| § | Router 3000 Products. The Router 3000 series of products provide a fixed configuration platform to securely connect small offices and remote offices of large enterprises. |
7
Table of Contents
Mobility and Wireless LAN
We offer wireless networking products and solutions that enable users to stay connected to the
network while at their desks or roaming within an enterprise or a large campus environment. The
productivity increase associated with this ease of information access in a secure manner is driving
many businesses to deploy wireless networks. We offer a complete portfolio of high-performance,
standards-based wireless solutions, including 802.11 a/b/g wireless standards, along with wireless
security and policy enforcement.
Our wireless product offerings include the following:
| § | Wireless LAN Access Points – stand-alone and managed; | ||
| § | Wireless Controllers and Switches; | ||
| § | Wireless Routers; | ||
| § | Wireless Bridges; and | ||
| § | Wireless Switch Manager. |
Network and Security Management
We offer flexible and comprehensive network and security management application packages for
advanced IT environments. Our network and security management applications help our customers
manage large and small wired and wireless networks with tools for network monitoring, device
control and fast problem resolution. Our network management applications include the following
solutions:
| § | Network Supervisor. Practical, easy-to-use software, downloadable from the Internet, maps and monitors the network and quickly alerts administrators to emerging problems. | ||
| § | Network Director. Turnkey management application suite offering advanced monitoring and control features to IT managers. | ||
| § | Enterprise Management Suite. Comprehensive and flexible solutions for very large enterprise environments. | ||
| § | Solutions for Open Management Platforms. A selection of solutions that enable enterprises to choose management applications that meet their business and technical needs. | ||
| § | Security Management System. A scalable and flexible reporting tool used to manage our intrusion prevention system, TippingPoint SMS enables users to manage multiple devices and reports on network security activity. |
Services
We provide our channel partners and customers a single point of accountability for service
performance and quality. Our global service offerings cover key aspects of support that customers
need to keep their data networking and voice solutions operating effectively, including telephone
support, hardware replacement, software updates, dedicated on-site engineers and spare parts. We
also offer high-end professional services and training to provide complete product plus service
solutions for our customers. Our portfolio of professional services includes assessment and
design, project management, training and certifications, installation, and integration services
that are especially important to our customers that purchase higher-end switches, routers and IP
telephony communications systems.
We have a team of highly skilled and professional in-house services experts and also partner with
select third party service providers and we offer customers the benefits of virtually integrated
services resources. Additionally, we have agreements with local and regional professional
services providers to augment our onsite coverage and meet the demand for our services.
H3C
H3C Technologies, our wholly-owned Chinese subsidiary, began operations on November 17, 2003. H3C
is domiciled in Hong Kong, and its principal operating center is in Hangzhou, China.
8
Table of Contents
H3C
SEGMENT PRODUCTS AND SERVICES
H3C products can generally be classified in the following categories:
| § | Networking – LAN Switches, Routers, Network Management Software and Access Control Server; | ||
| § | Security – Firewalls and VPN Gateways; | ||
| § | Emerging Technology – IP Storage and IP Video Surveillance; and | ||
| § | Services. |
Each of H3C’s principal product categories are described in greater detail below. H3C is
significantly dependent on its China operations.
LAN Switches
H3C offers customers a full portfolio of LAN switch products ranging from switches for the small
business market to enterprise-class switches to Metro Ethernet Switches geared to the carrier
markets. H3C’s switches enable customers to easily upgrade their network solution as their
business and network requirements grow. H3C switches also include robust network security
features, and are built to support the convergence of data, voice and video.
| § | Core Routing Switches. The S9500 Series 10G Multi-service Core Routing Switch is a new generation high performance switch. It is extensively applied as the core layer of E-government networks, campus networks, education networks and other enterprise networks and core layer or aggregation layer of carriers’ IP Metro Area Networks (MANs). Moreover, based on the 10G platform, it supports the new generation high-speed 10Gbps interface card that provides interconnection between MANs, campus networks and data centers to construct end-to-end Ethernet, featuring cost-effective, high performance and reliability to support abundant services. Furthermore, it provides Layer 2 and Layer 3 wire-speed packet forwarding and distributed Multi-protocol Label Switching (MPLS) wire-speed forwarding by its high performance, high density and high reliability chassis architecture design. It also provides rich service functions, such as a QoS guarantee, complete security management and high reliability. The S9500 series is designed to fully satisfy the requirements of end-users seeking, its high capability, high reliability and multiple services. | ||
| § | Multi-Service Switches. The S7500 Series high-end multi-service switch features high performance, high port density and high flexibility. It can be applied to the core layer of enterprise networks, campus networks and education MANs, to the convergence layer of carriers’ IP MANs, and to the access layer of data centers. The S7500 Series switch can provide Layer 2 and Layer 3 switching. It can provide high-speed links for MAN, campus networks and data centers based on the 10GE platform and offer service functions, such as NAT/NetStream/PBR and PoE solutions, a powerful QoS guarantee, a comprehensive security management mechanism and high level carrier-class reliability, designed to fully satisfy the requirements of high-end users for multiple services. | ||
| § | Layer 3 Intelligent and Resilient Switches. The S5600 Series Switches are innovative switches that improve LAN operating efficiency by integrating leading technology called Intelligent Resilient Framework (IRF). These switches allow high stacking bandwidth up to 96G, high density GE, 10GE uplink and a swappable power supply unit. This series represents the next generation of desktop switches, which can help customers implement a gigabit Ethernet core network or aggregation layer with high availability as well as scalability. | ||
| § | Layer 2 Intelligent Gigabit Ethernet Switches. The S5000 Series are intelligent Layer 2 wire-speed Gigabit Ethernet switching products that provide high capacity with a full range of features. With the high performance ASIC and flexible modular structure, they provide Layer 2-Layer 7 intelligent flow classification and Access Control Lists (ACL) policies. They implement complete service control and user management, so they are suitable for the access layer switches in enterprise networks and MANs. |
9
Table of Contents
| § | Fast Ethernet Layer 3 Intelligent and Resilient Switches. The S3900 Series Ethernet Switches are a new generation of premier multi-layer switches that are designed to meet the enterprise customers’ requirement of designing and implementing a unified, highly resilient network. One of the most important and innovative elements of these switches, is their IRF technology that allows network managers to build affordable stackable networks with the high resilience, flexibility and exceptional performance of larger systems. | ||
| § | 10/100 Mbps Enhanced Layer 3 Switches. The S3500 Series Switches are Layer 3 wire-speed Ethernet switches with 10/100M aggregation in service provider data centers, server cluster, wiring cabinet and MANs. It provides six types of high performance Ethernet switches. Running on H3C’s (VRP) networking operating system, this series of products provides abundant routing protocols, Virtual LAN (VLAN) switching, traffic management, QoS, powerful bandwidth control and user management. | ||
| § | 10/100 Mbps Enhanced Layer 2 Intelligent and Access Switches. The S3000 and S2000-EI Series are intelligent Layer 2 wire-speed Ethernet switching products that are designed to meet the needs of large-capacity switching and high QoS requirements. This series utilizes high performance ASICs and a flexible modular structure, providing Layer 2 through Layer 7 intelligent flow classification, complete QoS, comprehensive service control and subscriber management. It can be used as the access layer switch for service control, user management and network security guarantee in enterprise networks and MANs. | ||
| § | Unmanaged Ethernet Switches. The S1000/1200 Series is a non-intelligent, Layer 2 wire speed switch. By deploying power plug and play and fan-less design, it provides a perfect silent desktop access solution for offices. The S1000 series provides 10/100M Ethernet ports while the S1200 series supports 10/100/1000M Ethernet ports. With minimum cost required for network management, this product line is an ideal choice for the small and home office environment. |
Routers
H3C offers a full portfolio of router products from carrier-class core routers to modular routers
to small business access routers designed to scale as these businesses grow. H3C router products
are classified as either NetEngine Series Routers or AR Series Routers. All NetEngine routers are
IPv6 ready and include carrier-class availability with redundancy in all key modules to support
multiple services such as Multi-protocol Label Switching Virtual Private Network (MPLS VPN),
Multi-protocol Label Switching Traffic Engineering (MPLS TE), Multicasting and Netstream. The AR
Series Routers support multiple services, integrating data voice and video in one device. They are
also easy to manage, offer VPN functionality as well as support multiple security products
including firewalls, IPS and Intrusion Detection Systems (IDS).
| § | NetEngine SeriesRouters. The NetEngine family of routers is purchased from Huawei Technologies under an original equipment manufacturing agreement. These core routers consist of products from a super-large capacity core router, which can be applied in the national backbone networks, provincial backbone networks and other super-large networks (including those serving at the backbone network edge and MAN core, to those working at the core networks of industries and enterprises). Incorporating advanced technologies such as a 10G/40G interface, three-stage switching fabric, optical shelf interconnection for multi-chassis stack, network processors (NP) for forwarding engine, and the mature, stable VRP routing software, it can meet the availability requirements and the multi-service demands of carrier-class and large enterprise networks. | ||
| § | AR Series Routers. The AR Series Routers support multiple services, integrating data voice and video in one device. The BIMS system provides easy-to-use management tools. These routers offer VPN functionality (L2TP, GRE, IPSec and MPLS VPN) as well as support multiple security products including firewalls, IPS and Intrusion Detection Systems (IDS), ACL, Authentification, Authorization, and Accounting (AAA), CA, and Huawei Terminal Access Controller Access Control System (Huawei-TACAS+). |
10
Table of Contents
| § | Intelligent Multi-Service Enterprise Core Routers. The AR46 Intelligent Multi-Service Enterprise Core Routers are multi-service routers with high performance and reliability developed for enterprise, industry and carrier networks. AR46 routers can serve as central routers for carrier networks. The AR46 routers are designed to meet enterprise and carrier requirements for network performance, service integration, high reliability, high security and three-in-one solutions. | ||
| § | Modular Branch Routers. The AR28 Series are modular multi-service branch routers, providing flexible LAN and WAN options, comprehensive security and VPN solutions, and voice and data integration. The extended performance, high density, enhanced security and concurrent applications enable the AR28 Series to meet the growing demands of enterprises. | ||
| § | Fixed Port Branch Routers. The AR18 Series Access Routers are fixed-port products for small-sized enterprises and branch offices. They feature enhanced security, superior reliability and advanced QoS services. |
Network Management System
The Quidview network management software is a suite of scalable tools for simplifying network
management and maintenance. Quidview implements comprehensive IP-based network management
applications, providing total and unified network management solutions, such as centralized network
monitoring, fault management, performance monitoring, multi-vendor device management, device
management and cluster management. It has the ability to construct effective network management
solutions, network environments at all levels, according to user’s demands.
Comprehensive Access Management Server (CAMS)
CAMS is a comprehensive identity-based access control server for the network infrastructure of H3C
switches, routers and security devices. As the enterprise network user management center, CAMS
provides LAN, VPN, wireless access management, authentication, authorization and accounting. CAMS
is at the heart of the integration and control layer, constructing a multiple service management,
maintenance, and security control framework with high interoperability within existing enterprise
systems.
Firewalls
SecPath Firewalls are new-generation firewalls designed to provide a flexible, high-performance
security solution for large and medium-enterprise central sites and service providers. SecPath
firewall series products integrate DoS, DDoS depth defense system, VPN and traffic management
functionality and offer high levels of total throughput for firewall and VPN support.
VPN Gateways
SecPath VPN Gateways provide total VPN solutions from SOHO to large enterprise. They support all
mainstream VPN technologies (such as Layer 2 Tunneling Protocol Virtual Private Network (L2TP VPN),
Generic Router Encapsulation Virtual Private Network (GRE VPN), IP Security Virtual Private Network
(IPSec VPN), Secure Socket Level Virtual Private Network (SSL VPN), Dynamic VPN and MPLS VPN),
providing complete QoS and flow control ability, enabling users to deploy cost-effective remote
access, extranet and intranet security.
IP Storage
The NeoOcean series of IP storage products are used in IPTV/ stream-media VOD/medical care/power
supply/ social insurance/ taxation datacenters and disaster back-up centers.
11
Table of Contents
IP Video Surveillance
These newly developed products can be deployed in public security checkpoints, road safety
monitoring spots, cashier checkout counters, hotels and private property monitor locations. Market
demands are driven by metro-level applications, mass utilization and high resolution needs. The
increase in national safety and public security concerns around the world has contributed to market
demand for these products.
Services
H3C global service offerings cover key aspects of support that customers need to keep their data
networking and voice solutions operating effectively, including telephone support, hardware
replacement, software updates, dedicated on-site engineers and spare parts. H3C also offers
high-end professional services and training to provide complete product plus service solutions for
its customers. The portfolio of professional services includes assessment and design, project
management, training and certifications, installation, and integration services that are especially
important to customers that purchase higher-end switches, routers and IP telephony communications
systems.
CUSTOMERS AND MARKETS
Through our SCN segment we have a global installed base of enterprise and small and medium-sized
business customers. These organizations range across a number of vertical industries, including
education, government, healthcare, manufacturing, finance, insurance and real estate. In addition
to a growing number of enterprise customers (in areas such as government, finance, education,
education, energy, communication, manufacturing, health and commercial buildings markets), H3C also
has access to a strong, increasing base of carrier customers, primarily through OEM sales to
Huawei.
H3C’s customers and end-users span across a wide range of enterprises and vertical markets. Huawei
traditionally has sold H3C products primarily to the carrier markets in both China and overseas.
Through channel partners in and outside of China and through other key strategic partners H3C
maintains coverage of the IP networking and data communication market in most geographies and
industries.
We target major customer groups that:
| § | view their networks as mission-critical tools that help them to deliver mandatory and/or value-add differentiated services to their customers or constituents; | ||
| § | seek convergence-ready voice and data solutions and wireless solutions that are standards-based to reduce complexity and protect their investments; and | ||
| § | value networking solutions that are affordable to acquire, operate, maintain and expand. |
SALES, MARKETING AND DISTRIBUTION
We use a broad distribution channel to bring our products and solutions to our customers. Our
two-tier distribution channel comprises distributors and resellers.
Although a majority of our sales of enterprise networking products are made through our two-tier
distribution channel, we also work with global systems integrators, service providers and direct
marketers. Additionally, we maintain a field sales organization targeting small, medium and large
enterprise accounts in conjunction with our partners.
COMPETITION
We compete in the networking infrastructure market, providing a broad portfolio of secure,
converged voice and data networking products to small, medium, and large size organizations and,
through our H3C segment’s OEM sales, carrier customers. The market for our products is
competitive, fragmented and rapidly changing. We expect competition to continue to intensify.
Many of our competitors are bringing new solutions to market, focusing on specific segments of our
target markets and establishing alliances and original equipment manufacturers (OEM) relationships
with larger companies, some of which are our partners as well.
12
Table of Contents
Our principal competitors include Avaya Inc., Cisco Systems, Inc., D-Link Systems, Inc., Enterasys
Networks, Inc., Extreme Networks, Inc., F5 Networks, Inc., Foundry Networks, Inc., Hewlett-Packard
Company, Internet Security Systems, Inc. (acquired by IBM), Juniper Networks, Inc, McAfee, Inc.,
Alcatel, Mitel Networks Corporation, NETGEAR, Inc., and Nortel Networks Corporation. In addition,
H3C also competes with key regional competitors such as Allied Telsis, Inc. (formerly Allied
Telesyn), Buffalo Inc., Digital China, Hitachi, Huawei, and ZTE Corporation. Many of our
competitors are larger than us and possess greater financial resources.
We believe the primary competitive factors in the enterprise networking infrastructure market are
as follows:
| § | Maintain tier-one capability and presence. To maintain tier-one capability and presence, a provider must have a comprehensive distribution channel and a strong financial position. In addition, that provider must have a globally-recognized and preferred brand and provide strong service and support capabilities. | ||
| § | Offer innovative products and solutions. To be considered innovative, a provider must deliver a broad line of products and solutions and maintain a substantial intellectual property portfolio. |
RESEARCH AND DEVELOPMENT
Our research and development approach focuses internal investments upon those core activities that
are necessary to deliver differentiated products and solutions and drive reductions in product
costs. Our current areas of focus include security, convergence, wireless networking, and advanced
switching and routing solutions. For activities such as mature technologies or widely available
product design components, we work with contract developers and third parties for sourcing these
components. We believe this two-part approach increases our ability to bring products to market
in a timely and cost effective manner and ensures that we are focused upon those product attributes
that matter most to our customers and clearly differentiate the products we deliver.
Our SCN segment relies on H3C’s engineering talent for new product development of enterprise
switches and routers and on certain third party developers for small and medium size networking
offerings. Our SCN segment develops our voice and security offerings, including, TippingPoint’s
Intrusion Prevention Systems and Digital Vaccine security products. H3C uses its own engineers to
develop the H3C core product portfolio.
Our research and development expenditures were $215.6 million in fiscal 2007, $101.9 million in
fiscal 2006, and $94.6 million in fiscal 2005.
SIGNIFICANT CUSTOMERS AND PRODUCTS
For information regarding customer and product concentration for each of the last three fiscal
years, see Note 19 to our Consolidated Financial Statements in Item 8 of this Annual Report on Form
10-K.
FINANCIAL INFORMATION ABOUT SEGMENT, FOREIGN AND DOMESTIC OPERATIONS AND EXPORT
SALES
Segment financial data are set forth in Management’s Discussion and Analysis of Financial Condition
and Results of Operations in Item 7, and in Note 19 of the Notes to the Company’s Consolidated
Financial Statements, which appears in Item 8 of this Annual Report on Form 10-K for the fiscal
year ended May 31, 2007. A significant portion of our revenues are derived from overseas
operations. The profitability of our segments is affected by fluctuations in the value of the U.S.
dollar relative to foreign currencies. See the Geographic Information portion of Note 20 for
further information relating to sales and long-lived assets by geographic area and Management’s
Discussion and Analysis of Financial Condition and Results of Operations.
We market our products in all significant global markets, primarily through subsidiaries, sales
offices, sales representatives, and relationships with OEMs and distributors with local presence.
Outside the U.S., we have several research and development groups, with the two most significant
being in China and the U.K. We also use contract developers in India. We maintain sales offices
in 35 countries outside the U.S.
13
Table of Contents
BACKLOG
Our backlog as of June 1, 2007, the last day of our 2007 fiscal year, was approximately $65.7
million (including $54.8 million of H3C backlog as of March 31, 2007), compared with backlog of
approximately $69.8 million (including $45.9 million of H3C backlog as of March 31, 2006) as of
June 2, 2006, the last day of our 2006 fiscal year. We include in our backlog purchase orders for
which a delivery schedule has been specified for product shipment within one year. Generally,
orders are placed by our customers on an as-needed basis and may be canceled or rescheduled by the
customers without significant penalty to the customer. Accordingly, backlog as of any particular
date is not necessarily indicative of our future sales.
SEASONALITY
Our H3C segment’s calendar first quarter generally experiences some seasonal effect on sales, due
to the Chinese New Year which typically falls during that quarter. Our SCN segment revenues and
earnings have not demonstrated consistent seasonal characteristics.
MANUFACTURING AND COMPONENTS
For the SCN segment we outsource the majority of our manufacturing and our supply chain management
operations to contract manufacturers and original design manufacturer suppliers, with our H3C
segment handling the remainder of these functions. This is part of our strategy to maintain global
manufacturing capabilities and to reduce our costs. This subcontracting includes activities such as
material procurement, assembly, test, shipment to our customers and repairs. We believe this
approach enables us to reduce fixed costs and to quickly respond to changes in market demand. We
have contract manufacturing arrangements with several companies, of which Jabil Circuits and Accton
Technology Corp. were the two most significant during fiscal 2007 and Flextronics International and
Jabil Circuits were the two most significant during fiscal 2006. Based on current and forecasted
demand, our contract manufacturers are expected to have an adequate supply of components required
for the production of our products.
We determine the components that are incorporated in our products and design the supply chain
solution. Our suppliers manufacture based on rolling forecasts. Each of the suppliers procures
components necessary to assemble the products in our forecast and test the products according to
our specifications. Products are then shipped directly to our logistics provider. We generally do
not own the components and our customers take title to our products upon shipment from the
logistics provider or, in some cases, upon payment. In certain circumstances, we may be liable to
our suppliers for carrying costs and obsolete material charges for excess components purchased
based on our forecasts.
For the H3C segment, a significant portion of self-designed products are also manufactured by
contract manufacturers, mainly Flextronics, System Integration Electronics and Flash Electronics.
However, H3C does retain an in-house manufacturing capability and capacity for pilot run, low
volume production, as well as special projects, and this capability includes a state-of-the-art SMT
(surface mount technology) line, backend assembly and test lines and distribution facilities.
Although we have contracts with our manufacturers, those contracts set forth a framework within
which the supplier may accept purchase orders from us. The contracts do not require them to
manufacture our products on a long-term basis.
We use standard parts and components for our products where it is appropriate. We purchase certain
key components used in the manufacture of our products from single or limited sources.
Purchase commitments with our single- or limited-source suppliers are generally on a purchase order
basis. A number of vendors supply standard product integrated circuits and microprocessors for our
products.
INTELLECTUAL PROPERTY AND RELATED MATTERS
Through our research and development activities over many years, we have developed a substantial
portfolio of patents covering a wide variety of networking technologies. This ownership of core
networking technologies creates opportunities to leverage our engineering investments and develop
more integrated, powerful, and innovative networking solutions for customers.
14
Table of Contents
We rely on U.S. and foreign patents, copyrights, trademarks, and trade secrets to establish and
maintain proprietary rights in our technology and products. We have an active program to file
applications for and obtain patents in the U.S. and in selected foreign countries where potential
markets for our products exist. Our general policy has been to seek to patent those patentable
inventions that we expect to incorporate in our products or that we expect will be valuable
otherwise. As of June 1, 2007, our SCN segment had 1,433 issued U.S. patents (including 1400
utility patents and 33 design patents) and 410 foreign issued patents. Numerous patent
applications that relate to our research and development activities are currently pending in the
U.S. and other countries. We also have patent cross license agreements with other companies. The
H3C portfolio includes 104 issued Chinese patents, over 718 pending Chinese applications, and 17
pending foreign applications. During fiscal 2007, we continued our patent licensing program,
through which we identify potential sources of licensing revenue, including investigation of
situations in which we believe that other companies may be improperly using our patented
technology.
Our SCN segment has 45 registered trademarks in the U.S. and has a total of 579 registered
trademarks in 80 foreign countries. H3C has 6 registered trademarks in China and has a total of 62
registered trademarks in 8 foreign countries. Numerous applications for registration of domestic
and foreign trademarks are currently pending for both our SCN and H3C segments.
EMPLOYEES
| Total | ||||
Sales and marketing |
1,855 | |||
Customer service and supply chain operations |
975 | |||
Research and development |
2,829 | |||
General and administrative |
650 | |||
Total |
6,309 | |||
The SCN segment has 1,456 employees and the H3C segment has 4,853 employees.
Our employees are not represented by a labor organization and we consider our employee relations to
be satisfactory. The SCN segment employee data is as of June 1, 2007 and the H3C segment employee
data is as of March 31, 2007, the date of the H3C balance sheet we consolidated into our fiscal
year 2007 balance sheet.
Please see “Management’s Discussion and Analysis of Financial Condition and Results of Operations”
for a discussion of certain restructuring actions affecting SCN employee headcount.
EXECUTIVE OFFICERS OF THE REGISTRANT
The following table lists the names, ages and positions held by all executive officers of 3Com as
of July 31, 2007. There are no family relationships between any director (or nominee) or executive
officer and any other director (or nominee) or executive officer of 3Com.
| Name | Age | Position | ||||
Edgar Masri
|
49 | President and Chief Executive Officer, 3Com; Chief Executive Officer, H3C Technologies Co., Limited | ||||
Neal D. Goldman
|
56 | Executive Vice President, Chief Administrative and Legal Officer and Secretary, 3Com | ||||
Jay Zager
|
57 | Executive Vice President and Chief Financial Officer | ||||
Robert Dechant
|
45 | Senior Vice President and General Manager, Data and Voice Business Unit | ||||
James Hamilton
|
43 | President, TippingPoint Division | ||||
Dr. Shusheng Zheng
|
40 | Chief Operating Officer, H3C Technologies Co., Limited | ||||
15
Table of Contents
In addition, Messrs. Masri, Goldman, Zager and Zheng serve on the Boards of Directors of various
subsidiaries of 3Com.
Edgar Masri has been our President and Chief Executive Officer since August 2006. Mr. Masri is
also Chief Executive Officer of H3C Technologies Co., Limited, our China-based networking equipment
subsidiary. Mr. Masri joined our Board of Directors in September 2006. Before re-joining 3Com,
Mr. Masri was a General Partner from 2000 to March 2006, and more recently an advisor, at Matrix
Partners, a leading technology venture capital firm, where he made investments in the wireless,
broadband and semiconductor industries. Mr. Masri was also Chief Operating Officer at Redline
Communications, a leading provider of advanced broadband wireless access and backhaul solutions
based in Canada, from April to August of 2006. Mr. Masri spent fifteen years as a senior manager
at 3Com, from 1985 to 2000. During this time he served as Senior Vice President and General
Manager of our Network Systems Business Unit and Premises Distribution Unit, President of 3Com
Ventures and held senior roles in our marketing group. Mr. Masri holds a Master’s degree in
electrical engineering and computer science and earned an MBA from Stanford University.
Neal D. Goldman has been 3Com’s Executive Vice President, Chief Administrative and Legal Officer
and Secretary since March 2007, and he has served as our Senior Vice President, Management
Services, General Counsel and Secretary since September 2003. Mr. Goldman also serves on the Board
of H3C Technologies. Prior to joining 3Com, Mr. Goldman worked for Polaroid Corporation from
August 1997 to September 2003. From March 2003 to September 2003, he was Executive Vice President,
Business Development and Chief Legal Officer of Polaroid and prior to that Mr. Goldman served as
Executive Vice President, Chief Administrative and Legal Officer from July 2001 to June 2002. From
August 1997 to July 2001, Mr. Goldman held a number of senior management and executive positions at
Polaroid, including Senior Vice President, General Counsel and Secretary and Deputy General
Counsel. Before joining Polaroid, Mr. Goldman served as Vice President, General Counsel and
Secretary at Nets, Inc. from March 1996 to June 1997. Before joining Nets, Inc., Mr. Goldman held a
number of positions with Lotus Development Corporation, including Vice President and General
Counsel from November 1995 to February 1996 and Deputy General Counsel and Assistant Secretary from
April 1990 to November 1995.
Jay Zager has been our Executive Vice President and Chief Financial Officer since June 2007.
Immediately prior to joining 3Com, Mr. Zager was an executive at Gerber Scientific, Inc., a leading
international supplier of sophisticated automated manufacturing systems for sign making and
specialty graphics, apparel and flexible materials, and ophthalmic lens processing. Mr. Zager
joined Gerber in February 2005 as Senior Vice President and Chief Financial Officer and was
appointed Executive Vice President and Chief Financial Officer in April 2006, a position he held
until June 2007. As a member of the senior management team of Gerber, he was responsible for
financial reporting, accounting, treasury operations, business planning, corporate development,
investor relations, tax/pension administration and information technology. Prior to joining
Gerber, Mr. Zager was Senior Vice President and Chief Financial Officer of Helix Technology Corp.,
a semiconductor equipment manufacturer, from February 2002 to February 2005. Earlier, from 2000 to
2001, he was Executive Vice President and Chief Financial Officer of Inrange Technologies Corp., a
storage networking company. Before Inrange, he was with the Compaq/Digital Equipment organization
for 14 years, holding a number of senior financial and business management positions including Vice
President, Business Development and Vice President, Chief Financial Officer of Worldwide
Engineering & Research. Mr. Zager received a Masters degree in Finance and Strategic Planning from
Sloan School of Management, Massachusetts Institute of Technology and a Bachelor of Science degree
in Operations Research from Massachusetts Institute of Technology.
Robert Dechant has been 3Com’s Senior Vice President and General Manager, Data and Voice Business
Unit since October 2006, and was our Senior Vice President, Worldwide Sales and Marketing from
April 2006 to October 2006. Prior to 3Com, from March 2003 to September 2004, Mr. Dechant was
Executive Vice President of Sales and Marketing for Modus Media International where he led sales,
marketing and client management on a global basis. Before Modus, Mr. Dechant served as Chief
Operating Officer (from December 2001 to January 2003) and Senior Vice President of Sales and
Marketing (from July 1997 to November 2001) at Stream International, Inc. He also held sales and
marketing leadership positions with Software Support Inc. which was acquired by Convergys
Corporation and Worldtek Travel, Inc. He also spent nine years in sales and marketing positions at
IBM.
16
Table of Contents
James Hamilton has served as 3Com’s President of the TippingPoint Division since November 2005.
From January to November of 2005, Mr. Hamilton served as TippingPoint’s Chief Operating Officer.
At the time 3Com acquired TippingPoint in January 2005, Mr. Hamilton was President and COO of
TippingPoint, a position he held from October 2003 to the date of acquisition. Prior to
TippingPoint, Mr. Hamilton was President and Chief Executive Officer of Efficient Networks, Inc., a
subsidiary of Siemens AG, from February 2002 to April 2003. From April 2001 to February 2002, Mr.
Hamilton served in other senior roles at Efficient Networks. Prior to Efficient Networks’
acquisition by Siemens in April 2001, he served as Executive Vice President of Worldwide Sales and
Marketing as well as General Manager of the company’s four products divisions from 1999 to 2001.
Prior to Efficient Networks, Mr. Hamilton served as Vice President of Worldwide Sales and Service
for Picazo Communications, Inc., an IP telephony company sold to Intel Corporation in late 1999. He
has previous experience as Director of the Communications Products Group at Compaq Computer
Corporation, Vice President of Sales at NetWorth, Inc., which was sold to Compaq in 1995, and
managed the North American reseller channel at 3Com Corporation.
Dr. Shusheng Zheng has served as the Chief Operating Officer of our H3C Technologies Co., Limited
subsidiary since its inception in the Fall of 2003. Previously, Dr. Zheng worked at Huawei
Technologies from 1993 to 2003. At Huawei, Dr. Zheng held positions in the research and
development department, was Director of Manufacturing and Customer Service, Head of Sales and
Marketing for the datacom business, and finally president of Huawei’s switching business unit
starting in 1998. Dr. Zheng holds a PhD in Telecommunication Science from Zhejiang University in
China.
ITEM 1A RISK FACTORS
Risk factors may affect our future business and results. The matters discussed below could cause
our future results to materially differ from past results or those described in forward-looking
statements and could have a material adverse effect on our business, financial condition, results
of operations and stock price.
Risks Related to Historical Losses, Financial Condition and Substantial Indebtedness
We have incurred significant net losses in recent fiscal periods, including $89 million for the
year ended May 31, 2007, $101 million for the year ended May 31, 2006 and $196 million for year
ended May 31, 2005, and we may not be able to return to profitability.
We cannot provide assurance that we will return to profitability. While we continue to take steps
designed to improve our results of operations, we have incurred significant net losses in recent
periods. We face a number of challenges that have affected our operating results during the
current and past several fiscal years. Specifically, we have experienced, and may continue to
experience, the following, particularly in our SCN segment:
| • | declining sales due to price competition and reduced incoming order rate; | ||
| • | operating expenses that, as a percentage of sales, have exceeded our desired financial model; | ||
| • | management changes; | ||
| • | disruptions and expenses resulting from our workforce reductions, management changes and employee attrition; | ||
| • | risk of increased excess and obsolete inventories; and | ||
| • | interest expense resulting from our senior secured loan. |
If we cannot overcome these challenges, reduce our expenses and/or increase our revenue, we may not
become profitable.
We may not be able to compensate for lower sales or unexpected cash outlays with cost reductions
sufficient to generate positive net income or cash flow.
If we do not increase our sales, we may need to further reduce costs in order to achieve
profitability. As we have implemented significant cost reduction programs over the last several
years, it may be difficult to make significant further cost reductions without in turn reducing our
sales. If we are not able to effectively reduce our costs and expenses, particularly in our SCN
segment, we may not be able to generate positive net income. If we continue to experience negative
cash flow from operations from our SCN segment over a prolonged period of time or if we suffer
unexpected cash outflows, our liquidity and ability to operate our business effectively could be
adversely affected.
We are unable to predict the exact amount of increased sales and/or cost reductions required for us
to generate positive net income because it is difficult to predict the amount of our future sales
and gross margins. Moreover, the amount of our future sales depends, in part, on future economic
and market conditions, which are difficult to forecast accurately.
17
Table of Contents
Efforts to reduce operating expenses have involved, and could involve further, workforce
reductions, closure of offices and sales or discontinuation of businesses, leading to reduced sales
and other disruptions in our business; if these efforts are not successful, we may experience
higher expenses than we desire.
Our operating expenses as a percent of sales continue to be higher than our desired long-term
financial model. We have taken, and will continue to take, actions to reduce these expenses. For
example, in June 2006 we announced a restructuring plan which focused on reducing components of our
SCN operating segment cost structure, including the closure of certain facilities, a reduction in
workforce and focused sales, marketing and services efforts. Such actions have and may in the
future include integration of businesses and regions, reductions in our workforce, closure of
facilities, relocation of functions and activities to lower cost locations, the sale or
discontinuation of businesses, changes or modifications in information technology systems or
applications, or process reengineering. As a result of these actions, the employment of some
employees with critical skills may be terminated and other employees have, and may in the future,
leave our company voluntarily due to the uncertainties associated with our business environment and
their job security. In addition, reductions in overall staffing levels could make it more
difficult for us to sustain historic sales levels, to achieve our growth objectives, to adhere to
our preferred business practices and to address all of our legal and regulatory obligations in an
effective manner, which could, in turn, ultimately lead to missed business opportunities, higher
operating costs or penalties. In addition, we may choose to reinvest some or all of our realized
cost savings in future growth opportunities or in our H3C integration efforts. Any of these events
or occurrences, including the failure to succeed in achieving net cost savings, will likely cause
our expense levels to continue to be at levels above our desired model, which, in turn, could
result in a material adverse impact on our ability to become profitable (and, if we become
profitable, to sustain such profitability).
Our substantial debt could adversely affect our financial condition; and the related debt service
obligations may adversely affect our cash flow and ability to invest in and grow our businesses.
We now have, and for the foreseeable future will continue to have, a significant amount of
indebtedness. As of May 31, 2007, our total debt balance was $430 million, of which $94 million
was classified as a current liability. These amounts represent borrowing under a senior secured
loan incurred to finance a portion of the purchase price for the March 2007 acquisition of the
remaining 49 percent equity interest in H3C. In addition, despite current debt levels, the terms
of our indebtedness allow us or our subsidiaries to incur more debt, subject to certain
limitations.
While our senior secured loan is outstanding, we will have annual debt service obligations
(interest and principal) of between approximately $48 million and $172 million. The interest rate
on this loan is floating based on the LIBOR rate; accordingly, if the LIBOR rate is increased,
these amounts could be higher. The maturity date on this loan is September 28, 2012. We intend to
fulfill our debt service obligations primarily from cash generated by our H3C segment operations,
if any, and, to the extent necessary, from its existing cash and investments. Because we
anticipate that a substantial portion of the cash generated by our operations will be used to
service this loan during its term, such funds will not be available to use in future operations, or
investing in our businesses. Further, a significant portion of the excess cash flow generated by
our H3C segment, if any, must be used annually to prepay principal on the loan. The foregoing may
adversely impact our ability to expand our businesses or make other investments. In addition, if
we are unable to generate sufficient cash to meet these obligations and must instead use our
existing cash or investments at our H3C or SCN segments, we may have to reduce, curtail or
terminate other activities of our businesses.
Our indebtedness could have significant negative consequences to us. For example, it could:
| • | increase our vulnerability to general adverse economic and industry conditions; | ||
| • | limit our ability to obtain additional financing; | ||
| • | require the dedication of a substantial portion of any cash flow from operations to the payment of principal of, and interest on, our indebtedness, thereby reducing the availability of such cash flow to fund growth, working capital, capital expenditures and other general corporate purposes; | ||
| • | limit our flexibility in planning for, or reacting to, changes in our business and our industry; and | ||
| • | place us at a competitive disadvantage relative to our competitors with less debt. |
18
Table of Contents
The restrictions imposed by the terms of our senior secured loan facility could adversely impact
our ability to invest in and grow our H3C business.
Covenants in the agreements governing our senior secured loan materially restrict our H3C
operations, including H3C’s ability to incur debt, pay dividends, make certain investments and
payments, make acquisitions of other businesses and encumber or dispose of assets. These negative
covenants restrict our flexibility in operating our H3C business. The agreements also impose
affirmative covenants, including financial reporting obligations and compliance with law. In
addition, in the event our H3C segment’s financial results do not meet our plans, the failure to
comply with the financial covenants contained in the loan agreements could lead to a default if we
are unable to amend such financial covenants. Our lenders may attempt to call defaults for
violations of financial covenants (or other items, even if the underlying financial performance of
H3C is satisfactory) in an effort to extract waiver or consent fees from us or to force a
refinancing. A default and acceleration under one debt instrument or other contract may also
trigger cross-acceleration under other debt instruments or other agreements, if any. An event of
default, if not cured or waived, could have a material adverse effect on us because the lenders
will be able to accelerate all outstanding amounts under the loan, foreclose on the collateral
(which consists primarily of the assets of our H3C segment and could involve the lenders taking
control over our H3C segment), and/or require 3Com Corporation, 3Com Holdings Limited or 3Com
Technologies to use any of their substantial cash balances under their parental guarantees of this
debt, if such guarantees have not yet been released by such time. Any of these actions would
likely result in a material adverse effect on our business and financial condition.
An adverse change in the interest rates for our borrowings could adversely affect our financial
condition.
Interest to be paid by us on our senior secured loan is at an interest rate based on the LIBOR
rate, plus an applicable margin. The published LIBOR rate is subject to change on a periodic
basis. Recently, interest rates have trended upwards in major global financial markets. If these
interest rate trends continue, this will result in increased interest rate expense as a result of
higher LIBOR rates. Continued increases in interest rates could have a material adverse effect on
our financial position, results of operations and cash flows, particularly if such increases are
substantial. In addition, interest rate trends could affect global economic conditions.
Rating downgrades may make it more expensive for us to refinance our debt or borrow money.
Moody’s Investors Service has assigned a Ba2 rating to our senior secured loans at H3C and a Ba2
corporate family rating (stable outlook) to H3C Holdings Limited, the borrower. Standard & Poor’s
Ratings Services assigned these loans a ‘BB’ rating (with a recovery rating of ‘1’) and assigned a
BB- corporate credit rating (stable outlook) to H3C Holdings Limited. We are required to maintain
a rating from each of these agencies during the term of the loan. These credit ratings are subject
to change at the discretion of the rating agencies. If our credit ratings are downgraded, it would
likely make it more expensive for us to refinance our existing loan or raise additional capital in
the future. Such refinancing or capital raising may be on terms that may not be acceptable to us
or otherwise not available. Any future adverse rating agency actions with respect to our ratings
could have an adverse effect on the market price of our securities, our ability to compete for new
business and our ability to access capital markets.
Risks Related to H3C Segment and Dependence Thereon
We are significantly dependent on our H3C segment; if H3C is not successful we will likely
experience a material adverse impact to our business, business prospects and operating results.
For the year ended May 31, 2007, H3C accounted for approximately 53 percent of our consolidated
revenue and approximately 59 percent of our consolidated gross profit. H3C, which is domiciled in
Hong Kong and has its principal operations in Hangzhou, China, is subject to all of the operational
risks that normally arise for a technology company with global operations, including risks relating
to research and development, manufacturing, sales, service, marketing, and corporate functions.
Furthermore, H3C may not be successful in selling directly to Chinese customers, particularly those
in the public sector, to the extent that such customers favor Chinese-owned competitors. Given the
significance of H3C to our financial results, if H3C is not successful, our business will likely be
adversely affected.
19
Table of Contents
Sales from our H3C segment, and therefore in China, constitute a material portion of our total
sales, and our business, financial condition and results of operations will to a significant degree
be subject to economic, political and social events in the PRC.
Our sales are significantly dependent on China, with approximately 46 percent of our consolidated
revenues attributable to sales in China for the fiscal year ended May 31, 2007. We expect that a
significant portion of our sales will continue to be derived from China for the foreseeable future.
As a result, our business, financial condition and results of operations are to a significant
degree subject to economic, political, legal and social developments and other events in China and
surrounding areas. We discuss risks related to the PRC in further detail below.
Our H3C segment is dependent on Huawei Technologies in several material respects, including as an
important customer; should Huawei reduce its business with H3C, our business will likely be
materially adversely affected.
H3C derives a material portion of its sales from Huawei. In the twelve months ended May 31, 2007,
Huawei accounted for approximately 35 percent of the revenue for our H3C segment and approximately
20 percent of our consolidated revenue. Huawei has no minimum purchase obligations with respect to
H3C. Should Huawei reduce its business with H3C, H3C’s sales will suffer. On March 29, 2007 we
acquired Huawei’s 49 percent interest in H3C for $882 million, giving us 100 percent ownership of
H3C. Since Huawei is no longer an owner of H3C, it is possible that over time Huawei will purchase
fewer products and services from H3C. We will need to continue to provide Huawei with products and
services that satisfy its needs or we risk the possibility that it sources products from another
vendor or internally develops these products. Further, we have and expect to continue to incur
costs relating to transition matters with respect to support that Huawei previously provided for
H3C when it was a shareholder. In addition, our China headquarters in Hangzhou, PRC is owned by
Huawei and leased to us under a lease agreement that expires in December 2008; if we cannot renew
this lease on terms favorable to us or find alternate facilities, we may suffer disruption in our
H3C business. If any of the above risks occur, it will likely have an adverse impact on H3C’s
sales and business performance.
We must execute on a global strategy to leverage the benefits of our H3C acquisition, including
integration activities we determine to undertake; if we are not successful in these efforts, our
business will suffer.
Our H3C acquisition presents unique challenges that we must address. We must successfully execute
on managing our two business segments, and, to the extent we so choose, integrating these
businesses, in order to fully benefit from this acquisition. As a joint venture owned by two
separate companies, H3C operated in many ways independently from 3Com and Huawei. H3C’s business
is largely based in the PRC and therefore significant cultural, language, business process and
other differences exist between our SCN segment and H3C. In order to more closely manage and, to
the extent we choose, integrate H3C, we expect to incur significant transition costs, including
management retention costs and other related items. There may also be business disruption as
management and other personnel focus on global management activities and integration matters.
In order to realize the full benefits of this acquisition, we will need to manage our two business
segments and employ strategies to leverage H3C. These efforts will require significant time and
attention of management and other key employees at 3Com and H3C. Depending on the decisions we
make on various strategic alternatives available to us, we may develop new or adjusted global
design and development initiatives, go-to-market strategies, branding tactics or other strategies
that take advantage and leverage H3C’s and SCN’s respective strengths. If we are not successful at
transitioning effectively to full ownership of H3C, or if we do not execute on a global strategy
that enables us to leverage the benefits of this acquisition, our business will be substantially
harmed.
Risks Related to Personnel
Our success is dependent on continuing to hire and retain qualified managers and other personnel,
including at our H3C segment and reducing senior management turnover in our SCN segment; if we are
not successful in attracting and retaining these personnel, our business will suffer.
Competition for qualified employees is intense. If we fail to attract, hire, or retain qualified
personnel, our business will be harmed. We have experienced significant turnover in our senior
management team in the last several years and we may continue to experience change at this level.
If we cannot retain qualified senior managers, our business may not succeed.
20
Table of Contents
The senior management team at H3C has been highly effective since H3C’s inception in 2003. We need
to continue to incentivize and retain H3C management. We cannot be sure that we will be successful
in these efforts. If we are not successful, our H3C business may suffer, which, in turn, will have
a material adverse impact on our consolidated business. Many of these senior managers, and other
key H3C employees, originally worked for Huawei prior to the inception of H3C. Subject to
non-competition agreements with us (if applicable), these employees could return to work for Huawei
at any time. Huawei is not subject to any non-solicitation obligations in respect of H3C or 3Com.
Further, former Huawei employees that work for H3C may retain financial interests in Huawei.
Risks Related to Competition
If we do not respond effectively to increased competition caused by industry volatility and
consolidation our business could be harmed.
Our business could be seriously harmed if we do not compete effectively. We face competitive
challenges that are likely to arise from a number of factors, including the following:
| • | industry volatility resulting from rapid product development cycles; | ||
| • | increasing price competition due to maturation of basic networking technologies; | ||
| • | industry consolidation resulting in competitors with greater financial, marketing, and technical resources; and | ||
| • | the presence of existing competitors with greater financial resources together with the potential emergence of new competitors with lower cost structures and more competitive offerings. |
Our competition with Huawei in the enterprise networking market could have a material adverse
effect on our sales and our results of operations; and after a contractual non-compete period
expires, Huawei can increase its level of competition, which would likely materially and adversely
affect our business.
As Huawei expands its international operations, there could be increasing instances where we
compete directly with Huawei in the enterprise networking market. As an OEM customer of H3C,
Huawei has had, and continues to have, access to H3C’s products for resale. This access enhances
Huawei’s current ability to compete directly with us. We could lose a competitive advantage in
markets where we compete with Huawei, which in turn could have a material adverse effect on our
sales and overall results of operations. In addition, Huawei’s obligation not to offer or sell
enterprise class, and small-to-medium size business (or SMB), routers and switches that are
competitive with H3C’s products continues until September 29, 2008. After that date, we are
subject to the risk of increased competition from Huawei, which could materially harm our results
of operations. More specifically, after the non-compete period expires, Huawei may offer and sell
its own enterprise or SMB routers and switches, or resell products that it sources from our
competitors. Huawei is not prohibited from developing (but not offering or selling) competing
products during the non-compete period. Huawei is also not prohibited from currently selling
products in ancillary areas—such as security, voice over internet protocol and storage
products—that are also sold today by H3C.
Huawei’s incentive not to compete with H3C or us, and its incentive to assist H3C, may diminish now
that Huawei does not own any interest in H3C. In addition, Huawei maintains a strong presence
within China and the Asia Pacific region and has significant resources with which to compete within
the networking industry, including the assets of Harbour Networks, a China-based competitor of H3C.
We cannot predict whether Huawei will compete with us. If competition from Huawei increases, our
business will likely suffer.
Finally, if any of H3C’s senior managers, and other key H3C employees that originally worked for
Huawei prior to the inception of H3C, return to work for Huawei, the competitive risks discussed
above may be heightened. Subject to non-competition agreements with us (if applicable), these
employees could return to work for Huawei at any time. Huawei is not subject to any
non-solicitation obligations in respect of H3C or 3Com. Further, former Huawei employees that work
for H3C may retain financial interests in Huawei.
21
Table of Contents
Risks Related to Business and Technology Strategy
We may not be successful at identifying and responding to new and emerging market and product
opportunities, or at responding quickly enough to technologies or markets that are in decline.
The markets in which we compete are characterized by rapid technology transitions and short product
life cycles. Therefore, our success depends on our ability to do the following:
| • | identify new market and product opportunities; | ||
| • | predict which technologies and markets will see declining demand; | ||
| • | develop and introduce new products and solutions in a timely manner; | ||
| • | gain market acceptance of new products and solutions, particularly in targeted emerging markets; and | ||
| • | rapidly and efficiently transition our customers from older to newer enterprise networking technologies. |
Our financial position or results of operations could suffer if we are not successful in achieving
these goals. For example, our business would suffer if any of the following occurs:
| • | there is a delay in introducing new products; | ||
| • | we lose certain channels of distribution or key partners; | ||
| • | our products do not satisfy customers in terms of features, functionality or quality; or | ||
| • | our products cost more to produce than we expect. |
Because we will continue to rely on original design manufacturers to assist in product design of
some of our products, we may not be able to respond to emerging technology trends through the
design and production of new products as well as if we were working independently.
We expect to utilize strategic relationships and other alliances as key elements in our strategy.
If we are not successful in forming desired ventures and alliances or if such ventures and
alliances are not successful, our ability to achieve our growth and profitability goals could be
adversely affected.
We have announced alliances with third parties, such as IBM and Trapeze Networks. In the future,
we expect to evaluate other possible strategic relationships, including joint ventures and other
types of alliances, and we may increase our reliance on such strategic relationships to broaden our
sales channels, complement internal development of new technologies and enhancement of existing
products, and exploit perceived market opportunities.
If we fail to form the number and quality of strategic relationships that we desire, or if such
strategic relationships are not successful, we could suffer missed market opportunities, channel
conflicts, delays in product development or delivery, or other operational difficulties. Further,
if third parties acquire our strategic partners or if our competitors enter into successful
strategic relationships, we may face increased competition. Any of these difficulties could have
an adverse effect on our future sales and results of operations.
Our strategy of outsourcing functions and operations may fail to reduce cost and may disrupt our
operations.
We continue to look for ways to decrease cost and improve efficiency by contracting with other
companies to perform functions or operations that, in the past, we have performed ourselves. We
have outsourced the majority of our manufacturing and logistics for our SCN products. We now rely
on outside vendors to meet the majority of our manufacturing needs as well as a significant portion
of our IT needs for the SCN segment. Additionally, we outsource certain functions for technical
support and product return services. We are currently transitioning our outsourced customer
service and support functions from a single vendor to a combination of vendors complemented by
internal sources. During this transition period, and under our new support model, if we do not
provide our customers with a high quality of service, we risk losing customers and/or increasing
our support costs. To achieve future cost savings or operational benefits, we may expand our
outsourcing activities to cover additional services which we believe a third party may be able to
provide in a more efficient or effective manner than we could do internally ourselves.
22
Table of Contents
Although we believe that outsourcing will result in lower costs and increased efficiencies, this
may not be the case. Because these third parties may not be as responsive to our needs as we would
be ourselves, outsourcing increases the risk of disruption to our operations. In addition, our
agreements with these third parties sometimes include substantial penalties for terminating such
agreements early or failing to maintain minimum service levels. Because we cannot always predict
how long we will need the services or how much of the services we will use, we may have to pay
these penalties or incur costs if our business conditions change.
Our reliance on industry standards, technological change in the marketplace, and new product
initiatives may cause our sales to fluctuate or decline.
The enterprise networking industry in which we compete is characterized by rapid changes in
technology and customer requirements and evolving industry standards. As a result, our success
depends on:
| • | the convergence of technologies, such as voice, data and video on single, secure networks; | ||
| • | the timely adoption and market acceptance of industry standards, and timely resolution of conflicting U.S. and international industry standards; and | ||
| • | our ability to influence the development of emerging industry standards and to introduce new and enhanced products that are compatible with such standards. |
Slow market acceptance of new technologies, products, or industry standards could adversely affect
our sales or overall results of operations. In addition, if our technology is not included in an
industry standard on a timely basis or if we fail to achieve timely certification of compliance to
industry standards for our products, our sales of such products or our overall results of
operations could be adversely affected.
We focus on enterprise networking, and our results of operations may fluctuate based on factors
related entirely to conditions in this market.
Our focus on enterprise networking may cause increased sensitivity to the business risks associated
specifically with the enterprise networking market and our ability to execute successfully on our
strategies to provide superior solutions for larger and multi-site enterprise environments. To be
successful in the enterprise networking market, we will need to be perceived by decision making
officers of large enterprises as committed for the long-term to the high-end networking business.
Also, expansion of sales to large enterprises may be disruptive in a variety of ways, such as
adding larger systems integrators that may raise channel conflict issues with existing
distributors, or a perception of diminished focus on the small and medium enterprise market.
Risks Related to Operations and Distribution Channels
A significant portion of our SCN sales is derived from a small number of distributors. If any of
these partners reduces its business with us, our business could be seriously harmed.
We distribute many of our products through two-tier distribution channels that include
distributors, systems integrators and value added resellers, or VARs. A significant portion of our
sales is concentrated among a few distributors; our two largest distributors accounted for a
combined 35 percent of SCN sales and 18 percent of our consolidated revenue for the year ended May
31, 2007 and a combined 35 percent of SCN sales and 30 percent of our consolidated revenue for the
year ended May 31, 2006. If either of these distributors reduces its business with us, our sales
and overall results of operations could be adversely affected.
We depend on distributors who maintain inventories of our products. If the distributors reduce
their inventories of our products, our sales could be adversely affected.
We work closely with our distributors to monitor channel inventory levels and ensure that
appropriate levels of products are available to resellers and end users. Our target range for
channel inventory levels is between three and five weeks of supply on hand at our distributors.
Partners with a below-average inventory level may incur “stock outs” that would adversely impact
our sales. Our distribution agreements typically provide that our distributors may cancel their
orders on short notice with little or no penalty. If our channel partners reduce their levels of
inventory of our products, our sales would be negatively impacted during the period of change.
23
Table of Contents
If we are unable to successfully develop relationships with system integrators, service providers,
and enterprise VARs, our sales may be negatively affected.
As part of our sales strategy, we are targeting system integrators, or SIs, service providers, or
SPs, and enterprise value-added resellers, or eVARs. In addition to specialized technical
expertise, SIs, SPs and eVARs typically offer sophisticated services capabilities that are
frequently desired by larger enterprise customers. In order to expand our distribution channel to
include resellers with such capabilities, we must be able to provide effective support to these
resellers. If our sales, marketing or services capabilities are not sufficiently robust to provide
effective support to such SIs, SPs, and eVARs, we may not be successful in expanding our
distribution model and current SI, SP, and eVAR partners may terminate their relationships with us,
which would adversely impact our sales and overall results of operations.
We may pursue acquisitions of other companies that, if not successful, could adversely affect our
business, financial position and results of operations.
In the future, we may pursue acquisitions of companies to enhance our existing capabilities. There
can be no assurances that acquisitions that we might consummate will be successful. If we pursue
an acquisition but are not successful in completing it, or if we complete an acquisition but are
not successful in integrating the acquired company’s technology, employees, products or operations
successfully, our business, financial position or results of operations could be adversely
affected.
We may be unable to manage our supply chain successfully, which would adversely impact our sales,
gross margin and profitability.
Current business conditions and operational challenges in managing our supply chain affect our
business in a number of ways:
| • | in the past, some key components have had limited availability; | ||
| • | as integration of networking features on a reduced number of computer chips continues, we are increasingly facing competition from parties who are our suppliers; | ||
| • | our ability to accurately forecast demand is diminished; | ||
| • | our reliance on, and long-term arrangements with, third-party manufacturers places much of the supply chain process out of our direct control and heightens the need for accurate forecasting and reduces our ability to transition quickly to alternative supply chain strategies; and | ||
| • | we may experience disruptions to our logistics. |
Some of our suppliers are also our competitors. We cannot be certain that in the future our
suppliers, particularly those who are also in active competition with us, will be able or willing
to meet our demand for components in a timely and cost-effective manner.
There has been a trend toward consolidation of vendors of electronic components. Our reliance on a
smaller number of vendors and the inability to quickly switch vendors increases the risk of
logistics disruptions, unfavorable price fluctuations, or disruptions in supply, particularly in a
supply-constrained environment.
Supplies of certain key components have become tighter as industry demand for such components has
increased. If the resulting increase in component costs and time necessary to obtain these
components persists, we may experience an adverse impact to gross margin.
If overall demand for our products or the mix of demand for our products is significantly different
from our expectations, we may face inadequate or excess component supply or inadequate or excess
manufacturing capacity. This would result in orders for products that could not be manufactured in
a timely manner, or a buildup of inventory that could not easily be sold. Either of these
situations could adversely affect our market share, sales, and results of operations or financial
position.
24
Table of Contents
Our strategies to outsource the majority of our manufacturing requirements to contract
manufacturers may not result in meeting our cost, quality or performance standards. The inability
of any contract manufacturer to meet our cost, quality or performance standards could adversely
affect our sales and overall results from operations.
The cost, quality, performance, and availability of contract manufacturing operations are and will
be essential to the successful production and sale of many of our products. We may not be able to
provide contract manufacturers with product volumes that are high enough to achieve sufficient cost
savings. If shipments fall below forecasted levels, we may incur increased costs or be required to
take ownership of inventory. In addition, a significant component of maintaining cost
competitiveness is the ability of our contract manufacturers to adjust their own costs and
manufacturing infrastructure to compensate for possible adverse exchange rate movements. To the
extent that the contract manufacturers are unable to do so, and we are unable to procure
alternative product supplies, then our own competitiveness and results of operations could be
adversely impacted.
In portions of our business we have implemented a program with our manufacturing partners to ship
products directly from regional shipping centers to customers. Through this program, we are
relying on these partners to fill customer orders in a timely manner. This program may not yield
the efficiencies that we expect, which would negatively impact our results of operations. Any
disruptions to on-time delivery to customers would adversely impact our sales and overall results
of operations.
If we fail to adequately evolve our financial and managerial control and reporting systems and
processes, including the management of our H3C segment, our ability to manage and grow our business
will be negatively affected.
Our ability to successfully offer our products and implement our business plan in a rapidly
evolving market depends upon an effective planning and management process. We will need to
continue to improve our financial and managerial control and our reporting systems and procedures
in order to manage our business effectively in the future. If we fail to implement improved
systems and processes, our ability to manage our business and results of operations could be
adversely affected. For example, now that we own all of H3C, we are spending additional time,
resources and capital to manage its business, operations and financial results. If we are not able
to successfully manage H3C, our business results could be adversely affected.
Risks Related to our Operations in the People’s Republic of China
China’s governmental and regulatory reforms and changing economic environment may impact our
ability to do business in China.
As a result of the historic reforms of the past several decades, multiple government bodies are
involved in regulating and administrating affairs in the enterprise networking industry in China.
These government agencies have broad discretion and authority over all aspects of the networking,
telecommunications and information technology industry in China; accordingly their decisions may
impact our ability to do business in China. Any of the following changes in China’s political and
economic conditions and governmental policies could have a substantial impact on our business:
| • | the promulgation of new laws and regulations and the interpretation of those laws and regulations; | ||
| • | enforcement and application of rules and regulations by the Chinese government; | ||
| • | the introduction of measures to control inflation or stimulate growth; or | ||
| • | any actions that limit our ability to develop, manufacture, import or sell our products in China, or to finance and operate our business in China. |
If China’s entry into the World Trade Organization, or the WTO, results in increased competition or
has a negative impact on China’s economy, our business could suffer. Since early 2004, the Chinese
government has implemented certain measures to control the pace of economic growth. Such measures
may cause a decrease in the level of economic activity in China, which in turn could adversely
affect our results of operations and financial condition.
25
Table of Contents
Uncertainties with respect to the Chinese legal system may adversely affect us.
We conduct our business in China primarily through H3C, a Hong Kong entity which in turn owns
several Chinese entities. These entities are generally subject to laws and regulations applicable
to foreign investment in China. In addition, there are uncertainties regarding the interpretation
and enforcement of laws, rules and policies in China. Because many laws and regulations are
relatively new and the Chinese legal system is still evolving, the interpretations of many laws,
regulations and rules are not always uniform. Moreover, the interpretation of statutes and
regulations may be subject to government policies reflecting domestic political changes. Finally,
enforcement of existing laws or contracts based on existing law may be uncertain, and it may be
difficult to obtain swift and equitable enforcement, or to obtain enforcement of a judgment by a
court of another jurisdiction. Any litigation in China may be protracted and result in substantial
costs and diversion of resources and management’s attention.
If PRC tax benefits available to H3C are reduced or repealed, our business could suffer.
If the PRC government changes, removes or withdraws any of the tax benefits currently enjoyed by
our H3C segment, it will likely adversely affect our results of operations. For example, H3C
enjoys preferential income tax rates due to its status as a newly-formed high technology enterprise
headquartered within a high tech zone in Hangzhou, PRC. In March 2007 the People’s National
Congress in the PRC approved a new tax reform law, effective on January 1, 2008, the broad
intention of which is to align the tax regime applicable to foreign owned Chinese enterprises with
that applicable to domestically-owned Chinese enterprises. If applicable to H3C, the effect of
this new law would be to increase the statutory income tax rate for H3C in the PRC. It is proposed
that some high-tech enterprises will be exempt from the increased rate; although much of the detail
of the new law is yet to be issued in regulations, we currently believe that we will continue to
qualify for the foreseeable future as a high-tech enterprise entitled to our existing tax
concessions.
If H3C is not exempt from this new law, other tax benefits currently enjoyed by H3C are withdrawn
or reduced, or new taxes are introduced which have not applied to H3C before, there would likely be
a resulting increase to H3C’s statutory tax rates in the PRC. Increases to tax rates in the PRC,
where our H3C segment is profitable, could adversely affect our results of operations.
H3C is subject to restrictions on paying dividends and making other payments to us.
Chinese regulations currently permit payment of dividends only out of accumulated profits, as
determined in accordance with Chinese accounting standards and regulations. H3C does business
primarily through a Chinese entity that is required to set aside a portion of its after-tax profits
– currently 10 percent — according to Chinese accounting standards and regulations to fund certain
reserves. The Chinese government also imposes controls on the conversion of Renminbi into foreign
currencies and the remittance of currencies out of China. We may experience difficulties in
completing the administrative procedures necessary to obtain and remit foreign currency. These
restrictions may in the future limit our ability to receive dividends or repatriate funds from H3C.
In addition, the credit agreement governing our senior secured loan also imposes significant
restrictions on H3C’s ability to dividend or make other payments to our SCN segment.
We are subject to risks relating to currency rate fluctuations and exchange controls and we do not
hedge this risk in China.
A significant portion of our sales and a portion of our costs are made in China and denominated in
Renminbi. At the same time, our senior secured bank loan – which we intend to service and repay
primarily through cash flow from H3C’s PRC operations – is denominated in US dollars. In July
2005, China uncoupled the Renminbi from the U.S. dollar and let it float in a narrow band against a
basket of foreign currencies. The move initially revalued the Renminbi by 2.1 percent against the
U.S. dollar; however, it is uncertain what further adjustments may be made in the future. The
Renminbi-U.S. dollar exchange rate could float, and the Renminbi could appreciate or depreciate
relative to the U.S. dollar. Any movement of the Renminbi may materially and adversely affect our
cash flows, revenues, operating results and financial position, and may make it more difficult for
us to service our U.S. dollar-denominated senior secured bank loan. We do not currently hedge the
currency risk in H3C through foreign exchange forward contracts or otherwise and China employs
currency controls restricting Renminbi conversion, limiting our ability to engage in currency
hedging activities in China. Various foreign exchange controls are applicable to us in China, and
such restrictions may in the future make it difficult for H3C or us to repatriate earnings, which
could have an adverse effect on our cash flows and financial position.
26
Table of Contents
Risks Related to Intellectual Property
If our products contain undetected software or hardware errors, we could incur significant
unexpected expenses and could lose sales.
High technology products sometimes contain undetected software or hardware errors when new products
or new versions or updates of existing products are released to the marketplace. Undetected errors
could result in higher than expected warranty and service costs and expenses, and the recording of
an accrual for related anticipated expenses. From time to time, such errors or component failures
could be found in new or existing products after the commencement of commercial shipments. These
problems may have a material adverse effect on our business by causing us to incur significant
warranty and repair costs, diverting the attention of our engineering personnel from new product
development efforts, delaying the recognition of revenue and causing significant customer relations
problems. Further, if products are not accepted by customers due to such defects, and such returns
exceed the amount we accrued for defect returns based on our historical experience, our operating
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 to identify 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 loss of market acceptance of our products and any necessary revisions may cause us to
incur significant expenses. The occurrence of any such problems would likely have a material
adverse effect on our business, operating results and financial condition.
We may need to engage in complex and costly litigation in order to protect, maintain or enforce our
intellectual property rights; in some jurisdictions, such as China, our rights may not be as strong
as the rights we enjoy in the U.S.
Whether we are defending the assertion of intellectual property rights against us, or asserting our
intellectual property rights against others, intellectual property litigation can be complex,
costly, protracted, and highly disruptive to business operations because it may divert the
attention and energies of management and key technical personnel. Further, plaintiffs in
intellectual property cases often seek injunctive relief and the measures of damages in
intellectual property litigation are complex and often subjective and uncertain. In addition, such
litigation may subject us to counterclaims or other retaliatory actions that could increase its
costs, complexity, uncertainty and disruption to the business. Thus, the existence of this type of
litigation, or any adverse determinations related to such litigation, could subject us to
significant liabilities and costs. Any one of these factors could adversely affect our sales, gross
margin, overall results of operations, cash flow or financial position.
In addition, the legal systems of many foreign countries do not protect or honor intellectual
property rights to the same extent as the legal system of the United States. For example, in
China, the legal system in general, and the intellectual property regime in particular, are still
in the development stage. It may be very difficult, time-consuming and costly for us to attempt to
enforce our intellectual property rights, and those of H3C, in these jurisdictions.
We may not be able to defend ourselves successfully against claims that we are infringing the
intellectual property rights of others.
Many of our competitors, such as telecommunications, networking, and computer equipment
manufacturers, have large intellectual property portfolios, including patents that may cover
technologies that are relevant to our business. In addition, many smaller companies, universities,
and individual inventors have obtained or applied for patents in areas of technology that may
relate to our business. The industry continues to be aggressive in assertion, licensing, and
litigation of patents and other intellectual property rights.
27
Table of Contents
In the course of our business, we receive claims of infringement or otherwise become aware of
potentially relevant patents or other intellectual property rights held by other parties. We
evaluate the validity and applicability of these intellectual property rights, and determine in
each case whether to negotiate licenses or cross-licenses to incorporate or use the proprietary
technologies, protocols, or specifications in our products, and whether we have rights of
indemnification against our suppliers, strategic partners or licensors. If we are unable to obtain
and maintain licenses on favorable terms for intellectual property rights required for the
manufacture, sale, and use of our products, particularly those that must comply with industry
standard protocols and specifications to be commercially viable, our financial position or results
of operations could be adversely affected. In addition, if we are alleged to infringe the
intellectual property rights of others, we could be required to seek licenses from others or be
prevented from manufacturing or selling our products, which could cause disruptions to our
operations or the markets in which we compete. Finally, even if we have indemnification rights in
respect of such allegations of infringement from our suppliers, strategic partners or licensors, we
may not be able to recover our losses under those indemnity rights.
OSN, our new open source strategy, subjects us to additional intellectual property risks, such as
less control over development of certain technology that forms a part of this strategy and a higher
likelihood of litigation.
We recently announced Open Services Networking, or OSN, a new networking strategy that uses open
source software, or OSS, licenses. The underlying source code for OSS is generally made available
to the general public with either relaxed or no intellectual property restrictions. This allows
users to create user-generated software content through either incremental individual effort, or
collaboration. The use of OSS means that for such software we do not exercise control over many
aspects of the development of the open source technology. For example, the vast majority of
programmers developing OSS used by us are neither our employees nor contractors. Therefore, we
cannot predict whether further developments and enhancements to OSS selected by us would be
available. Furthermore, rival OSS applications often compete for market share. Should our choice
of application fail to compete favorably, its OSS development may wane or stop. In addition, OSS
has few technological barriers to entry by new competitors and it may be relatively easy for new
competitors, who have greater resources than us, to enter our markets and compete with us. Also,
because OSS is often compiled from multiple components developed by numerous independent parties
and usually comes “as is” and without indemnification, OSS is more vulnerable to third party
intellectual property infringement claims. Finally, some of the more prominent OSS licenses, such
as the GNU General Public License, are the subject of litigation. It is possible that a court
could hold such licenses to be unenforceable or someone could assert a claim for proprietary rights
in a program developed and distributed under them. Any ruling by a court that these licenses are
not enforceable or that open source components of our product offerings may not be liberally
copied, modified or distributed may have the effect of preventing us from selling or developing all
or a portion of our products. If any of the foregoing occurred, it could cause a material adverse
impact on our business.
Risks Related to the Trading Market
Fluctuations in our operating results and other factors may contribute to volatility in the market
price of our stock.
Historically, our stock price has experienced volatility. We expect that our stock price may
continue to experience volatility in the future due to a variety of potential factors such as:
| • | fluctuations in our quarterly results of operations and cash flow; | ||
| • | changes in our cash and equivalents and short term investment balances; | ||
| • | variations between our actual financial results and published analysts’ expectations; and | ||
| • | announcements by our competitors. |
In addition, over the past several years, the stock market has experienced significant price and
volume fluctuations that have affected the stock prices of many technology companies. These
factors, as well as general economic and political conditions or investors’ concerns regarding the
credibility of corporate financial statements and the accounting profession, may have a material
adverse affect on the market price of our stock in the future.
28
Table of Contents
Risks Related to Anti-takeover Mechanisms
We have various mechanisms in place to discourage takeover attempts, which may reduce or eliminate
our stockholders’ ability to sell their shares for a premium in a change of control transaction.
Various provisions of our certificate of incorporation and bylaws and of Delaware corporate law may
discourage, delay or prevent a change in control or takeover attempt of our company by a third
party that is opposed by our management and board of directors. Public stockholders who might
desire to participate in such a transaction may not have the opportunity to do so. These
anti-takeover provisions could substantially impede the ability of public stockholders to benefit
from a change of control or change in our management and board of directors. These provisions
include:
| • | no cumulative voting for directors, which would otherwise allow less than a majority of stockholders to elect director candidates; | ||
| • | control by our board of directors of the size of our board of directors and our classified board of directors; | ||
| • | prohibition on the ability of stockholders to call special meetings of stockholders; | ||
| • | the ability of our board of directors to alter our bylaws without stockholder approval; | ||
| • | prohibition on the ability of stockholders to take actions by written consent; | ||
| • | advance notice requirements for nominations of candidates for election to our board of directors or for proposing matters that can be acted upon by our stockholders at stockholder meetings; | ||
| • | certain amendments to our certificate of incorporation and bylaws require the approval of holders of at least 662/3 percent of the voting power of all outstanding stock; and | ||
| • | the ability of our board of directors to issue, without stockholder approval, preferred stock with rights that are senior to those of our common stock. |
In addition, our board of directors has adopted a stockholder rights plan, the provisions of which
could make it more difficult for a potential acquirer of 3Com to consummate an acquisition
transaction. Also, Section 203 of the Delaware General Corporation Law may prohibit large
stockholders, in particular those owning 15 percent or more of our outstanding voting stock, from
merging or consolidating with us.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2. PROPERTIES
We lease properties in the United States and a number of foreign countries. For information
regarding property, plant and equipment by geographic region for each of the last two fiscal years,
see Note 20 to our Consolidated Financial Statements in Item 8 of this Annual Report on Form 10-K.
The following table summarizes our significant leased real estate properties as of June 1, 2007
(all facilities are for our SCN segment except where indicated otherwise):
| Location | Sq. Ft. | Owned/Leased | Primary Use | |||||
United States—Boston Area
|
201,000 | Leased | Corporate headquarters, office, research and development, and customer service. | |||||
United States—Austin Area
|
70,000 | Leased | TippingPoint’s main office, research and development, and customer service. | |||||
United States—Chicago Area
|
43,000 | Leased | Office, research and development, and customer service. | |||||
Europe—U.K.
|
39,000 | Leased | Office, research and development, and customer service. | |||||
China—Hangzhou
|
1,682,000 | Leased | Office, research and development, manufacturing, sales, and training. Used by our H3C segment. Lease expires January 2009. | |||||
China—Beijing
|
481,000 | Leased | Research and development, training, sales and customer service. Used by our H3C segment. | |||||
29
Table of Contents
As part of our initiatives to maximize our efficiency, we are consolidating our operations wherever
feasible and are actively engaged in efforts to dispose of excess facilities. As of June 1, 2007,
we lease and sublease to third-party tenants approximately 49,000 square feet in various other
facilities throughout North America and Europe. The facilities under sub-lease are leased
facilities agreements that expire at various times between 2008 and 2009.
We believe that our facilities are adequate for our present needs in all material respects.
ITEM 3. LEGAL PROCEEDINGS
The material set forth in Note 22 to the Consolidated Financial Statements included in Item 8 of
Part II of this Annual Report on Form 10-K is incorporated herein by reference.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders in the fourth quarter of the fiscal year
covered by this Annual Report on Form 10-K.
PART II
| ITEM 5. | MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES |
Our common stock trades on the NASDAQ Global Select Market under the symbol COMS and has been
quoted on NASDAQ since our initial public offering on March 21, 1984. The following table sets
forth the high and low sale prices as reported on NASDAQ during the last two fiscal years. As of
July 27, 2007, we had approximately 4,642 stockholders of record. We have not paid, and do not
anticipate that we will pay, cash dividends on our common stock.
| Fiscal 2007 | High | Low | Fiscal 2006 | High | Low | |||||||||||||
First Quarter |
$ | 5.31 | $ | 3.95 | First Quarter | $ | 4.00 | $ | 3.21 | |||||||||
Second Quarter |
5.24 | 3.95 | Second Quarter | 4.30 | 3.37 | |||||||||||||
Third Quarter |
4.24 | 3.73 | Third Quarter | 5.27 | 3.47 | |||||||||||||
Fourth Quarter |
4.79 | 3.60 | Fourth Quarter | 5.70 | 4.25 | |||||||||||||
The following table summarizes repurchases of our stock, including shares returned to satisfy
tax withholding obligations, in the quarter ended June 1, 2007:
| Total Number of | Approximate Dollar | |||||||||||||||
| Shares Purchased as | Value of Shares | |||||||||||||||
| Total Number | Average | Part of Publicly | that May Yet Be | |||||||||||||
| of Shares | Price Paid | Announced Plans or | Purchased Under the | |||||||||||||
| Period | Purchased | per Share | Programs(1) | Plans or Programs | ||||||||||||
March 3, 2007 through March 30, 2007 |
396,751 | (2) | $ | 3.89 | — | $ | 100,000,000 | |||||||||
March 31, 2007 through April 27, 2007 |
13,634 | (2) | 3.94 | — | — | |||||||||||
April 28, 2007 through June 1, 2007 |
12,082 | (2) | 4.17 | — | — | |||||||||||
Total |
422,467 | $ | 3.90 | — | $ | — | ||||||||||
| (1) | On March 23, 2005, our Board of Directors had approved a stock repurchase program providing for expenditures of up to $100.0 million through March 31, 2007, provided that all repurchases are pre-approved by the Audit and Finance Committee of the Board of Directors. We did not repurchase shares of our common stock pursuant to this authorization in the year ended May 31, 2007. The program has now expired. | |
| (2) | Represents shares surrendered to us to satisfy tax withholding obligations that arose upon the vesting of restricted stock awards. |
30
Table of Contents
COMPARISON OF STOCKHOLDER RETURN
Set forth on the next page is a line graph comparing the cumulative total return of our common
stock with the cumulative total return of the Standard & Poor’s 500 Stock Index, our New Peer
Group(1) and our Old Peer Group(1) for the period commencing on May 31, 2002
and ending on June 1, 2007 (fiscal year end)(2)(3). We historically have constructed
our peer group based on comparable market offerings, revenue composition and size. In
re-evaluating our peer group this year, we removed one peer that is no longer publicly-traded. We
also added one new peer; in light of the evolving nature of our business, we believe this addition
to the peer group provides a more meaningful comparison in terms of competition in one of our
important product offerings and other relevant factors. This information shall not be deemed to be
“filed” with the Securities and Exchange Commission and shall not be incorporated by reference into
any filing under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as
amended, unless we specifically incorporate it by reference.
| (1) | Our New Peer Group consists of Avaya, Inc., Cisco Systems, Inc., Extreme Networks, Inc., Foundry Networks, Inc., McAfee, Inc. and Netgear Inc. Our Old Peer Group consists of Avaya, Inc., Cisco Systems, Inc., Extreme Networks, Inc., Foundry Networks, Inc. and Netgear Inc. Internet Security Systems Inc. was acquired in 2006 and has been removed from the Old Peer Group. | |
| (2) | Assumes that $100.00 was invested on May 31, 2002 in our common stock and each index, and that all dividends were reinvested. No cash dividends have been declared on our common stock. Stockholder returns over the indicated period should not be considered indicative of future stockholder returns. | |
| (3) | 3Com uses a 52-53 week fiscal year ending on the Friday nearest to May 31. |
COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*
Among 3Com Corporation, The S&P 500 Index,
A New Peer Group And An Old Peer Group
Among 3Com Corporation, The S&P 500 Index,
A New Peer Group And An Old Peer Group
| * | $100 invested on 5/31/02 in stock or index-including reinvestment of dividends. Index calculated on month-end basis. | |
| Copyright © 2007, Standard & Poor’s, a division of The McGraw -Hill Companies, Inc. All rights reserved. w w w .researchdatagroup.com/S&P.htm |
||
31
Table of Contents
DATA POINTS FOR PERFORMANCE GRAPH
| 5/31/02 | 5/30/03 | 5/28/04 | 6/3/05 | 6/2/06 | 6/1/07 | |||||||||||||||||||
3Com Corporation |
100.00 | 88.31 | 116.37 | 63.67 | 85.61 | 84.35 | ||||||||||||||||||
S&P 500 |
100.00 | 91.94 | 108.79 | 117.75 | 127.92 | 157.08 | ||||||||||||||||||
New Peer Group |
100.00 | 103.16 | 141.66 | 123.05 | 130.39 | 172.01 | ||||||||||||||||||
Old Peer Group |
100.00 | 104.12 | 142.98 | 122.20 | 130.38 | 171.23 | ||||||||||||||||||
ITEM 6. SELECTED FINANCIAL DATA
The data set forth below should be read in conjunction with Item 7, “Management’s Discussion and
Analysis of Financial Condition and Results of Operations,” and our consolidated financial
statements and related notes appearing elsewhere in this Annual Report on Form 10-K. Our fiscal
year ends on the Friday closest to May 31. Fiscal 2007 consists of the 52 weeks ended June 1, 2007.
Fiscal year 2006 consists of the 52 weeks ended June 3, 2006. Fiscal 2005 consisted of 53 weeks
and ended on June 2, 2005. Fiscal years 2004 and 2003 each consisted of 52 weeks and fiscal 2004
ended on June 3, 2004, fiscal 2003 ended on May 30, 2003. For convenience, the consolidated
financial statements have been shown as ending on the last day of the calendar month. The
following balance sheet data and statements of operations data for each of the five years ended May
31, 2007 were derived from our audited consolidated financial statements. Consolidated balance
sheets as of May 31, 2006 and 2005 and the related consolidated statements of operations and cash
flows for each of the three years in the period ended May 31, 2007 and notes thereto appear
elsewhere in this Annual Report on Form 10-K.
On May 23, 2003, we completed the sale of our CommWorks division. Accordingly, the information set
forth in the table below is presented to reflect the CommWorks division as discontinued operations.
On January 27, 2006 we acquired an additional 2 percent ownership in our H3C joint venture and
became the majority shareholder (we have since acquired full ownership of H3C). Accordingly, the
information set forth in the tables below is presented to reflect the consolidated results as of
that date.
| Fiscal Year May 31, | ||||||||||||||||||||
| (In thousands, except per share amounts) | 2007 | 2006 | 2005 | 2004 | 2003 | |||||||||||||||
Sales |
$ | 1,267,481 | $ | 794,807 | $ | 651,244 | $ | 698,884 | $ | 932,866 | ||||||||||
Net (loss) |
(88,589 | ) | (100,675 | ) | (195,686 | ) | (349,263 | ) | (283,754 | ) | ||||||||||
(Loss) from continuing operations
before cumulative effect of accounting
change |
(88,589 | ) | (100,675 | ) | (195,686 | ) | (346,863 | ) | (230,093 | ) | ||||||||||
(Loss) per share from continuing
operations before cumulative effect of
accounting change
Basic and diluted |
$ | (0.22 | ) | $ | (0.26 | ) | $ | (0.51 | ) | $ | (0.91 | ) | $ | (0.64 | ) | |||||
The provisions of Statement of Financial Accounting Standard (SFAS) No. 144, “Accounting for the
Impairment or Disposal of Long-Lived Assets,” are applicable to disposals occurring after our
adoption of SFAS No. 144, effective June 1, 2002. In accordance with such provisions, the table
below does not reflect the CommWorks division as a discontinued operation. Accordingly, the
information set forth in the table below is presented to reflect the consolidated balances as of
that date.
| Balances as of May 31, | ||||||||||||||||||||
| (In thousands) | 2007 | 2006 | 2005 | 2004 | 2003 | |||||||||||||||
Cash, equivalents and short-term investments |
$ | 559,217 | $ | 864,347 | $ | 844,104 | $ | 1,383,356 | $ | 1,484,588 | ||||||||||
Total assets |
2,151,092 | 1,861,361 | 1,592,967 | 1,820,818 | 2,062,360 | |||||||||||||||
Working capital, (1) |
257,614 | 778,064 | 667,949 | 1,213,108 | 1,314,012 | |||||||||||||||
Deferred taxes and long-term obligations |
23,725 | 13,788 | 8,484 | 15,135 | 4,595 | |||||||||||||||
Long term debt |
336,000 | — | — | — | — | |||||||||||||||
Retained deficit |
(1,176,406 | ) | (1,087,512 | ) | (967,952 | ) | (755,244 | ) | (405,981 | ) | ||||||||||
Stockholders’ equity |
1,151,299 | 1,202,362 | 1,274,923 | 1,499,114 | 1,718,597 | |||||||||||||||
| (1) | Working capital is defined as total current assets less total current liabilities. |
32
Table of Contents
On November 15, 2006, 3Com initiated a bid process under a shareholders’ agreement for its H3C
joint venture by submitting a bid to buy Huawei’s entire ownership interest in H3C. On November
27, 2006, Huawei accepted 3Com’s bid to buy its remaining 49 percent of H3C for $882 million. The
transaction was approved by the PRC government.
On March 29, 2007, 3Com Technologies completed its purchase of the remaining 49 percent of H3C it
did not already own at which time the purchase price was paid in full. Huawei-3Com Co., Limited is
now known as H3C Technologies Co., Limited, or H3C. During fiscal 2006 we exercised our right to
purchase an additional two percent ownership interest in H3C and entered into an agreement with
Huawei for an aggregate purchase price of $28.0 million. We were granted regulatory approval by the
Chinese government and subsequently completed this transaction on January 27, 2006 (date of
acquisition). We consolidated H3C’s financial statements from the date of acquisition. The
acquisition is being accounted for as a purchase, and accordingly, the assets purchased and
liabilities assumed are included in the consolidated balance sheet as of May 31, 2006 using H3C’s
March 31, 2006 balance sheet data. Because H3C follows a calendar year end, we report its results
on a two-month lag. The operating results of H3C are included in the consolidated financial
statements from the date of acquisition, resulting in the latter two months of H3C’s three months
ended March 31, 2006 being included in our year ended May 31, 2006 statement of operations.
Our acquisition of TippingPoint on January 31, 2005 was accounted for as a purchase, and
accordingly, the assets purchased and liabilities assumed are included in the consolidated balance
sheet as of May 31, 2005. The operating results of TippingPoint are included in the consolidated
financial statements since the date of acquisition. Accordingly, fiscal 2006 contains a full year
of TippingPoint’s results compared to five months of results in fiscal 2005.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTRODUCTION
The following discussion should be read in conjunction with the Consolidated Financial Statements
and notes thereto included in Item 8 of Part II of this Annual Report on Form 10-K.
BUSINESS OVERVIEW
We are incorporated in Delaware. A pioneer in the computer networking industry, we provide secure,
converged networking solutions, as well as maintenance and support services, for enterprises and
public sector organizations of all sizes. Headquartered in Marlborough, Massachusetts, we have
worldwide operations, including sales, marketing, research and development, and customer service
and support capabilities.
Our products and services can generally be classified in the following categories:
| § | Networking; | ||
| § | Security; | ||
| § | Voice; | ||
| § | Services; and | ||
| § | Legacy Connectivity Products. |
We have undergone significant changes in recent years, including:
| § | forming the Huawei-3Com joint venture or H3C; | ||
| § | acquisition of majority ownership of H3C and subsequently purchasing Huawei’s remaining 49 percent ownership interest in H3C; | ||
| § | financing a portion of the purchase price for the acquisition of Huawei’s 49 percent ownership in H3C by entering into a $430 million senior secured credit agreement; | ||
| § | restructuring activities which included outsourcing of information technology, all manufacturing activity in our SCN segment, and significant headcount reductions in other functions, and selling excess facilities; | ||
| § | significant changes to our executive leadership; | ||
| § | acquiring TippingPoint Technologies, Inc.; and | ||
| § | realigning our SCN sales and marketing channels and expenditures. |
33
Table of Contents
We believe an overview of these significant recent events is helpful to gain a clearer
understanding of our operating results.
Significant Events
H3C
On November 17, 2003, we formed our joint venture, Huawei-3Com Co., Limited (now known as H3C
Technologies Co., Limited) which is domiciled in Hong Kong and has its principal operating center
in Hangzhou, China. We contributed $160.0 million in cash, assets related to our operations in
China and Japan, and licenses to intellectual property related to those operations in exchange for
a 49 percent ownership interest of the joint venture. During fiscal 2006, we exercised our right
to purchase an additional two percent ownership interest in H3C and entered into an agreement with
Huawei, our joint venture partner, for an aggregate purchase price of $28.0 million in cash. We
were granted regulatory approval by the PRC, and subsequently completed this transaction on January
27, 2006 (date of acquisition). Consequently, we owned a majority interest in the joint venture and
determined that the criteria of Emerging Issues Task Force No. 96-16, “Investor’s Accounting for an
Investee When the Investor Has a Majority of the Voting Interest but the Minority Shareholder or
Shareholders Have Certain Approval or Veto Rights” was met. Accordingly, we consolidated H3C’s
financial statements from the date of the acquisition of the additional two percent ownership
interest.
Under the H3C shareholders’ agreement, both partners had the right to initiate a bid process to
purchase all of the other partner’s ownership interest at any time after the third anniversary of
H3C’s formation. We initiated the bidding process on November 15, 2006 to buy Huawei Technologies’
49 percent stake in H3C, and our bid of $882 million was accepted by Huawei on November 27, 2006.
The transaction closed on March 29, 2007.
We financed a portion of the purchase price for the acquisition of Huawei’s 49 percent ownership in
H3C through a $430 million senior secured credit agreement with several lenders. Details of the
borrowing are more fully discussed in the “Liquidity and Capital Resources” section below.
New Products
We have introduced multiple new products targeted at the small, medium and large enterprise
markets, including modular switches and routers, as well as voice over IP, or VoIP, security,
wireless and unified switching solutions. We also announced our Open Services Networking, or OSN,
strategy.
Business Environment and Future Trends
Networking industry analysts and participants differ widely in their assessments concerning the
prospects for near-term industry growth. Industry factors and trends also present significant
challenges in the medium-term with respect to our goals for sales growth, gross margin improvement
and profitability. Such factors and trends include:
| § | Intense competition in the market for higher end, enterprise core routing and switching products; | ||
| § | Aggressive product pricing by competitors targeted at gaining share in market segments where we have had a strong position historically, such as the small to medium-sized enterprise market; and | ||
| § | The advanced nature and ready availability of merchant silicon, which allows low-end competitors to deliver competitive products and makes it increasingly difficult for us to differentiate our products. |
34
Table of Contents
We believe that long-term success in this environment requires us to be a global technology leader.
Now that we have closed our H3C transaction, we intend to leverage our global footprint to more
effectively sell our products into expanding markets and to utilize cost-effective technology
development strategies. We also believe that our long-term success is dependent on investing in
the development of key technologies. Accordingly, our key focus of fiscal 2008 will continue to
be to manage our H3C operating segment for expected continued long-term growth, to make targeted
investments in the integration of sales efforts and back office functions between H3C and SCN, as
well as to manage our SCN operating segment towards our goal of a return to profitability while
maintaining investment levels in key technologies. In fiscal 2008, we also intend to continue
investing in the H3C segment. This is expected to involve continued investment in research and
development, increased focus on growth both inside and outside of China, growing the dedicated H3C
infrastructure in concert with a global 3Com consolidated plan, and managing certain key aspects of
employee retention as discussed below. In addition we may make certain targeted investments in the
integration of the H3C and SCN operating segments designed to drive more profitable near and
long-term growth of the business.
We continue to face significant challenges in the SCN segment with respect to sales growth, gross
margin and profitability. We believe future sales growth for the SCN segment depends to a
substantial degree on increased sales of our networking products, and we believe our best growth
opportunity requires us to expand our product lines targeting small and medium businesses, or SMB,
customers as well as selected medium-enterprise customers. These product enhancements are expected
to be based in part upon leveraging open source and open architecture platforms to differentiate
our networking offerings. These are also expected to be complemented by expanded security
offerings such as the development of attack, access and application controls.
Finally, we intend to look to improve our channels to market on these products, especially
through relationships with system integrators and service providers. In order to achieve our sales
goals in the SCN segment for fiscal 2008, it is important that we continue to enhance the features
and capabilities of our products in a timely manner in order to expand our addressable market
opportunities, distribution channels and market competitiveness. Also, we expect a very
competitive pricing environment for the foreseeable future; this will likely continue to exert
downward pressure on our SCN sales, gross margin and profitability.
Another key priority will be the integration of H3C. Our integration focus will initially include:
| § | Launching the second phase of our integration of our Asia Pacific Region sales models for data networking sales, especially in the medium-enterprise market; and | ||
| § | Integrating certain information technology (IT), supply chain and customer support functions to enable seamless go-to-market models and achieve synergies between our operating segments. |
Other important factors in the continued success of our H3C business are expected to include:
retaining key management and employees, continuing sales through Huawei as an OEM partner of H3C in
the near to medium term, and continuing the year-over-year growth in H3C. H3C’s China sales growth
has been historically strong, however we expect this growth to be closer to market rates in fiscal
2008. We intend to retain employees through a long-term retention and incentive structure at H3C.
We also currently have the intention to execute an initial public offering (IPO) of common stock of
our wholly owned subsidiary TippingPoint, our business that develops, markets and sells security
products and services, such as its intrusion prevention system appliances and its security
protection updates through its Digital Vaccine service. Any sale of TippingPoint stock would be
registered under the Securities Act of 1933, and such shares of common stock would only be offered
and sold by means of a prospectus. This Annual Report does not constitute an offer to sell or the
solicitation of any offer to buy any securities of TippingPoint, and there will not be any sale of
any such securities in any state in which such offer, solicitation, or sale would be unlawful prior
to registration or qualification under the securities laws of such state. We currently expect to
file a registration statement related to the IPO by the end of the calendar year. We currently
intend to remain a majority TippingPoint shareholder following the IPO and plan to reduce our
ownership over time in subsequent transactions.
35
Table of Contents
BASIS OF PRESENTATION
Our fiscal year ends on the Friday closest to May 31. Fiscal 2007 consisted of 52 weeks and ended
on June 1, 2007. Fiscal year 2006, consisted of 52 weeks ended on June 2, 2006, and fiscal year
2005 consisted of 53 weeks and ended on June 3, 2005. For convenience, the consolidated financial
statements have been shown as ending on the last day of the calendar month.
During fiscal 2006 we exercised our right to purchase an additional two percent ownership interest
in H3C and entered into an agreement with Huawei for an aggregate purchase price of $28.0 million.
We were granted regulatory approval by the Chinese government and subsequently completed this
transaction on January 27, 2006 (date of acquisition). Since that time, we have owned a majority
interest in the joint venture and have determined that the criteria of Emerging Issues Task Force
No. 96-16, “Investor’s Accounting for an Investee When the Investor Has a Majority of the Voting
Interest but the Minority Shareholder or Shareholders Have Certain Approval or Veto Rights” have
been met. Accordingly, we consolidated H3C’s financial statements from the date of acquisition,
and, until we became a 100 percent owner of H3C as described below, recorded Huawei’s proportionate
share of the income of H3C as a minority interest in the income of consolidated joint venture.
Both joint venture partners had the right to initiate a bid process to purchase all of the other
partner’s ownership interest at any time after the third anniversary of H3C’s formation. On
November 15, 2006, 3Com initiated a bid process under the shareholders’ agreement by submitting a
bid to buy Huawei’s entire ownership interest in H3C. On November 27, 2006, Huawei accepted 3Com’s
last bid to buy Huawei’s remaining 49 percent share for $882 million. The transaction was approved
by the PRC government and on March 29, 2007, 3Com Technologies completed its purchase at which time
the purchase price was paid in full. Huawei-3Com Co., Limited is now known as H3C Technologies
Co., Limited, or H3C.
On March 22, 2007, H3C Holdings Limited (the “Borrower”), an indirect wholly-owned subsidiary of
3Com Corporation, entered into a Credit and Guaranty Agreement dated as of March 22, 2007 among the
Borrower, 3Com Corporation, 3Com Holdings Limited and 3Com Technologies, as Holdco Guarantors,
various Lenders, Goldman Sachs Credit Partners L.P., as Mandated Lead Arranger, Bookrunner,
Administrative Agent and Syndication Agent (“GSCP”), and Industrial and Commercial Bank of China
(Asia) Limited, as Collateral Agent (the “Existing Credit Agreement”). Under the Existing Credit
Agreement, on March 28, 2007 the Borrower borrowed $430 million (the “Existing Loan”) to finance a
portion of the purchase price for the March 29, 2007 acquisition (the “Acquisition”) of Huawei’s 49
percent stake in H3C.
On May 25, 2007, the parties amended and restated the Existing Credit Agreement in order to, among
other things, convert the Existing Loan into two tranches with different principal amortization
schedules and different interest rates (the “A&R Loans”). The other provisions of the Existing
Credit Agreement, including covenants, collateral, temporary guarantees and other provisions,
remain largely unchanged. The closing of the A&R Loans occurred on May 31, 2007.
Following the H3C 2 percent acquisition we determined that our chief decision making officer
receives reports, manages, and operates our business as two separate units, the SCN business and
the H3C business. As a result we currently report two operating segments, SCN and H3C. See
footnote Note 19 of the Consolidated Financial Statements for additional information on our
segments.
Prior to the additional 2 percent acquisition we accounted for our investment in H3C by the equity
method. Under this method, we recorded our proportionate share of H3C’s net income or loss based
on the most recently available quarterly financial statements of H3C under the caption “Equity
interest in income (loss) of unconsolidated joint venture” in our consolidated financial
statements.
Our acquisition of TippingPoint on January 31, 2005, was accounted for as a purchase, and
accordingly, the assets purchased and liabilities assumed are included in the consolidated balance
sheet as of May 31, 2005. The operating results of TippingPoint are included in the consolidated
financial statements since the date of acquisition. Accordingly, fiscal 2006 contains a full year
of TippingPoint’s results compared to five months of results in fiscal 2005.
36
Table of Contents
CRITICAL ACCOUNTING POLICIES
Our significant accounting policies are outlined in Note 2 to the Consolidated Financial
Statements, which appear in Item 8 of Part II of this Annual Report on Form 10-K. Some of those
accounting policies require us to make estimates and assumptions that affect the amounts reported
by us. The following items require the most significant judgment and often involve complex
estimation:
Revenue recognition: We recognize a sale when the product has been delivered and risk of loss has
passed to the customer, collection of the resulting receivable is reasonably assured, persuasive
evidence of an arrangement exists, and the fee is fixed or determinable. The assessment of whether
the fee is fixed or determinable considers whether a significant portion of the fee is due after
our normal payment terms. If we determine that the fee is not fixed or determinable, we recognize
revenue at the time the fee becomes due, provided that all other revenue recognition criteria have
been met. Also, sales arrangements may contain customer-specific acceptance requirements for both
products and services. In such cases, revenue is deferred at the time of delivery of the product or
service and is recognized upon receipt of customer acceptance.
For arrangements that involve multiple elements, such as sales of products that include maintenance
or installation services, revenue is allocated to each respective element based on its relative
fair value and recognized when revenue recognition criteria for each element have been met. We use
the residual method to recognize revenue when an arrangement includes one or more elements to be
delivered at a future date and vendor-specific objective evidence of the fair value of all the
undelivered elements exists. Under the residual method, the fair value of the undelivered elements
is deferred and the remaining portion of the arrangement fee is recognized as revenue. If evidence
of fair value of one or more undelivered elements does not exist, revenue is deferred and
recognized when delivery of those elements occurs or when fair value can be established.
We assess collectibility based on a number of factors, including general economic and market
conditions, past transaction history with the customer, and the creditworthiness of the customer.
If we determine that collection of the fee is not reasonably assured, then we defer the fee and
recognize revenue upon receipt of payment. We do not typically request collateral from our
customers. In the H3C segment, certain customers pay accounts receivable with bills receivable
from Chinese banks with maturities less than six months. These are also referred to as “bankers’
acceptances”.
A significant portion of our sales is made to distributors and value added resellers (VARs).
Revenue is generally recognized when title and risk of loss pass to the customer, assuming all
other revenue recognition criteria have been met. Sales to these customers are recorded net of
appropriate allowances, including estimates for product returns, price protection, and excess
channel inventory levels. We maintain reserves for potential allowances and adjustments; if the
actual level of returns and adjustments differ from the assumptions we use to develop those
reserves, additional allowances and charges might be required.
For sales of products that contain software that is marketed separately, we apply the provisions of
AICPA Statement of Position 97-2, “Software Revenue Recognition,” as amended. Sales of services,
including professional services, system integration, project management, and training, are
recognized upon delivery of performance. Other service revenue, such as that related to maintenance
and support contracts, is recognized ratably over the contract term, provided that all other
revenue recognition criteria have been met. Royalty revenue is generally recognized when we receive
payment.
Allowance for doubtful accounts: We monitor payments from our customers on an on-going basis and
maintain allowances for doubtful accounts for estimated losses resulting from the inability of our
customers to make required payments. When we evaluate the adequacy of our allowances for doubtful
accounts, we take into account various factors including our accounts receivable aging, customer
creditworthiness, historical bad debts, and geographic and political risk. If the financial
condition of our customers were to deteriorate, resulting in an impairment of their ability to make
payments, additional allowances might be required.
Inventories: Inventory is stated at the lower of standard cost, which approximates cost, or net
realizable value. We perform detailed reviews related to the net realizable value of inventory on
an ongoing basis, for both inventory on hand and inventory that we are committed to purchase,
giving consideration to deterioration, obsolescence, and other factors. If actual market conditions
differ from those projected by management and our estimates prove to be inaccurate, additional
write-downs or adjustments to cost of sales might be required; alternatively, we might realize
benefits through cost of sales for sale or disposition of inventory that had been previously
written off.
37
Table of Contents
Goodwill and intangible assets: Carrying values of goodwill and other intangible assets with
indefinite lives are reviewed for possible impairment in accordance with the applicable accounting
literature. We test our goodwill for impairment annually during our third fiscal quarter and in
interim periods if certain events occur indicating that the carrying value of goodwill may be
impaired. We review the value of our intangible assets in accordance with the applicable accounting
literature for impairment whenever events or changes in business circumstances indicate that the
carrying amount of the assets may not be fully recoverable or that the useful lives of these assets
are no longer appropriate. As of May 31, 2007, we had $766.4 million of goodwill and $371.3 million
of net intangible assets remaining on our balance sheet, which we currently believe to be
realizable based on the estimated fair value of these assets. We estimate fair value of goodwill
using third-party valuation reports and the fair value of our intangible assets using estimated
future cash flows of the associated products and technology. It is possible that the estimates and
assumptions used in assessing the carrying value of these assets, such as future sales and expense
levels, may need to be re-evaluated in the case of continued market deterioration, which could
result in further impairment of these assets.
Equity securities and other investments: We account for non-marketable equity securities and other
investments at historical cost or, if we have the ability to exert significant influence over the
investee, by the equity method. Investments accounted for by the equity method include investments
in limited partnership venture capital funds and, prior to the acquisition of majority ownership on
January 27, 2006, the investment in H3C. In accounting for these investments by the equity method,
we record our proportionate share of the fund’s net income or loss, or H3C’s net income or loss,
based on the most recently available quarterly financial statements. Since H3C has adopted a
calendar year basis of reporting, we reported our equity in H3C’s net income or loss based on H3C’s
most recent quarterly financial statements, two months in arrears. For the year ended May 31, 2006
we accounted for H3C under the equity method for ten months of the year.
We review all of our investments for impairment whenever events or changes in business
circumstances indicate that the carrying amount of the investment may not be fully recoverable. The
impairment review requires significant judgment to identify events or circumstances that would
likely have a significant adverse effect on the fair value of the investment. Investments
identified as having an indication of impairment are subject to further analysis to determine if
the impairment is other than temporary; in the event that the investment impairment is other than
temporary, we would write the investment down to its impaired value.
Stock-based Compensation. In December 2004, the Financial Accounting Standards Board (“FASB”)
issued SFAS No. 123(R), which requires all stock-based compensation to employees (as defined in
SFAS No. 123(R)), including grants of employee stock options, restricted stock awards, and
restricted stock units, to be recognized in the financial statements based on their fair values.
Estimates of the fair value of equity awards in future periods will be affected by the market price
of our common stock, as well as the actual results of certain assumptions used to value the equity
awards. These assumptions include, but are not limited to, the expected volatility of the common
stock, the expected term of options granted, and the risk free interest rate.
The fair value of stock options and employee stock purchase plan shares is determined by using the
Black-Scholes option pricing model and applying the single-option approach to the stock option
valuation. The options generally have vesting on an annual basis over a vesting period of four
years. We estimate the expected option term by analyzing the historical term period from grant to
exercise and also considers the expected term for those options that are outstanding. The expected
term of employee stock purchase plan shares is the average of the remaining purchase periods under
each offering period. For equity awards granted after June 1, 2006, the volatility of the common
stock is estimated using the historical volatility.
The risk-free interest rate used in the Black-Scholes option pricing model is determined by looking
at historical U.S. Treasury zero-coupon bond issues with terms corresponding to the expected terms
of the equity awards. In addition, an expected dividend yield of zero is used in the option
valuation model, because we do not expect to pay any cash dividends in the foreseeable future.
Lastly, in accordance with SFAS No. 123(R), we are required to estimate forfeitures at the time of
grant and revise those estimates in subsequent periods if actual forfeitures differ from those
estimates. In order to determine an estimated pre-vesting option forfeiture rate, we used
historical forfeiture data, which yields a forfeiture rate of 27 percent. We believe this
historical forfeiture rate to be reflective of our anticipated rate on a go-forward basis. This
estimated forfeiture rate has been applied to all unvested options and restricted stock outstanding
as of June 1, 2006 and to all options and restricted stock granted since June 1, 2006. Therefore,
stock-based compensation expense is recorded only for those options and restricted stock that are
expected to vest.
Restructuring charges: Over the last several years we have undertaken significant restructuring
initiatives. These initiatives have required us to record restructuring charges related to
severance and outplacement costs, lease cancellations, accelerated depreciation and write-downs of
held for sale properties, write-downs of other long-term assets, and other restructuring costs.
38
Table of Contents
Given the significance of our restructuring activities and the time required for execution and
completion of such activities, the process of estimating restructuring charges is complex and
involves periodic reassessments of estimates made at the time the original decisions were made. The
accounting for restructuring costs and asset impairments requires us to record charges when we have
taken actions or have the appropriate approval for taking action, and when a liability is incurred.
Our policies require us to periodically evaluate the adequacy of the remaining liabilities under
our restructuring initiatives. As we continue to evaluate the business, we might be required to
record additional charges for new restructuring activities as well as changes in estimates to
amounts previously recorded.
Product Warranty: A limited warranty is provided on most of our products for periods ranging from
90 days to limited lifetime, depending upon the product, and allowances for estimated warranty
costs are recorded during the period of sale. The determination of such allowances requires us to
make estimates of product return rates and expected costs to repair or replace the products under
warranty. If actual return rates and/or repair and replacement costs differ significantly from our
estimates, adjustments to recognize additional cost of sales might be required.
Income taxes: We are subject to income tax in a number of jurisdictions. A certain degree of
estimation is required in recording the assets and liabilities related to income taxes, and it is
reasonably possible that such assets may not be recovered and that such liabilities may not be paid
or that payments in excess of amounts initially estimated and accrued may be required. We assess
the likelihood that our deferred tax assets will be recovered from our future taxable income and,
to the extent we believe that recovery is not likely, we establish a valuation allowance. We
consider historical taxable income, estimates of future taxable income, and ongoing prudent and
feasible tax planning strategies in assessing the amount of the valuation allowance. Based on
various factors, including our recent losses, retained deficit, operating performance in fiscal
2007, and estimates of future profitability, we have concluded that future taxable income will,
more likely than not, be insufficient to recover our U.S. net deferred tax assets as of May 31,
2007. Accordingly, we have established an appropriate valuation allowance to offset such deferred
tax assets. In addition to valuation allowances against deferred tax assets, we maintain reserves
for potential tax contingencies arising in jurisdictions in which we do or have done business. Many
of these contingencies arise from periods when we were a substantially larger company. Such
reserves are based on our assessment of the likelihood of an unfavorable outcome and the expected
potential loss from such contingency, and are monitored by management. These reserves are
maintained until such time as the matter is settled or the statutory period for adjustment has
passed. Adjustments could be required in the future if we determine that the amount to be realized
is greater or less than the valuation allowance we have recorded or that our reserves for tax
contingencies are inadequate. We have U.S. federal loss carryforwards of approximately $2.5
billion as of May 31, 2007 expiring between fiscal years 2008
and 2027, substantially all of which
expire between fiscal years 2021 and 2027.
39
Table of Contents
RESULTS OF OPERATIONS
YEARS ENDED MAY 31, 2007, 2006, AND 2005
YEARS ENDED MAY 31, 2007, 2006, AND 2005
As a result of the acquisition of H3C, we currently report two operating segments, SCN and H3C, for
the years ended May 31, 2007 and 2006. For the year ended May 31, 2005 we managed and reported our
operations as a single, integrated business.
The following table sets forth, for the fiscal years indicated, the percentage of total sales
represented by the line items reflected in our consolidated statements of operations.
| 2007 | 2006 | 2005 | ||||||||||
Sales |
100.0 | % | 100.0 | % | 100.0 | % | ||||||
Cost of sales |
54.4 | 58.7 | 64.0 | |||||||||
Gross profit margin |
45.6 | 41.3 | 36.0 | |||||||||
Operating expenses: |
||||||||||||
Sales and marketing |
25.2 | 34.6 | 37.4 | |||||||||
Research and development |
17.0 | 12.8 | 14.5 | |||||||||
General and administrative |
7.4 | 9.1 | 9.2 | |||||||||
Amortization and write-down of intangible assets |
3.4 | 2.6 | 1.4 | |||||||||
In-process research and development |
2.8 | 0.1 | 1.0 | |||||||||
Restructuring charges |
0.3 | 1.8 | 3.7 | |||||||||
Total operating expenses |
56.1 | 61.0 | 67.2 | |||||||||
Operating loss |
(10.5 | ) | (19.7 | ) | (31.2 | ) | ||||||
Gain on investments, net |
0.1 | 0.5 | 0.2 | |||||||||
Interest income, net |
3.2 | 3.6 | 3.3 | |||||||||
Other income (expense), net |
3.1 | 1.0 | (0.7 | ) | ||||||||
Loss from operations before income taxes, equity
interest in loss of unconsolidated joint venture and
minority interest in income of consolidated joint
venture |
(4.1 | ) | (14.6 | ) | (28.4 | ) | ||||||
Income tax (provision) benefit |
(0.8 | ) | 1.9 | (0.5 | ) | |||||||
Equity interest in income (loss) of unconsolidated joint
venture |
— | 1.4 | (1.1 | ) | ||||||||
Minority interest in income of consolidated joint venture |
(2.1 | ) | (1.4 | ) | — | |||||||
Net loss |
(7.0 | )% | (12.7 | )% | (30.0 | )% | ||||||
Comparison of fiscal 2007 and 2006
During the year ended June 1, 2007 we continued to experience strong results in our H3C segment
offset by declines in our SCN segment’s sales and we continued to reduce operating expenses in our
SCN business segment, offset in part by continued investment in the TippingPoint security business.
Sales
The increase in sales from the 2006 fiscal year to the 2007 fiscal year was primarily due to the
inclusion of full year H3C sales in the current period, as well as increased sales of TippingPoint
security products. The increase was partially offset by decreases in networking revenues in our
SCN segment.
40
Table of Contents
The following table shows our sales from products categories in absolute dollars and as a
percentage of total sales for fiscal 2007 and fiscal 2006 (in millions):
| Fiscal Year | ||||||||||||||||
| 2007 | 2006 | |||||||||||||||
Networking |
$ | 1,028.1 | 81.1 | % | $ | 577.0 | 72.6 | % | ||||||||
Security |
120.1 | 9.5 | 88.0 | 11.1 | ||||||||||||
Voice |
68.0 | 5.4 | 56.6 | 7.1 | ||||||||||||
Services |
35.9 | 2.8 | 33.4 | 4.2 | ||||||||||||
Connectivity Products |
15.4 | 1.2 | 39.8 | 5.0 | ||||||||||||
Total |
$ | 1,267.5 | $ | 794.8 | ||||||||||||
Networking revenue includes sales of our Layer 2 and Layer 3 stackable 10/100/1000 managed
switching lines, our modular switching lines, routers, wireless switching offerings and our small
to medium-sized enterprise market products. Sales of our networking products in fiscal 2007
increased 78 percent from fiscal 2006. The increase in sales was primarily driven by the inclusion
of full year results from our H3C segment offset in part by decreases in SCN sales.
Security revenue includes our TippingPoint™ products and services, as well as other security
products, such as virtual private network, or VPN, and network access control, or NAC, offerings.
Sales of our security products in fiscal 2007 increased 36 percent from fiscal 2006. The increase
is primarily attributable to organic growth in sales of security products in fiscal 2007 and the
inclusion of H3C’s full year results of security product sales.
Voice revenue includes our VCX™ and NBX® voice-over-internet protocol, or VoIP, product lines, as
well as voice gateway offerings. Sales of our VoIP telephony products in fiscal 2007 increased 20
percent from fiscal 2006. The increase was primarily driven by the inclusion of full year results
from our H3C segment.
Services revenue includes professional services and maintenance contracts, excluding TippingPoint
maintenance which is included in security revenue. Service revenue in fiscal 2007 increased 7
percent from fiscal 2006. The increase in sales was primarily driven by the inclusion of full year
results from our H3C segment.
Connectivity Products revenue includes our legacy network interface card, personal computer card,
and mini-peripheral component interconnect offerings. At the end of fiscal 2007 sales of these
products are close to zero with continued revenue only expected to be from royalty arrangements.
Sales by geographic region are as follows (in millions):
| Fiscal Year | ||||||||||||||||
| 2007 | 2006 | |||||||||||||||
North America |
$ | 233.7 | 18.4 | % | $ | 248.5 | 31.3 | % | ||||||||
Latin and South America |
70.4 | 5.6 | 72.2 | 9.1 | ||||||||||||
Europe, Middle East, and Africa |
272.8 | 21.5 | 298.5 | 37.5 | ||||||||||||
Asia Pacific |
103.5 | 8.2 | 91.4 | 11.5 | ||||||||||||
China |
587.1 | 46.3 | 84.2 | 10.6 | ||||||||||||
Total |
$ | 1,267.5 | $ | 794.8 | ||||||||||||
Sales information by geography to the extent available is reported based on the customer’s
designated delivery point, except in the case of H3C’s OEM sales which are based on the hub
locations of H3C’s OEM partners. China sales increased 597 percent primarily due to the inclusion
of H3C results for the full year in fiscal 2007.
41
Table of Contents
Gross Profit Margin
Gross profit margin improved 4.3 percent to 45.6 percent in the twelve months ended June 1, 2007
from 41.3 percent in the same period in the previous fiscal year. Significant components of the
improvement in gross profit margins were as follows:
| Twelve Months | ||||
| Ended | ||||
| June 1, 2007 | ||||
1) Consolidation of H3C |
6.5 | % | ||
2) SCN cost improvements |
2.3 | % | ||
3) SCN product mix and selling price reductions |
(3.3 | %) | ||
4) SCN volume impact |
(1.2 | %) | ||
Total |
4.3 | % | ||
| 1) | The increase is due to the consolidation of H3C results in the current period. The H3C segment generally has higher gross margins. | |
| 2) | The increase in the SCN margin was primarily the result of lower product material and delivery costs. | |
| 3) | The decrease in the SCN margin was the result of lower average selling prices and an unfavorable shift in product mix. | |
| 4) | The decrease in the SCN margin was the result of lower revenue on the portion of our costs that are fixed in nature. |
Operating Expenses
Operating expenses in fiscal 2007 were $711.0 million, compared to $485.2 million in fiscal 2006, a
net increase of $225.8 million. Included in the increase in operating expenses were H3C operating
expenses of $354.0 million for the full year ended May 31, 2007 as compared to $36.6 million for
the two months consolidated in 2006. In addition, the incurrence of the change-in-control portion
of H3C’s EARP bonus program contributed compensation expenses of $51.5 million in the year ended
May 31, 2007, which were not incurred in the previous fiscal year. This increase was partially
offset by significant cost reduction in our SCN segment as compared to the previous year. The full
year inclusion of H3C was the primary contributor to increases in sales and marketing expenses of
$45.0 million, research and development expenses of $113.8 million, general and administrative
expenses of $21.3 million, and amortization of intangibles of $21.6 million. Purchase accounting
charges related to the acquisition of the remaining 49 percent interest of H3C was the main
contributor to the increase in in-process research and development of $35.1 million. These
increases were partially offset by the decrease of restructuring charges of $10.9 million.
As a percent of sales, total operating expenses in fiscal 2007 were 56.1 percent, compared to 61.0
percent in fiscal 2006. In aggregate, sales and marketing, research and development, and general
and administrative expenses were 49.6 percent of sales in fiscal 2007, compared to 56.5 percent in
fiscal 2006, and increased $180.0 million in fiscal 2007 compared to fiscal 2006. We believe that
to a significant degree, these expenses are controllable and discretionary over time, but they are
not directly variable with sales levels within a particular period. The most significant component
of the increase of $180.0 was the inclusion of $292 million of H3C expenses for the entire fiscal
year ended May 31, 2007 partially offset by significant cost reductions in our SCN segment.
A more detailed discussion of the factors affecting each major component of total operating
expenses is provided below.
Sales and Marketing. Sales and marketing expenses in fiscal 2007 increased $45.0 million compared
to fiscal 2006. This increase was due primarily to the inclusion of H3C expenses for the entire
fiscal year ended May 31, 2007. In addition, the incurrence of the change-in-control portion of
H3C’s EARP bonus program contributed compensation expenses of $17.7 million in our H3C segment in
the year ended May 31, 2007. The expenses were not incurred in the previous fiscal year and were
partially offset by a reduction in the SCN sales and marketing expenses. The reduction of the SCN
sales and marketing expenses were primarily related to the reduction of programmatic marketing
expenses, and a reduction in employee related expenses due to our restructuring efforts.
42
Table of Contents
Research and Development. Research and development expenses in fiscal 2007 increased $113.8
million compared to fiscal 2006. This increase was due primarily to the inclusion of H3C expenses
for the entire fiscal year ended May 31, 2007. In addition, the incurrence of the
change-in-control portion of H3C’s EARP bonus program contributed compensation expenses of $27.2
million in our H3C segment in the year ended May 31, 2007. These expenses were not incurred in the
previous fiscal year and were partially offset by the reduction in SCN research and development
expenses. The decrease in the SCN research and development costs was related to reduced
non-recurring engineering projects and employee related expenses in the non-TippingPoint related
portion of our SCN segment which was slightly offset by increased investment in TippingPoint
research and development.
General and Administrative. General and administrative expenses in fiscal 2007 increased $21.3
million from fiscal 2006. This increase is primarily due to the inclusion of H3C expenses for the
entire fiscal year ended May 31, 2007. In addition, the incurrence of the change-in-control
portion of H3C’s EARP bonus program contributed compensation expenses of $6.6 million in our H3C
segment in the year ended May 31, 2007. These expenses were not incurred in the previous fiscal
year and were partially offset by a reduction in the SCN general and administrative expenses. The
reduction of the SCN general and administrative expenses were primarily related to the reduced
workforce-related expenses due to our restructuring initiatives and reduced IT and
facilities-related expenses.
Amortization and Write-Down of Intangibles. Amortization and write-down of intangibles were $42.5
million in fiscal 2007 and $20.9 million in fiscal 2006, an increase of $21.6 million.
Amortization and write-down of intangibles increased due primarily to the inclusion of H3C expenses
for the entire fiscal year ended May 31, 2007. The amortization expense related to the March 29,
2007 purchase of 49 percent of H3C in 2007 is through March 31, 2007 as we record H3C results on a
two month lag.
In-process research and development. $34.1 million of the total purchase price of 49 percent of the
remaining minority interest in H3C has been preliminarily allocated to in-process research and
development and was expensed in the fourth quarter of fiscal 2007. Projects that qualify as
in-process research and development represent those that have not yet reached technological
feasibility and which have no alternative future use. At the time of acquisition, H3C had multiple
in-process research and development efforts under way for certain current and future product lines.
Restructuring Charges. Restructuring charges were $3.5 million in fiscal 2007 and $14.4 million in
fiscal 2006. Restructuring charges in fiscal 2007 were composed primarily of charges for actions
taken in fiscal 2007, including employee severance and outplacement costs of $12.1 million, and
facilities-related credits of $7.5 million. Restructuring charges for fiscal 2007 were the result
of reductions in workforce and continued efforts to consolidate and dispose of excess facilities.
Further actions may be taken if our business activity declines or additional cost reduction efforts
are necessary.
Gain on Investments, Net
During fiscal 2007, net gains on investments were $1.1 million, primarily reflecting gains from
sales of certain equity securities. During fiscal 2006, net gains on investments were $4.3
million, primarily reflecting gains from sales of certain equity securities.
Interest Income and Other Income (Expense), Net
Interest and other income, net, was $79.2 million in fiscal 2007, an increase of $41.9 million
compared to $37.3 million in fiscal 2006. Contributing to the increase was $30.6 million of other
income from H3C for an operating subsidy program by the Chinese VAT authorities in the form of a
partial refund of VAT taxes collected by H3C from purchasers of software products. An increase in
interest income accounted for $12.0 million of the increase, primarily attributable to higher
interest rates applicable to short-term investments and the inclusion of a full year of results of
H3C. Interest income and interest expense related to H3C are included through the period ended
March 31, 2007. Thus, there is only three days of interest expense recorded related to the debt
incurred on March 28, 2007. In fiscal 2006 our results reflected a quarterly VAT payment that was
received during the two month period of H3C’s results that are in our consolidated financials.
Future subsidy payments, which are funded by VAT receipts, are subject to the discretion of Chinese
VAT authorities.
43
Table of Contents
Income Tax (Provision) Benefit
Our income tax provision was $10.2 million in fiscal 2007, compared to an income tax benefit of
$14.8 million in fiscal 2006. The income tax provision for fiscal 2007 was the result of providing
for taxes in certain state and foreign jurisdictions. The tax benefit for fiscal 2006 was the
result of a $23.0 million benefit resulting from a tax settlement with foreign tax authorities in
the second quarter of fiscal 2006, for which reserves had been provided in prior years and which
have now been reversed into income upon reaching settlement. Partially offsetting the income tax
benefit for fiscal 2006 was the provision of additional taxes in certain state and foreign
jurisdictions.
Minority Interest of Huawei in the Income of Consolidated Huawei-3Com Joint Venture
In fiscal 2007, we recorded a charge of $26.2 million related to the acquisition of the 49 percent
interest in H3C held by Huawei prior to our purchase. In fiscal 2006, we recorded a charge of
$11.1 million representing Huawei’s 49 percent interest in the net income reported by the former
H3C joint venture for the two month period included in our fiscal 2006.
Comparison of fiscal 2006 and 2005
Sales
The increase in sales from the 2005 fiscal year to the 2006 fiscal year was primarily due to the
inclusion of two months of H3C sales in the fiscal 2006, as well as increased sales of TippingPoint
security products and the inclusion of TippingPoint’s results for the full year. The increase was
partially offset by decreases in networking revenues in our SCN segment.
The following table shows our sales from products categories in absolute dollars and as a
percentage of total sales for fiscal 2006 and fiscal 2005 (in millions):
| Fiscal Year | ||||||||||||||||
| 2006 | 2005 | |||||||||||||||
Networking |
$ | 577.0 | 72.6 | % | $ | 494.5 | 75.9 | % | ||||||||
Security |
88.0 | 11.1 | 25.8 | 4.0 | ||||||||||||
Voice |
56.6 | 7.1 | 44.9 | 6.9 | ||||||||||||
Services |
33.4 | 4.2 | 32.0 | 4.9 | ||||||||||||
Connectivity Products |
39.8 | 5.0 | 54.0 | 8.3 | ||||||||||||
Total |
$ | 794.8 | $ | 651.2 | ||||||||||||
Sales of networking products in fiscal 2006 increased 17 percent from fiscal 2005. Networking
revenue includes sales of the H3C sourced enterprise products, our Layer 2 and Layer 3 stackable
10/100/1000 managed switching lines, wireless and OfficeConnect hardware, baseline branded small
to medium-sized enterprise market products, and H3C’s router and switching products. The increase
in sales was primarily driven by the inclusion of two months results from the H3C joint venture.
We also saw growth from the introduction of the 5500 line of Layer 3 switches sourced from H3C as
well as growth in our modular core and router products. This growth was partially offset by a
decline in demand for Layer 2 switches and a reduction in average selling prices resulting from
significant price competition, particularly for our 10/100 Mbps switching products as the industry
migrates to gigabit switching solutions, and by a shift in mix towards lower-priced products.
Sales of security products in fiscal 2006 increased 241 percent from fiscal 2005. Security revenue
includes our TippingPoint products and services, as well as other security products, such as our
embedded firewall product. The increase is primarily attributable to the inclusion of
TippingPoint’s sales for the full period and, to a lesser extent, organic growth in sales of
security products in fiscal 2006 and the inclusion of H3C’s security product sales. Sales of our
embedded firewall products increased in the year ended May 31, 2006.
VoIP Telephony revenue includes our VCX and NBX VoIP product lines. Sales of our VoIP telephony
products in fiscal 2006 increased 26 percent from fiscal 2005. The increase in such sales was due
largely to growth in the demand for our NBX products as well as a shift in focus to larger
enterprise contracts. Incremental sales of VCX products and to a lesser extent, the inclusion of
H3C’s voice products also contributed to the increase in VoIP telephony sales in fiscal 2006.
44
Table of Contents
Services revenue includes professional services and maintenance contracts, excluding TippingPoint
maintenance which is included in security.
Connectivity Products revenue includes our legacy network interface card, personal computer card,
and mini-peripheral component interconnect offerings. Sales of our connectivity products continue
to decrease as these applications are integrated into other solutions, and these offerings continue
to move toward the end of the product life cycle.
Sales by geographic region are as follows (in millions):
| Fiscal Year | ||||||||||||||||
| 2006 | 2005 | |||||||||||||||
North America |
$ | 248.5 | 31.3 | % | $ | 214.1 | 32.9 | % | ||||||||
Latin and South America |
72.2 | 9.1 | 57.7 | 8.9 | ||||||||||||
Europe, Middle East, and Africa |
298.5 | 37.5 | 294.7 | 45.2 | ||||||||||||
Asia Pacific |
175.6 | 22.1 | 84.7 | 13.0 | ||||||||||||
Total |
$ | 794.8 | $ | 651.2 | ||||||||||||
Sales information by geography to the extent available is reported based on the customer’s
designated delivery point, except in the case of H3C’s OEM sales which are based on the hub
locations of H3C’s OEM partners. Asia Pacific sales increased 107 percent primarily due to the
inclusion of H3C results for two months in fiscal 2006.
Gross Profit Margin
Gross profit margin as a percentage of sales improved 5.3 percentage points from 36.0 percent of
sales in fiscal 2005 to 41.3 percent of sales in fiscal 2006. Significant components of the
improvement in gross profit margin were as follows:
1) Increased sales of security products and inclusion of
TippingPoint higher margin products for full current period |
3.6 | % | ||
2) Consolidation of H3C higher margin products |
2.1 | |||
3) SCN product mix and selling price reductions |
(2.4 | ) | ||
4) Royalty payment reductions |
1.1 | |||
5) Other |
0.9 | |||
Total |
5.3 | % | ||
| 1) | The increase was the result of higher average selling prices and margin for TippingPoint’s security products compared to other SCN products as well as the inclusion of a full year of TippingPoint results in fiscal year 2006. | |
| 2) | The increase is due to the inclusion of two months of results of H3C which generally have higher gross margins. | |
| 3) | The decrease in the SCN margin was the result of lower average selling prices and an unfavorable shift in product mix. These declines were partially offset by product cost reductions. | |
| 4) | Fiscal year 2005 included final disbursements on two significant royalty payments. | |
| 5) | Other cost reduction activities included freight consolidation, and a reduction in the Connectivity Products business that consequently caused a decrease in unit shipment per revenue dollar which lowered variable costs. |
45
Table of Contents
Operating Expenses
Operating expenses in fiscal 2006 were $485.2 million, compared to $437.8 million in fiscal 2005, a
net increase of $47.4 million. Included in the increase in operating expenses were H3C operating
expenses of $36.6 million for the two month period ended May 31, 2006 and the inclusion of a full
year of TippingPoint operating expenses in fiscal 2006 as compared to five months in 2005. Both of
these factors were the primary contributors to increases in sales and marketing expenses of $31.0
million, research and development expenses of $7.3 million, general and administrative expenses of
$12.8 million, and amortization of intangibles of $11.9 million. The increase was partially offset
by the decrease of in-process research and development of $6.1 million and restructuring charges of
$9.5 million.
As a percent of sales, total operating expenses in fiscal 2006 were 61.0 percent, compared to 67.2
percent in fiscal 2005. In aggregate, sales and marketing, research and development, and general
and administrative expenses were 56.5 percent of sales in fiscal 2006, compared to 61.1 percent in
fiscal 2005, and increased $51.1 million in fiscal 2006 compared to fiscal 2005. We believe that to
a significant degree, these expenses are controllable and discretionary over time, but they are not
directly variable with sales levels within a particular period. The most significant component of
the increase of $51.1 was the inclusion of $30.2 million of H3C expenses for the two months ended
May 31, 2006.
A more detailed discussion of the factors affecting each major component of total operating
expenses is provided below.
Sales and Marketing. Sales and marketing expenses in fiscal 2006 increased $31.0 million compared
to fiscal 2005. This increase was due primarily to the inclusion of H3C expenses for the two
months ended May 31, 2006 and TippingPoint’s expenses for the entire 2006 fiscal period. In
addition, our investment in our branding campaign and the incurrence of performance related
compensation expenses in the year ended May 31, 2006, which were not incurred in the previous
fiscal year, contributed to the increase. Employee incentive compensation is aligned to the
accomplishment of specific financial objectives and certain of these objectives were met in the
current fiscal year, whereas these objectives were not met in the previous fiscal year. Partially
offsetting these increases were reduced headcount and related expenses in fiscal 2006, compared to
the same period in fiscal 2005.
Research and Development. Research and development expenses in fiscal 2006 increased $7.3 million
compared to fiscal 2005. This increase was due primarily to the inclusion of H3C expenses for the
two months ended May 31, 2006 and the inclusion of TippingPoint’s expenses in the 2006 fiscal
period. In addition, a $4.2 million charge resulting from the impairment of licensed software was
incurred for which we had no alternative future use. The increase was offset by reduced workforce
expenses as a result of restructuring activities and reduced project spending in the current year.
General and Administrative. General and administrative expenses in fiscal 2006 increased $12.8
million from fiscal 2005. This increase is due to H3C expenses for the two months ended May 31,
2006 and the inclusion of TippingPoint’s expenses in the 2006 fiscal period and $4.6 million
related to executive transition costs in the current year. In addition, we incurred performance
related compensation expenses in the year ended May 31, 2006, which were not incurred in the
previous fiscal year.
Amortization and Write-Down of Intangibles. Amortization and write-down of intangibles were $20.9
million in fiscal 2006 and $9.0 million in fiscal 2005, an increase of $11.9 million. Amortization
and write-down of intangibles increased due to $132.6 million of purchased intangibles acquired in
the acquisition of 2 percent of the equity of H3C in fiscal 2006 that are being amortized on a
straight-line basis over their estimated useful lives of between three and five years. Partially
offsetting this increase was a reduction in impairment charges.
In-process research and development. $0.7 million of the total purchase price of 2 percent of the
equity of H3C has been preliminarily allocated to in-process research and development and was
expensed in the fourth quarter of fiscal 2006. Projects that qualify as in-process research and
development represent those that have not yet reached technological feasibility and which have no
alternative future use. At the time of acquisition, H3C had multiple in-process research and
development efforts under way for certain current and future product lines.
Restructuring Charges. Restructuring charges were $14.4 million in fiscal 2006 and $23.9 million
in fiscal 2005. Restructuring charges in fiscal 2006 were composed primarily of charges for actions
taken in fiscal 2006, including employee severance and outplacement costs of $9.6 million, and
facilities-related charges of $1.6 million. Restructuring charges for fiscal 2006 were the result
of reductions in workforce and continued efforts to consolidate and dispose of excess facilities.
46
Table of Contents
We announced in June 2006 a multi-faceted SCN restructuring. The plan focuses on reducing
components of the SCN operating segment cost structure in order to achieve our goal of future
profitability. The plan includes: the closure of approximately 21 facilities around the world; a
reduction in workforce of approximately 250 full-time employees, equating to approximately 15
percent of our SCN headcount; and focusing our sales, marketing, and services effort.
Further actions may be taken if our business activity declines and additional cost reduction
efforts are necessary.
Gain on Investments, Net
During fiscal 2006, net gains on investments were $4.3 million, primarily reflecting gains from
sales of certain equity securities. During fiscal 2005, net gains on investments were $1.6
million, reflecting $2.2 million of recognized gains from the sale of an investment in a
privately-held company and public traded securities partially offset by a net loss of $0.6 million
due to fair value adjustments of investments in limited partnership venture capital funds.
Interest Income and Other Income (Expense), Net
Interest and other income, net, was $37.3 million in fiscal 2006, an increase of $20.7 million
compared to $16.6 million in fiscal 2005. An increase in interest income accounted for $7.7
million of this increase, primarily attributable to higher interest rates applicable to short-term
investments and the inclusion of two months of H3C results. Also contributing to the increase was
$7.4 million of other income from H3C for an operating subsidy program by the Chinese VAT
authorities in the form of a partial refund of VAT taxes collected by H3C from purchasers of
software products, and a reduction in interest expense due to the expiration of our revolving
credit facility in November 2004 according to its terms. Our results reflect a quarterly payment
that was received during the two month period of H3C’s results that are in our consolidated
financials.
Income Tax (Provision) Benefit
Our income tax benefit was $14.8 million in fiscal 2006, compared to an income tax provision of
$3.5 million in fiscal 2005. The tax benefit for fiscal 2006 was the result of a $23.0 million
benefit resulting from a tax settlement with foreign tax authorities in the second quarter of
fiscal 2006, for which reserves had been provided in prior years and have now been reversed into
income upon reaching settlement. Partially offsetting income tax benefit for fiscal 2006 was the
provision of additional taxes in certain state and foreign jurisdictions. Our income tax provision
for fiscal 2005 was the result of providing for taxes in certain state and foreign jurisdictions,
partially offset by the favorable resolution of an income tax audit in a foreign jurisdiction.
Equity Interest in Income (Loss) of Unconsolidated Joint Venture
As described more fully above, we accounted for our investment in H3C by the equity method prior to
the acquisition of majority ownership on January 27, 2006. In fiscal 2006 we recorded income of
$11.0 million representing our share of the net income from operations generated by H3C from April
1, 2005 through January 31, 2006. In fiscal 2005 we recorded a charge of $7.0 million representing
our share of the net loss from operations incurred by H3C from April 1, 2004 through March 31,
2005.
Minority Interest of Huawei in the (Income) of Consolidated Huawei-3Com Joint Venture
In fiscal 2006, we recorded a charge of $11.1 million representing Huawei 49 percent interest in
the net income reported by the H3C joint venture for the two month period included in our fiscal
2006.
47
Table of Contents
LIQUIDITY AND CAPITAL RESOURCES
Cash and equivalents and short-term investments as of May 31, 2007 were $559.2 million, a decrease
of approximately $305.1 million compared to the balance of $864.3 million as of May 31, 2006.
These balances were comprised of the following (in millions):
| 2007 | 2006 | 2005 | ||||||||||
Cash and equivalents |
$ | 559.2 | $ | 501.1 | $ | 268.5 | ||||||
Short-term investments |
— | 363.2 | 575.6 | |||||||||
Cash and equivalents and short term investments |
$ | 559.2 | $ | 864.3 | $ | 844.1 | ||||||
The May 31, 2007 balance included cash and equivalents in our H3C segment of $328.7 million.
The following table shows the major components of our consolidated statements of cash flows for the
last three fiscal years:
| Years Ended May 31, | ||||||||||||
| (in millions) | 2007 | 2006 | 2005 | |||||||||
Cash and equivalents, beginning of period |
$ | 501.1 | $ | 268.5 | $ | 476.3 | ||||||
Net cash provided by (used in) operating activities |
165.5 | (86.2 | ) | (135.6 | ) | |||||||
Net cash provided by (used in) investing activities |
(505.9 | ) | 300.8 | (12.7 | ) | |||||||
Net cash provided by (used in) financing activities |
387.9 | 15.7 | (59.4 | ) | ||||||||
Other |
10.6 | 2.3 | (0.1 | ) | ||||||||
Cash and equivalents, end of period |
$ | 559.2 | $ | 501.1 | $ | 268.5 | ||||||
Net cash provided by operating activities was $165.5 million for fiscal 2007. The increase in cash
was largely due to non-cash adjustments to our net loss which included $75.0 million of
depreciation and amortization, $35.8 million of IPR&D charges, the minority interest in H3C income
of $26.2 million and $20.1 million of stock based compensation, as well as significant reductions
in inventories and other liabilities, which were partially offset by our net loss. Based on
current business conditions and our current operating and financial plans, we believe that our
existing cash, cash equivalents and short-term investments will be sufficient to satisfy our
anticipated cash and debt payment requirements for at least the next 12 months.
Significant commitments that will require the use of cash in future periods include obligations
under debt, lease, contract manufacturing and outsourcing agreements, as shown in the following
table (in millions):
| Payments Due by Period | ||||||||||||||||||||
| Less than | More than | |||||||||||||||||||
| Contractual Obligations (1) | Total | one year | 1-3 years | 3-5 years | 5 years | |||||||||||||||
Operating leases |
$ | 47.2 | $ | 27.7 | $ | 19.5 | $ | — | $ | — | ||||||||||
Purchase commitments with
contract manufacturers
(2) |
70.3 | 70.3 | — | — | — | |||||||||||||||
Long term debt (3) |
430.0 | 94.0 | 144.0 | 192.0 | — | |||||||||||||||
Outsourcing agreements (4) |
12.0 | 12.0 | — | — | — | |||||||||||||||
Total |
$ | 559.5 | $ | 204.0 | $ | 163.5 | $ | 192.0 | $ | — | ||||||||||
| (1) | Includes SCN segment obligations as of May 31, 2007 and H3C segment obligations as of March 31, 2007. Does not include EARP payment requirements described below. | |
| (2) | We have entered into purchase agreements with our contract manufacturers. Pursuant to these agreements, if our actual orders and purchases fall below forecasted levels, we may be required to purchase finished goods inventory manufactured to meet our requirements. In addition, we may be required to purchase raw material and work in process inventory on-hand that is unique to our products, and we may be required to compensate the contract manufacturers with respect to their non-cancelable purchase orders for such inventory. The amount shown in the table above represents our estimate of inventory held by contract manufacturers that we could be required to purchase within the next 12 months. We do not expect any such required purchases to exceed our requirements for inventory to meet expected sales of our products to our customers. |
48
Table of Contents
| (3) | Represents required principal and interest payments on our senior secured loan, but does not include “excess cash flow” payments which are dependent on whether H3C generates any excess cash flow, as defined in the A&R Loans. | |
| (4) | Under our customer service, IT outsourcing agreements and research and development agreement we are subject to service level commitments and contractor commitments levels providing for annual minimum payments that vary depending on the levels we choose. The amounts shown in the table above represent the amounts that would be payable, based on current levels, through the expiration of the agreements. However, our IT agreement may be terminated at any time upon 120 days notice and the payment of a termination fee ranging from approximately $1.1 million to $1.5 million, and our research and development agreement may be terminated at any time with a $0.8 million payment. Our customer service agreement with Siemens expires in 2011 but we have communicated that we are terminating the contract for convenience on the third anniversary date, which is in October of 2007. We currently expect to incur approximately $1.7 million of termination fees. |
We have no material commitments for capital expenditures as of May 31, 2007 other than
ordinary course of business purchases of computer hardware, software and leasehold improvements.
Net cash used in investing activities was $505.9 million for fiscal 2007, including $898.5 million
used to purchase the remaining 49 percent interest in H3C and the purchase of the assets of Roving
Planet, and $28.3 million of outflows related to the purchase of property and equipment. We made
investments totaling $225.0 million in fiscal 2007 and $421.3 million in fiscal 2006, in municipal
and corporate bonds, government agency instruments and equity securities. Proceeds from maturities
and sales of municipal and corporate bonds, government agency instruments and equity securities
were $609.3 million in fiscal 2007 and $629.0 million in fiscal 2006. We also had $36.6 million of
proceeds from the sale of the Santa Clara facility and insurance proceeds for the previously
disclosed damage to our Hemel Hemstead facility. In September 2006 we sold all of our remaining
venture portfolio and generated cash of approximately $1.3 million with a loss on sale of
investments of $0.7 million. In August 2006, we sold certain limited partnership interests and
generated cash of approximately $17.0 million with a gain on sale of investment of $2.4 million and
eliminated our future capital call requirements.
Net cash provided by financing activities was $387.9 million for fiscal 2007, which includes $415.8
million of proceeds from the A&R Loans partially offset by $80.0 million of H3C return of capital
to 3Com and Huawei, its two shareholders at the time. Accordingly, our consolidated cash balance
was reduced by $40.8 million for Huawei’s share of the distribution. During fiscal 2007, we also
repurchased shares of restricted stock valued at $13.5 million upon vesting of awards from
employees consisting of shares to satisfy the tax withholding obligations that arise in connection
with such vesting. This was offset by proceeds of $23.6 million from issuances of our common stock
upon exercise of stock options. During fiscal 2005, we entered a new agreement facilitating the
issuance of standby letters of credit and bank guarantees required in the normal course of
business. As of May 31, 2007, such bank-issued standby letters of credit and guarantees totaled
$5.9 million, including $5.0 million relating to potential foreign tax, custom, and duty
assessments.
During fiscal 2007, we issued approximately 7.2 million shares of our common stock in connection
with our employee stock purchase and option plans with total proceeds from such issuances of $14.9
million. As of May 31, 2007, our outstanding stock options as a percentage of outstanding shares
were 13 percent.
On March 22, 2007, H3C Holdings Limited (the “Borrower”), an indirect wholly-owned subsidiary of
3Com Corporation, entered into a Credit and Guaranty Agreement with
various lenders (the “Credit Agreement”). On March
28, 2007, the Borrower borrowed $430 million under the Credit Agreement in the form of a senior
secured term loan to finance a portion of the purchase price for 3Com’s acquisition of 49 percent
of H3C.
On May 25, 2007, the parties amended and restated the Credit Agreement in order to, among other
things, convert the facility into two tranches with different principal amortization schedules and
different interest rates, as further described below (the “A&R Loans”). The parties closed the
A&R Loans on May 31, 2007. The A&R Loans are subject to the terms and conditions of an Amended and Restated Credit and
Guaranty Agreement dated as of May 25, 2007 and effective as of May 31, 2007 (the “A&R Credit
Agreement”).
As amended, borrowings under the Credit Agreement consist of two tranches with different principal
amortization schedules and different interest rates. We are required to maintain a rating from
Moody’s and S&P during the term of the A&R Loans.
49
Table of Contents
Interest on borrowings is payable semi-annually on March 28 and September 28, commencing on
September 28, 2007. All amounts outstanding under the Tranche A Term Facility will bear interest,
at the Borrower’s option, at the (i) LIBOR, or (ii) Base Rate (i.e., prime rate), in each case
plus the applicable margin percentage set forth in the table below, which is based on a
“leverage ratio” of consolidated indebtedness of the Borrower and its subsidiaries to EBITDA (as
defined in the A&R Credit Agreement, and calculated to exclude certain one-time nonrecurring
charges) for the relevant twelve-month period:
| Leverage Ratio | LIBOR + | Base Rate + | ||||||
>3.0:10
|
2.25 | % | 1.25 | % | ||||
< 3.0:1.0 but > 2.0:1.0
|
2.00 | % | 1.00 | % | ||||
< 2.0:1.0 but > 1.0:1.0
|
1.75 | % | 0.75 | % | ||||
< 1.0:1.0
|
1.50 | % | 0.50 | % | ||||
All amounts outstanding under the Tranche B Term Facility will bear interest, at the Borrower’s
option, at the (i) LIBOR plus 3.00 percent or (ii) Base Rate (i.e., prime rate) plus 2.00
percent. We have elected to use LIBOR as the reference rate for borrowings to date, and expect to
do so for the foreseeable future. In addition, the applicable margin for the Tranche A Term
Facility is 2.00 percent at May 31, 2007.
A default rate shall apply on all obligations in the event of default under the A&R Loans at a rate
per annum of 2 percent above the applicable interest rate.
The Borrower’s principal asset is 100 percent of the shares of H3C. Covenants and other
restrictions under the A&R Credit Agreement generally apply to the Borrower and its subsidiaries,
which we refer to as the “H3C Group.” 3Com’s SCN segment is not generally subject to the terms of
the A&R Credit Agreement, other than through parental guarantees. Required payments under the loan
are generally expected to be serviced by cash flows from the H3C Group and the loan is secured by
assets at the H3C level, as well as the parental guarantees (which are expected to be released
after H3C effects a successful capital reduction).
The A&R Loans may be prepaid in whole or in part without premium or penalty. The Borrower will be
required to make mandatory prepayments using net proceeds from H3C Group (i) asset sales, (ii)
insurance proceeds and (iii) equity offerings or debt incurrence. In addition, the Borrower will be
required to make annual prepayments in an amount equal to 75 percent of “excess cash flow” of the
H3C Group. This percentage will decrease to the extent that the Borrower’s leverage ratio is lower
than specified amounts. Any excess cash flow amounts not required to prepay the loan may be
distributed to and used by the Company’s SCN segment, provided certain conditions are met.
H3C and all other existing and future subsidiaries of the Borrower (other than PRC subsidiaries or
small “excluded subsidiaries”) will guarantee all obligations under the A&R Loans and are referred
to as “Guarantors.” Additionally, 3Com Corporation, 3Com Holdings Limited and 3Com Technologies,
will also guarantee all obligations under the A&R Loans until H3C effects a successful capital
reduction; these entities are not considered “Guarantors.” The loan obligations will be secured by
(1) first priority security interests in all assets of the Borrower and the Guarantors, including
their bank accounts, and (2) a first priority security interest in 100 percent of the capital stock
of the Borrower and H3C and the PRC subsidiaries of H3C.
The Borrower must maintain a minimum debt service coverage, minimum interest coverage, maximum
capital expenditures and a maximum total leverage ratio. Negative covenants restrict, among
other things, (i) the incurrence of indebtedness by the Borrower and its subsidiaries, (ii) the
making of dividends and distributions to 3Com’s SCN segment, (iii) the ability to make investments
including in new subsidiaries, (iv) the ability to undertake mergers and acquisitions and (v) sales
of assets. Also, cash dividends from the PRC subsidiaries to H3C, and H3C to the Borrower, will be
subject to restricted use pending payment of principal, interest and excess cash flow prepayments.
Standard events of default apply.
50
Table of Contents
Payments of principal on the A&R Loans are due as follows on September 28, for fiscal years ending
May 31 (in thousands):
| Tranche A | Tranche B | |||||||
2008 |
$ | 92,000 | $ | 2,000 | ||||
2009 |
46,000 | 2,000 | ||||||
2010 |
46,000 | 2,000 | ||||||
2011 |
46,000 | 2,000 | ||||||
2012 |
— | 20,000 | ||||||
2013 |
— | 172,000 | ||||||
The closing of the remaining 49 percent acquisition of H3C triggered a bonus program for
substantially all of H3C’s approximately 4,800 employees. This program, which was implemented by
Huawei and 3Com in a prior period, is called the Equity Appreciation Rights Plan, or EARP, and
funds a bonus pool based upon a percentage of the appreciation in H3C’s value from the initiation
of the program to the time of the closing of the Acquisition. A portion of the program is also
based on cumulative earnings of H3C. The total value of the EARP is expected to be approximately
$180 million. Approximately $94 million related to cumulative earnings and change-in-control was
accrued by March 31, 2007, and about $86 million is expected to vest in future periods. The first
cash pay-out under the program is currently expected to occur within 3Com’s first fiscal quarter of
2007, and we expect this payment to be approximately $94 million. We expect the unvested portion
will be accrued in our H3C operating segment over the next 4 fiscal years serving as a continued
retention and incentive program for H3C employees. The only stipulation for payout is that the
participants remain employed with the Company on the date of the payout which is required to be
made within a specified period after the anniversary date of our
49 percent H3C acquisition on
March 29, 2007.
Cash payment requirements under the Equity Appreciation Rights Plan for fiscal years ending May 31
are approximately as follows (in thousands):
2008 |
$ | 94,000 | ||
2009 |
39,000 | |||
2010 |
30,000 | |||
2011 |
17,000 |
It is expected that we will have significant cash outflows in fiscal 2008 of $108 million of loan
payments for principal and interest and approximately $94 million for EARP commitments.
EFFECTS OF RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
For additional information regarding recently issued accounting pronouncements, see Note 2 to our
Consolidated Financial Statements in Item 8 of this Annual Report on Form 10-K.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market Risk Disclosures. The following discussion about our market risk disclosures involves
forward-looking statements. Actual results could differ materially from those projected in the
forward-looking statements. We are exposed to market risk related to changes in interest rates,
foreign currency exchange rates, and equity security price risk. We do not use derivative
financial instruments for speculative or trading purposes.
Interest Rate Sensitivity. Interest to be paid by us on our senior secured loan is at an interest
rate based, at our option, on either the LIBOR or the prime rate, plus an applicable margin. We
expect the base interest rate generally to be based on the published LIBOR rate, which is subject
to change on a periodic basis. Recently, interest rates have trended upwards in major global
financial markets. If these interest rate trends continue, this will result in increased interest
rate expense as a result of higher LIBOR rates. Continued increases in interest rates could have a
material adverse effect on our financial position, results of operations and cash flows,
particularly if such increases are substantial. In addition, interest rate trends could affect
global economic conditions.
51
Table of Contents
Foreign Currency Exchange Risk. Our risk management strategy currently uses forward contracts to
hedge certain foreign currency exposures. The intent is to offset gains and losses that occur on
the underlying exposures with gains and losses resulting from the forward contracts that hedge
these exposures. We attempt to reduce the impact of foreign currency fluctuations on corporate
financial results by hedging existing foreign currency exposures and anticipated foreign currency
transactions expected to occur within one month. Anticipated foreign currency transaction exposures
with a maturity profile in excess of one month may be selectively hedged. Translation exposures
are not hedged. Due to the limitations on converting Renminbi, we are limited in our ability to
engage in currency hedging activities in China. Although the impact of currency fluctuations of
Renminbi to date has been slight, fluctuations in currency exchange rates in the future may have a
material adverse effect on our cash flow and results of operations.
Gains and losses on the forward contracts are largely offset by gains and losses on the underlying
exposure. A hypothetical ten percent appreciation of the U.S. Dollar from May 31, 2007 market
rates would increase the unrealized value of our forward contracts by $2.0 million. Conversely, a
hypothetical ten percent depreciation of the U.S. Dollar from May 31, 2007 market rates would
decrease the unrealized value of our forward contracts by $2.0 million. The gains or losses on the
forward contracts are largely offset by the gains or losses on the underlying transactions and
consequently we believe that a sudden or significant change in foreign exchange rates would not
have a material impact on future net income or cash flows.
Equity Security Price Risk. We hold publicly traded equity securities that are subject to market
price volatility. Equity security price fluctuations of plus or minus 50 percent would not have had
a material impact on our financial statements as of May 31, 2007.
52
Table of Contents
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULE
| Page | ||||
Consolidated Financial Statements: |
||||
| 54 | ||||
| 55 | ||||
| 56 | ||||
| 57 | ||||
| 58 | ||||
| 59 | ||||
Financial Statement Schedule: |
||||
| 105 | ||||
All other schedules are omitted, because they are not required, are not applicable, or the
information is included in the consolidated financial statements and notes thereto.
53
Table of Contents
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of 3Com Corporation
Marlborough, Massachusetts:
Marlborough, Massachusetts:
We have audited the accompanying
consolidated balance sheets of 3Com Corporation and subsidiaries
(3Com or the “Company”) as of June 1, 2007 and June 2, 2006, and the related consolidated statements
of operations, stockholders’ equity, and cash flows for each of the three years in the period ended
June 1, 2007. Our audits also included the consolidated financial statement schedule listed in the
Index at Item 15. These financial statements and financial statement schedule are the
responsibility of 3Com’s management. Our responsibility is to express an opinion on the financial
statements and financial statement schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight
Board (United States). Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material misstatement. An
audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the
financial statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects,
the financial position of 3Com at June 1, 2007 and June 2, 2006, and the results of its operations
and its cash flows for each of the three years in the period ended June 1, 2007 in conformity with
accounting principles generally accepted in the United States of America. Also, in our opinion,
such financial statement schedule referred to above, when considered 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, the Company adopted the provisions
of Statement of Financial Accounting Standards (“SFAS”) No. 123 (Revised), Share-Based Payment,
effective June 3, 2006.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight
Board (United States), the effectiveness of the Company’s internal control over financial reporting
as of June 1, 2007, based on the criteria established in Internal Control—Integrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated
July 31, 2007 expressed an unqualified opinion on management’s assessment of the effectiveness of
the Company’s internal control over financial reporting and an unqualified opinion on the
effectiveness of the Company’s internal control over financial reporting.
/s/ DELOITTE & TOUCHE LLP
Boston, Massachusetts
July 31, 2007
July 31, 2007
54
Table of Contents
3COM CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
| Years Ended May 31, | ||||||||||||
| 2007 | 2006 | 2005 | ||||||||||
Sales |
$ | 1,267,481 | $ | 794,807 | $ | 651,244 | ||||||
Cost of sales |
689,027 | 466,743 | 416,916 | |||||||||
Gross profit |
578,454 | 328,064 | 234,328 | |||||||||
Operating expenses: |
||||||||||||
Sales and marketing |
319,696 | 274,745 | 243,700 | |||||||||
Research and development |
215,632 | 101,870 | 94,584 | |||||||||
General and administrative |
93,875 | 72,596 | 59,833 | |||||||||
Amortization and write-down of intangible assets |
42,525 | 20,903 | 8,989 | |||||||||
In-process research and development |
35,753 | 650 | 6,775 | |||||||||
Restructuring charges |
3,494 | 14,403 | 23,922 | |||||||||
Total operating expenses |
710,975 | 485,167 | 437,803 | |||||||||
Operating loss |
(132,521 | ) | (157,103 | ) | (203,475 | ) | ||||||
Gain on investments, net |
1,143 | 4,333 | 1,580 | |||||||||
Interest income, net |
40,863 | 29,085 | 21,406 | |||||||||
Other income (expense), net |
38,291 | 8,235 | (4,785 | ) | ||||||||
Loss from operations before income taxes, equity interest in
income (loss) of unconsolidated joint venture, and minority
interest in income of consolidated joint venture |
(52,224 | ) | (115,450 | ) | (185,274 | ) | ||||||
Income tax (provision) benefit |
(10,173 | ) | 14,833 | (3,490 | ) | |||||||
Equity interest in income (loss) of unconsolidated joint venture |
— | 11,016 | (6,922 | ) | ||||||||
Minority interest in income of consolidated joint venture |
(26,192 | ) | (11,074 | ) | — | |||||||
Net loss |
$ | (88,589 | ) | $ | (100,675 | ) | $ | (195,686 | ) | |||
Basic and diluted net loss per share: |
||||||||||||
Net loss |
$ | (0.22 | ) | $ | (0.26 | ) | $ | (0.51 | ) | |||
Shares used in computing per share amounts: |
||||||||||||
Basic and diluted |
393,894 | 386,801 | 382,309 | |||||||||
The accompanying notes are an integral part of these consolidated financial statements.
55
Table of Contents
3COM CORPORATION
CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts)
| May 31, | ||||||||
| 2007 | 2006 | |||||||
ASSETS |
||||||||
Current assets: |
||||||||
Cash and equivalents |
$ | 559,217 | $ | 501,097 | ||||
Short-term investments |
— | 363,250 | ||||||
Notes receivable |
77,368 | 63,224 | ||||||
Accounts receivable, less allowance for doubtful
accounts of $15,292 and $16,422, respectively |
102,952 | 115,120 | ||||||
Inventories |
107,988 | 148,819 | ||||||
Other current assets |
50,157 | 57,835 | ||||||
Total current assets |
897,682 | 1,249,345 | ||||||
Property and equipment, less accumulated depreciation
and amortization of $234,554 and $232,944,
respectively |
76,460 | 89,109 | ||||||
Goodwill |
766,444 | 354,259 | ||||||
Intangible assets, net |
371,289 | 111,845 | ||||||
Deposits and other assets |
39,217 | 56,803 | ||||||
Total assets |
$ | 2,151,092 | $ | 1,861,361 | ||||
LIABILITIES AND STOCKHOLDERS’ EQUITY |
||||||||
Current liabilities: |
||||||||
Accounts payable |
$ | 110,430 | $ | 153,245 | ||||
Current portion of long-term debt |
94,000 | — | ||||||
Accrued liabilities and other |
435,638 | 318,036 | ||||||
Total current liabilities |
640,068 | 471,281 | ||||||
Deferred taxes and long-term obligations |
23,725 | 13,788 | ||||||
Long-term debt |
336,000 | — | ||||||
Minority interest |
— | 173,930 | ||||||
Stockholders’ equity: |
||||||||
Preferred stock, $0.01 par value, 10,000 shares
authorized; none outstanding |
— | — | ||||||
Common stock, $0.01 par value, 990,000 shares
authorized; shares issued: 399,064 and 393,442
respectively |
2,323,356 | 2,300,396 | ||||||
Unamortized stock-based compensation |
— | (7,565 | ) | |||||
Retained deficit |
(1,176,406 | ) | (1,087,512 | ) | ||||
Accumulated other comprehensive income (loss) |
4,349 | (2,957 | ) | |||||
Total stockholders’ equity |
1,151,299 | 1,202,362 | ||||||
Total liabilities and stockholders’ equity |
$ | 2,151,092 | $ | 1,861,361 | ||||
The accompanying notes are an integral part of these consolidated financial statements.
56
Table of Contents
3COM CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(In thousands)
| Accumulated | ||||||||||||||||||||||||||||||||
| Unamortized | Other | |||||||||||||||||||||||||||||||
| Common Stock | Treasury Stock | Stock-based | Retained | Comprehensive | ||||||||||||||||||||||||||||
| Shares | Amount | Shares | Amount | Compensation | Deficit | Income (Loss) | Total | |||||||||||||||||||||||||
Balances, May 31, 2004 |
392,738 | $ | 2,262,223 | — | $ | — | $ | (2,577 | ) | $ | (755,244 | ) | $ | (5,288 | ) | $ | 1,499,114 | |||||||||||||||
Components of comprehensive loss: |
||||||||||||||||||||||||||||||||
Net loss |
(195,686 | ) | (195,686 | ) | ||||||||||||||||||||||||||||
Unrealized loss on available-for-sale
securities, net of tax |
(213 | ) | (213 | ) | ||||||||||||||||||||||||||||
Net unrealized loss on derivative
instruments, net of tax |
(81 | ) | (81 | ) | ||||||||||||||||||||||||||||
Accumulated translation adjustments |
99 | 99 | ||||||||||||||||||||||||||||||
Total comprehensive loss |
(195,881 | ) | ||||||||||||||||||||||||||||||
Repurchase of common stock |
(36 | ) | (181 | ) | (14,983 | ) | (73,364 | ) | (73,545 | ) | ||||||||||||||||||||||
Common stock issued under stock plans, net
of cancellations |
675 | 3,698 | 6,848 | 33,543 | (4,760 | ) | (17,022 | ) | 15,459 | |||||||||||||||||||||||
Stock-based compensation expense |
395 | 2,446 | 2,841 | |||||||||||||||||||||||||||||
Stock issued in connection with acquisition |
36,055 | (9,120 | ) | 26,935 | ||||||||||||||||||||||||||||
Balances, May 31, 2005 |
393,377 | 2,302,190 | (8,135 | ) | (39,821 | ) | (14,011 | ) | (967,952 | ) | (5,483 | ) | 1,274,923 | |||||||||||||||||||
Components of comprehensive loss: |
||||||||||||||||||||||||||||||||
Net loss |
(100,675 | ) | (100,675 | ) | ||||||||||||||||||||||||||||
Unrealized gain on available-for-sale
securities, net of tax |
300 | 300 | ||||||||||||||||||||||||||||||
Accumulated translation adjustments |
2,226 | 2,226 | ||||||||||||||||||||||||||||||
Total comprehensive loss |
(98,149 | ) | ||||||||||||||||||||||||||||||
Repurchase of common stock |
(588 | ) | (2,848 | ) | (864 | ) | (4,228 | ) | (7,076 | ) | ||||||||||||||||||||||
Common stock issued under stock plans, net
of cancellations |
653 | 2,230 | 8,999 | 44,049 | (4,593 | ) | (18,885 | ) | 22,801 | |||||||||||||||||||||||
Stock-based compensation expense |
199 | 9,664 | 9,863 | |||||||||||||||||||||||||||||
Reduction of shares reserved for issuance
of options in connection with acquisition |
(1,375 | ) | 1,375 | — | ||||||||||||||||||||||||||||
Balances, May 31, 2006 |
393,442 | 2,300,396 | — | — | (7,565 | ) | (1,087,512 | ) | (2,957 | ) | 1,202,362 | |||||||||||||||||||||
Elimination of unamortized stock-based
compensation |
(7,565 | ) | 7,565 | — | ||||||||||||||||||||||||||||
Components of comprehensive loss: |
||||||||||||||||||||||||||||||||
Net loss |
(88,589 | ) | (88,589 | ) | ||||||||||||||||||||||||||||
Unrealized gain on available-for-sale
securities, net of tax |
2,310 | 2,310 | ||||||||||||||||||||||||||||||
Accumulated translation adjustments |
4,996 | 4,996 | ||||||||||||||||||||||||||||||
Total comprehensive loss |
(81,283 | ) | ||||||||||||||||||||||||||||||
Repurchase of common stock |
(2,359 | ) | (9,041 | ) | (870 | ) | (4,259 | ) | (163 | ) | (13,463 | ) | ||||||||||||||||||||
Common stock issued under stock plans, net
of cancellations |
7,981 | 19,471 | 870 | 4,259 | (142 | ) | 23,588 | |||||||||||||||||||||||||
Stock-based compensation expense |
20,095 | 20,095 | ||||||||||||||||||||||||||||||
Balances, May 31, 2007 |
399,064 | $ | 2,323,356 | — | $ | — | $ | — | $ | (1,176,406 | ) | $ | 4,349 | $ | 1,151,299 | |||||||||||||||||
The accompanying notes are an integral part of these consolidated financial statements.
57
Table of Contents
3COM CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
| Years Ended May 31, | ||||||||||||
| 2007 | 2006 | 2005 | ||||||||||
Cash flows from operating activities: |
||||||||||||
Net loss |
$ | (88,589 | ) | $ | (100,675 | ) | $ | (195,686 | ) | |||
Adjustments to reconcile net loss to net cash provided by (used
in) operating activities: |
||||||||||||
Depreciation and amortization |
74,990 | 44,685 | 51,852 | |||||||||
Write-down of intangibles |
— | — | 1,404 | |||||||||
Gain on property and equipment disposals |
(14,714 | ) | (646 | ) | (4,741 | ) | ||||||
Minority interest |
26,192 | 11,074 | — | |||||||||
Stock-based compensation expense |
20,095 | 9,863 | 2,841 | |||||||||
Gain on investments, net |
(1,417 | ) | (235 | ) | (1,580 | ) | ||||||
Deferred income taxes |
(10,487 | ) | 121 | 3,044 | ||||||||
In-process research and development |
35,753 | 650 | 6,775 | |||||||||
Equity interest in (income) loss of unconsolidated joint venture |
— | (11,016 | ) | 6,922 | ||||||||
Changes in assets and liabilities: |
||||||||||||
Accounts receivable |
(24,677 | ) | 5,913 | 4,708 | ||||||||
Inventories |
50,589 | (23,047 | ) | (9,629 | ) | |||||||
Other assets |
32,368 | 1,891 | 748 | |||||||||
Accounts payable |
(34,760 | ) | 3,430 | 19,224 | ||||||||
Other liabilities |
100,195 | (28,172 | ) | (21,476 | ) | |||||||
Net cash provided by (used in) operating activities |
165,538 | (86,164 | ) | (135,594 | ) | |||||||
Cash flows from investing activities: |
||||||||||||
Purchases of investments |
(225,005 | ) | (421,279 | ) | (618,320 | ) | ||||||
Proceeds from maturities and sales of investments |
609,342 | 629,036 | 931,122 | |||||||||
Purchases of property and equipment |
(28,331 | ) | (17,404 | ) | (21,121 | ) | ||||||
Businesses acquired in purchase transactions, net of cash
acquired |
(898,529 | ) | 110,407 | (355,686 | ) | |||||||
Proceeds from sale of property and equipment |
36,580 | — | 51,300 | |||||||||
Net cash (used in) provided by investing activities |
(505,943 | ) | 300,760 | (12,705 | ) | |||||||
Cash flows from financing activities: |
||||||||||||
Issuances of common stock |
23,588 | 22,801 | 15,459 | |||||||||
Repurchases of common stock |
(13,463 | ) | (7,076 | ) | (73,545 | ) | ||||||
Proceeds from long term debt |
415,811 | — | — | |||||||||
Repayments of borrowings |
— | — | (1,308 | ) | ||||||||
Dividend paid to minority interest shareholder |
(40,785 | ) | — | — | ||||||||
Other, net |
2,787 | — | — | |||||||||
Net cash provided by (used in) financing activities |
387,938 | 15,725 | (59,394 | ) | ||||||||
Effect of exchange rate changes on cash and equivalents |
10,587 | 2,241 | (46 | ) | ||||||||
Net change in cash and equivalents during period |
58,120 | 232,562 | (207,739 | ) | ||||||||
Cash and equivalents, beginning of period |
501,097 | 268,535 | 476,274 | |||||||||
Cash and equivalents, end of period |
$ | 559,217 | $ | 501,097 | $ | 268,535 | ||||||
Other cash flow information |
||||||||||||
Interest paid |
$ | 5,596 | $ | 212 | $ | 528 | ||||||
Income tax (payments) refunds received, net |
(18,970 | ) | (2,230 | ) | 10,402 | |||||||
Inventory transferred to property and equipment |
8,814 | 16,995 | 7,996 | |||||||||
The accompanying notes are an integral part of these consolidated financial statements.
58
Table of Contents
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1: Description of Business
We are incorporated in Delaware. A pioneer in the computer networking industry, we provide secure,
converged networking solutions, as well as maintenance and support services, for enterprises and
public sector organizations of all sizes. Headquartered in Marlborough, Massachusetts, we have
worldwide operations, including sales, marketing, research and development, and customer service
and support capabilities.
Note 2: Significant Accounting Policies
Fiscal year
Our fiscal year ends on the Friday closest to May 31. Fiscal 2007 consisted of 52 weeks and ended
on June 1, 2007. Fiscal 2006 consisted of the 52 weeks ended on June 2, 2006 and Fiscal 2005
consisted of the 53 weeks ended on June 3, 2005. For convenience, the consolidated financial
statements have been shown as ending on the last day of the calendar month.
Use of estimates in the preparation of consolidated financial statements
The preparation of the consolidated financial statements in conformity with accounting principles
generally accepted in the United States of America requires us to make assumptions and estimates
that affect the reported amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the consolidated financial statements and the reported amounts of sales,
costs and expenses during the reporting periods. Such management assumptions and estimates include
allowances for doubtful accounts receivable, product returns, rebates and price protection;
provisions for inventory to reflect net realizable value; estimates of fair value for investments
in privately held companies, goodwill and other intangible assets, estimation of fair value of
acquired businesses, and properties held for sale; valuation allowances against deferred income tax
assets; and accruals for severance costs, compensation, product warranty, other liabilities, and
income taxes, among others. Actual results could materially differ from those estimates and
assumptions.
Basis of presentation
The consolidated financial statements include the accounts of 3Com and its wholly-owned
subsidiaries. All significant intercompany balances and transactions are eliminated in
consolidation. As discussed in Notes 3 and 5, we accounted for our investment in the H3C joint
venture by the equity method until fiscal 2006, when we exercised our right to purchase an
additional 2 percent equity to give us a 51 percent majority ownership in H3C and we entered into
an agreement with Huawei, the other shareholder, for an aggregate purchase price of $28.0 million.
We were granted regulatory approval by the Chinese government and subsequently completed this
transaction on January 27, 2006 (date of acquisition). Since that time, we have owned a majority
interest in the joint venture and have determined that the criteria of Emerging Issues Task Force
No. 96-16, “Investor’s Accounting for an Investee When the Investor Has a Majority of the Voting
Interest but the Minority Shareholder or Shareholders Have Certain Approval or Veto Rights” have
been met. Accordingly, we consolidate H3C’s financial statements beginning February 1, 2006, a
date used under the principle of convenience close. H3C follows a calendar year basis of reporting
and therefore, H3C is consolidated on a two-month lag.
Segment reporting
As of May 31, 2007, we were organized in two reportable segments: Secured Converged Networking
(“SCN”) and H3C. The SCN reportable segment was comprised of all business activities outside of our
wholly-owned subsidiary, H3C, in China. The H3C segment was comprised of operations of our
wholly-owned subsidiary in China. Prior to 2006 we had one reportable segment.
Cash equivalents
Cash equivalents consist of highly liquid investments in debt securities with maturities of three
months or less when purchased.
59
Table of Contents
Short-term investments
Short-term investments primarily consist of investments in debt securities acquired with maturities
exceeding three months but less than one year. Our intent is to hold our investments in debt
securities to maturity. However, consistent with Statement of Financial Accounting Standards (SFAS)
No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” all investments in
debt securities and all investments in equity securities that have readily determinable fair values
have been classified as available-for-sale, since the sale of such investments may be required
prior to maturity to implement management strategies. Our short-term investments are reported at
fair value, with unrealized gains or losses excluded from earnings and included in other
comprehensive income (loss). Short-term investments are evaluated quarterly for other than
temporary declines in fair value, which are reported in earnings as identified. The cost of
investments sold is based on the specific identification method.
Allowance for doubtful accounts
We monitor payments from our customers on an on-going basis and
maintain allowances for doubtful accounts for estimated losses resulting from the inability of our
customers to make required payments. When we evaluate the adequacy of our allowances for doubtful
accounts, we take into account various factors including our accounts receivable aging, customer
creditworthiness, historical bad debts, and geographic and political risk. If the financial
condition of our customers were to deteriorate, resulting in an impairment of their ability to make
payments, additional allowances might be required.
Notes receivable
Notes receivable represent bills receivable from fourteen Chinese banks to our H3C wholly-owned
subsidiary that have maturities of less than six months. These notes originate from customers who
settle their commitments to H3C by providing us these bills issued by the Chinese banks. The
Chinese banks are responsible to pay H3C. The notes are also referred to as “bankers’
acceptances”.
Non-marketable equity securities and other investments
Non-marketable equity securities and other investments consist primarily of direct investments in
private companies and investments in limited partnership venture capital funds. Non-marketable
equity securities and other investments are accounted for at historical cost or, if we had
significant influence over the investee, by the equity method. Cost basis investments are evaluated
quarterly for other than temporary declines in fair value, which are reported in earnings as
identified. Investments accounted for by the equity method include investments in limited
partnership venture capital funds. The net income or loss of limited partnership venture capital
funds, and the fair values of the funds, are obtained from the funds’ most recently issued
financial statements. We record our proportionate share of the net income or loss of the funds, and
adjustments reflecting changes in the fair values of the funds, in gain on investments, net. Net
investment gains and losses recorded as a result of sales of our investments in the limited
partnership venture capital funds are based on the difference between the net sales proceeds and
the carrying value of the investment at the time of sale. Generally, in connection with such sales
and with the approval of the applicable fund’s general partners, we are released from all
obligations with respect to future capital calls associated with the investment sold except as
otherwise required by applicable law.
Concentration of credit risk
Financial instruments that potentially subject us to concentrations of credit risk consist
principally of cash and equivalents, short-term investments, notes receivable and accounts
receivable. For our cash and equivalents and notes receivable in China we maintain a minimum BB+
rating and for the period ended March 31, 2007 the average rating was A+.
Inventories
Inventories are stated at the lower of standard cost or market, which approximates actual cost.
Cost is determined using the first-in, first-out method.
Property and equipment
Property and equipment is stated at cost, net of accumulated depreciation and amortization.
Equipment under capital leases is stated at the lower of fair market value or the present value of
the minimum lease payments at the inception of the lease. We capitalize eligible costs related to
the application development phase of software developed internally or obtained for internal use.
Capitalized costs related to internal-use software are amortized using the straight-line method
over the estimated useful lives of the assets, which range from two to five years; the amounts
charged to amortization expense were $0.4 million in fiscal 2007, $0.7 million in fiscal 2006, and
$1.0 million in fiscal 2005.
60
Table of Contents
Long-lived assets
Long-lived assets and certain identifiable intangible assets to be held and used are subject to
periodic amortization and are reviewed for impairment whenever events or changes in circumstances
indicate that the carrying amount of such assets may not be recoverable. Determination of
recoverability of long-lived assets is based on an estimate of undiscounted future cash flows
resulting from the use of the asset and its eventual disposition. Measurement of an impairment loss
for long-lived assets and certain identifiable intangible assets that management expects to hold
and use is based on the fair value of the asset. Long-lived assets and certain identifiable
intangible assets to be disposed of are reported at the lower of carrying amount or fair value less
costs to sell.
Depreciation and amortization
Depreciation and amortization are computed using the straight-line method over the estimated useful
lives of the assets. Estimated useful lives of property and equipment are generally 2-15 years,
except for buildings for which the useful lives are 25-40 years. Depreciation and amortization of
leasehold improvements are computed using the shorter of the remaining lease terms or estimated
useful life.
Goodwill and purchased intangible assets
SFAS No. 142, “Goodwill and Other Intangible Assets”, requires goodwill to be tested for impairment
on an annual basis and between annual tests when events or circumstances indicate a potential
impairment. We test our goodwill for impairment annually during our third fiscal quarter. There
was no impairment of goodwill in fiscal 2007, 2006, or 2005. Furthermore, SFAS No. 142 requires
purchased intangible assets other than goodwill to be amortized over their useful lives unless
these lives are determined to be indefinite. Purchased intangible assets are carried at cost less
accumulated amortization. Amortization is computed over the estimated useful lives of the
respective assets, generally
27 years.
27 years.
Revenue recognition
We recognize the majority of product revenue in accordance with Staff Accounting Bulletin No. 101,
“Revenue Recognition in Financial Statements” and Staff Accounting Bulletin No. 104, “Revenue
Recognition.” Specifically, product revenue is recognized when persuasive evidence of an
arrangement exists, delivery has occurred and risk of loss has passed to the customer, the fee is
fixed or determinable, and collectibility is reasonably assured. In instances where the customer
specifies final acceptance of the product or service, revenue and related costs are deferred until
all acceptance criteria have been met. For sales of products that contain software that is marketed
separately, we apply the provisions of AICPA Statement of Position 97-2 “Software Revenue
Recognition,” as amended.
A significant portion of our sales are made to distributors and resellers through a two-tier
distribution channel. Revenue related to such sales is reduced for allowances for product returns,
price protection, rebates and other offerings established in our sales agreements. We allow for
product return rights that are generally limited to a percentage of sales over a one to three month
period.
Sales of services, including professional services, system integration, project management, and
training, are recognized upon completion of performance. Other service revenue, such as that
related to maintenance and support contracts, is recognized ratably over the contract term,
provided that all other revenue recognition criteria have been met. Royalty revenue is generally
recognized when we receive payment.
For arrangements that involve multiple elements, such as sales of products that include maintenance
or installation services, revenue is allocated to each respective element based on its relative
fair value and recognized when the revenue recognition criteria for each element have been met. We
use the residual method to recognize revenue when an arrangement includes one or more elements to
be delivered at a future date and objective and reliable evidence of the fair value of all the
undelivered elements exists. Under the residual method, the fair value of the undelivered elements
is deferred and the remaining portion of the arrangement fee is recognized as revenue for the
delivered elements, provided that all other revenue recognition criteria have been met. If
objective and reliable evidence of fair value of one or more undelivered elements does not exist,
revenue is deferred and recognized when delivery of those elements occurs or when fair value can be
established.
61
Table of Contents
Product warranty
We provide limited warranty on most of our products for periods ranging from 90 days to the
lifetime of the product, depending upon the product. The warranty generally includes parts, labor
and service center support. We estimate the costs that may be incurred under our warranty
obligations and record a liability in the amount of such costs at the time sales are recognized.
Factors that affect our warranty liability include the number of installed units, historical and
anticipated rates of warranty claims, and cost per claim. We periodically assess the adequacy of
our recorded warranty liabilities and adjust the amounts as necessary.
Advertising
Costs associated with cooperative advertising programs are estimated and recorded as a reduction of
revenue at the time the related sales are recognized. All other advertising costs are expensed as
incurred in sales and marketing.
Restructuring charges
In recent fiscal years, we have undertaken several initiatives involving significant changes in our
business strategy and cost structure. In connection with these initiatives, we have recorded
significant restructuring charges, as more fully described in Note 4. Generally, costs associated
with an exit or disposal activity are recognized when the liability is incurred. Costs related to
employee separation arrangements requiring future service beyond a specified minimum retention
period are recognized over the service period.
Foreign currency remeasurement and translation
Our foreign operations are subject to exchange rate fluctuations and foreign currency transaction
costs. The majority of our SCN sales transactions are denominated in U.S. dollars. The majority
of our H3C sales are denominated in Renminbi. For foreign operations with the local currency as
the functional currency, local currency denominated assets and liabilities are translated at the
year-end exchange rates, and sales, costs and expenses are translated at the average exchange rates
during the year. Gains or losses resulting from foreign currency translation are included as a
component of accumulated other comprehensive loss in the consolidated balance sheets. For foreign
operations with the U.S. dollar as the functional currency, foreign currency denominated assets and
liabilities are remeasured at the year-end exchange rates except for property and equipment which
are remeasured at historical exchange rates. Foreign currency denominated sales, costs and
expenses are recorded at the average exchange rates during the year. Gains or losses resulting
from foreign currency remeasurement are included in other income (expense), net, in the
consolidated statements of operations.
Our risk management strategy uses forward contracts to hedge certain foreign currency exposures.
The intent is to offset gains and losses that occur on the underlying exposures with gains and
losses resulting from the forward contracts that hedge these exposures. In accordance with SFAS
No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended, these
contracts are recorded at fair value, and fair value changes are expensed in the current period in
other income (expense), net. In addition, we enter into foreign exchange forward contracts to
hedge exposures related to anticipated foreign currency cash flows. Due to the limitations on
converting Renmimbi we do not engage in currency hedging activities in China. These contracts,
designated as cash flow hedges, also are recorded at fair value. The gain or loss from the
effective portion of the hedge is reported in the consolidated statement of operations in the same
period or periods and manner as the hedged transaction. The gain or loss from the ineffective
portion of the hedge is recognized in other income (expense), net, during the period of change. We
do not enter into derivatives for trading or other speculative purposes, nor do we use leveraged
financial instruments.
Other income (expense), net included net foreign currency losses of $1.2 million in fiscal 2007 and
$1.5 million in fiscal 2006 and 2005.
62
Table of Contents
Income taxes:
We are subject to income tax in a number of jurisdictions. A certain degree of estimation is
required in recording the assets and liabilities related to income taxes, and it is reasonably
possible that such assets may not be recovered and that such liabilities may not be paid or that
payments in excess of amounts initially estimated and accrued may be required. We assess the
likelihood that our deferred tax assets will be recovered from our future taxable income and, to
the extent we believe that recovery is not likely, we establish a valuation allowance. We consider
historical taxable income, estimates of future taxable income, and ongoing prudent and feasible tax
planning strategies in assessing the amount of the valuation allowance. Based on various factors,
including our recent losses, retained deficit, operating performance in fiscal 2007, and estimates
of future profitability, we have concluded that future taxable income will, more likely than not,
be insufficient to recover our U.S. net deferred tax assets as of May 31, 2007. Accordingly, we
have established an appropriate valuation allowance to offset such deferred tax assets. In
addition to valuation allowances against deferred tax assets, we maintain reserves for potential
tax contingencies arising in jurisdictions in which we do or have done business. Many of these
contingencies arise from periods when we were a substantially larger company. Such reserves are
based on our assessment of the likelihood of an unfavorable outcome and the expected potential loss
from such contingency, and are monitored by management. These reserves are maintained until such
time as the matter is settled or the statutory period for adjustment has passed. Adjustments could
be required in the future if we determine that the amount to be realized is greater or less than
the valuation allowance we have recorded or that our reserves for tax contingencies are inadequate.
We have U.S. federal loss carryforwards of approximately $2.5 billion as of May 31, 2007 expiring
between fiscal years 2008 and 2027, substantially all of which expire between fiscal years 2021 and
2027.
Comprehensive income (loss)
We account for comprehensive income (loss) in accordance with the provisions of SFAS No.130,
“Reporting Comprehensive Income.” SFAS No. 130 is a financial statement presentation standard that
requires us to disclose non-owner changes included in equity but not included in net income or
loss. Comprehensive income (loss) presented in the financial statements consists of foreign
currency translation and unrealized gains (losses) on available-for-sale securities.
An analysis of accumulated other comprehensive income (loss) follows (in thousands):
| Accumulated | ||||||||||||
| Accumulated | Other | |||||||||||
| Unrealized | Translation | Comprehensive | ||||||||||
| Gain (Loss) | Adjustment | Income (Loss) | ||||||||||
Balance as of May 31, 2004 |
$ | (2,107 | ) | $ | (3,181 | ) | $ | (5,288 | ) | |||
Change in period |
(294 | ) | 99 | (195 | ) | |||||||
Balance as of May 31, 2005 |
(2,401 | ) | (3,082 | ) | (5,483 | ) | ||||||
Change in period |
300 | 2,226 | 2,526 | |||||||||
Balance as of May 31, 2006 |
(2,101 | ) | (856 | ) | (2,957 | ) | ||||||
Change in period |
2,310 | 4,996 | 7,306 | |||||||||
Balance as of May 31, 2007 |
$ | 209 | $ | 4,140 | $ | 4,349 | ||||||
Stock-based Compensation
Prior to fiscal 2007, we accounted for stock-based compensation using the intrinsic value method
prescribed by Accounting Principles Board (APB) Opinion No. 25 “Accounting for Stock Issued to
Employees”. As described in Note 14, effective June 3, 2006, we adopted the fair value method of
accounting for stock-based compensation under Statement of Financial Accounting Standards (SFAS)
123(R) “Share-Based Payment”. Under the intrinsic value method, compensation cost associated with
a stock award was measured as the difference between the fair value of the common stock underlying
the award and the amount, if any, that as employee was required to pay for the award; measurement
generally occurred on the date of grant, which was the date on which the number of shares and price
to be paid was apparent. Under the fair value method, compensation cost associated with a stock
award is measured based on the estimated fair value of the award itself, determined using
established valuation models and principles, and is generally measured as on the date of grant.
The amounts measured under either method are generally recognized as expense over the requisite
service period, which is typically the vesting period.
Estimates of the fair value of equity awards in future periods will be affected by the market price
of our common stock, as well as the actual results of certain assumptions used to value the equity
awards. These assumptions include, but are not limited to, the expected volatility of the common
stock, the expected term of options granted, the risk free interest rate and dividend yield.
63
Table of Contents
The fair value of stock options and employee stock purchase plan shares is determined by using the
Black-Scholes option pricing model and applying the single-option approach to the stock option
valuation. The options generally have vesting on an annual basis over a vesting period of four
years. We estimate the expected option term by analyzing the historical term period from grant to
exercise and also consider the expected term for those options that are outstanding. The expected
term of employee stock purchase plan shares is the average of the remaining purchase periods under
each offering period. The volatility of the common stock is estimated using historical volatility.
The risk-free interest rate used in the Black-Scholes option pricing model is determined by looking
at historical U.S. Treasury zero-coupon bond issues with terms corresponding to the expected terms
of the equity awards. In addition, an expected dividend yield of zero is used in the option
valuation model, because we do not expect to pay any cash dividends in the foreseeable future. We
estimate forfeitures at the time of grant and revise those estimates in subsequent periods if
actual forfeitures differ from those estimates. In order to determine an estimated pre-vesting
option forfeiture rate, we used historical forfeiture data, which yields a forfeiture rate of 27
percent. We believe this historical forfeiture rate to be reflective of our anticipated rate on a
go-forward basis. This estimated forfeiture rate has been applied to all unvested options and
restricted stock outstanding as of June 1, 2006 and to all options and restricted stock granted
since June 1, 2006. Therefore, stock-based compensation expense is recorded only for those options
and restricted stock that are expected to vest.
Net loss per share
Basic earnings per share is computed using the weighted-average number of common shares
outstanding. Diluted earnings per share is computed using the weighted-average number of common
shares and potentially dilutive common shares outstanding during the period. Potentially dilutive
common shares consist of employee stock options and restricted stock, and are excluded from the
diluted earnings per share computation in periods where net losses were incurred.
Recently issued accounting pronouncements
In June 2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 48 (“FIN
48”), “Accounting for Uncertainty in Income Taxes,” which prescribes a comprehensive model for how
a company should recognize, measure, present and disclose in its financial statements uncertain tax
positions that the company has taken or expects to take on a tax return, including a decision
whether or not to file a return in a particular jurisdiction. Under this new guidance, the
financial statements will reflect expected future tax consequences including interest and penalties
of such positions presuming the taxing authorities’ full knowledge of the position and all relevant
facts, but without considering time values. This guidance also revises disclosure requirements and
introduces a prescriptive, annual, tabular roll-forward of unrecognized tax benefits. We are currently evaluating the impact of adopting FIN 48 and its impact on our financial position.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value
Measurements” (“SFAS No. 157”). SFAS No. 157 clarifies the principle that fair value should be
based on the assumptions market participants would use when pricing an asset or liability and
establishes a fair value hierarchy that prioritizes the information used to develop those
assumptions. Under the standard, fair value measurements would be separately disclosed by level
within the fair value hierarchy. SFAS No. 157 is effective for fiscal years beginning after
November 15, 2007 and is required to be adopted by 3Com in the first quarter of fiscal 2009. We
have not yet determined the impact, if any, that the implementation of SFAS No. 157 will have on
our results of operations or financial condition.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and
Financial Liabilities—Including an amendment of FASB Statement No. 115” (“SFAS 159”). SFAS 159
expands the use of fair value accounting but does not affect existing standards which require
assets or liabilities to be carried at fair value. Under SFAS 159, a company may elect to use fair
value to measure accounts and loans receivable, available-for-sale and held-to-maturity securities,
equity method investments, accounts payable, guarantees and issued debt. Other eligible items
include firm commitments for financial instruments that otherwise would not be recognized at
inception and non-cash warranty obligations where a warrantor is permitted to pay a third party to
provide the warranty goods or services. If the use of fair value is elected, any upfront costs and
fees related to the item must be recognized in earnings and cannot be deferred, e.g., debt issue
costs. The fair value election is irrevocable and generally made on an instrument-by-instrument
basis, even if a company has similar instruments that it elects not to measure based on fair value.
At the adoption date, unrealized gains and losses on existing items for which fair value has been
elected are reported as a cumulative adjustment to beginning retained earnings. Subsequent to the
adoption of SFAS 159, changes in fair value are recognized in earnings. SFAS 159 is effective for
fiscal years beginning after November 15, 2007 and is required to be adopted by 3Com in the first
quarter of fiscal 2009. 3Com currently is determining whether fair value accounting is appropriate
for any of its eligible items and cannot estimate the impact, if any, which SFAS 159 will have on
its consolidated results of operations and financial condition.
64
Table of Contents
In September 2006, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin
108 “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current
Year Financial Statements”, which expresses the staff’s views regarding the process of quantifying
financial statement misstatements. The Bulletin is effective at our fiscal year end 2008. The
Company believes the implementation will have no impact on our results of operations, cash flow or
financial position.
Note 3: Acquisitions
H3C
On November 17, 2003, we formed H3C, formerly known as the Huawei-3Com joint venture, with a
subsidiary of Huawei Technologies, Ltd. (Huawei). H3C is domiciled in Hong Kong, and has its
principal operating center in Hangzhou, China.
At the time of formation, we contributed cash of $160.0 million, assets related to our operations
in China and Japan, and licenses related to certain intellectual property in exchange for a 49
percent ownership interest. We recorded our initial investment in H3C at $160.1 million, reflecting
our carrying value for the cash and assets contributed. Huawei contributed its enterprise
networking business assets — including Local Area Network (LAN) switches and routers; engineering,
sales and marketing resources and personnel; and licenses to its related intellectual property — in
exchange for a 51 percent ownership interest. Huawei’s contributed assets were valued at $178.2
million at the time of formation.
Two years after formation of H3C, we had the one-time option to purchase an additional two percent
ownership interest from Huawei. On October 28, 2005, we exercised this right and entered into an
agreement to purchase an additional 2 percent ownership interest in H3C from Huawei for an
aggregate purchase price of $28.0 million. We were granted regulatory approval by the Chinese
government and subsequently completed this transaction on January 27, 2006 (date of acquisition).
Since then, we have owned a majority interest in the joint venture and determined that the criteria
of Emerging Issues Task Force No. 96-16, “Investor’s Accounting for an Investee When the Investor
Has a Majority of the Voting Interest but the Minority Shareholder or Shareholders Have Certain
Approval or Veto Rights” were met and, therefore, consolidated H3C’s financial statements beginning
February 1, 2006, a date used under the principle of a convenience close. As H3C reports on a
calendar year basis, we consolidate H3C based on H3C’s most recent financial statements, two months
in arrears.
Three years after formation of H3C, we and Huawei each had the right to initiate a bid process to
purchase the equity interest in H3C held by the other. 3Com initiated the bidding process on
November 15, 2006 to buy Huawei’s 49 percent stake in H3C and our bid of $882 million was accepted
by Huawei on November 27, 2006. The transaction closed on March 29, 2007, at which time the
purchase price was paid in full.
The acquisition transactions were all accounted for as purchases, and accordingly, the purchase
price was allocated to the assets purchased and liabilities assumed based on their estimated fair
values. Subsequent to obtaining control, the operating results of H3C for the period February
1, 2006 to March 31, 2006 are included in the consolidated financial statements, resulting in the
latter two months of H3C’s three months ended March 31, 2006 being included in our year ended May
31, 2006 statement of operations.
The purchase prices for our various transactions are shown below (in millions):
| 2007 | ||||||||||||
| 2003 | 2006 | Purchase | ||||||||||
| Investment | Purchase | (Preliminary) | ||||||||||
Cash paid for common stock |
$ | 160.0 | $ | 28.0 | $ | 882.0 | ||||||
Assets contributed |
0.1 | — | ||||||||||
Acquisition direct costs |
0.0 | 0.2 | 8.7 | |||||||||
Total purchase price |
$ | 160.1 | $ | 28.2 | $ | 890.7 | ||||||
65
Table of Contents
In accordance with SFAS No. 141, “Business Combinations,” the purchase price was allocated to the
tangible and intangible assets acquired and liabilities assumed, including in-process research and
development, based on their estimated fair values. The excess purchase price over those values is
recorded as goodwill. The fair values assigned to tangible and intangible assets acquired and
liabilities assumed are based on management’s estimates and assumptions, and other information
compiled by management. Goodwill recorded as a result of these acquisition is not deductible for
tax purposes. In accordance with SFAS No. 142, goodwill is not amortized but will be reviewed at
least annually for impairment. Purchased intangibles with finite lives will be amortized on a
straight-line basis over their respective estimated useful lives. The total purchase price has
been allocated as follows (in millions):
| 2003 | 2006 | 2007 | ||||||||||
| Investment | Purchase | Purchase | ||||||||||
Net tangible assets assumed |
$ | 7.4 | $ | 148.6 | ||||||||
Amortizable intangible assets: |
||||||||||||
Existing technology |
$ | 111.7 | 17.8 | 180.6 | ||||||||
Trade name and trademarks |
55.5 | |||||||||||
Non-compete agreement with Huawei |
33.0 | |||||||||||
Distributor agreements |
2.7 | 0.4 | 29.1 | |||||||||
Total amortizable intangible assets |
114.4 | 18.2 | 298.2 | |||||||||
Amortization prior to the 2006 acquisition |
(65.7 | ) | — | — | ||||||||
Net intangible assets |
48.7 | 18.2 | 298.2 | |||||||||
In-process research and development |
24.7 | 0.7 | 34.0 | |||||||||
Goodwill |
43.2 | 1.9 | 409.9 | |||||||||
Total preliminary purchase price allocation |
$ | 28.2 | $ | 890.7 | ||||||||
The preliminary allocation of the 2007 purchase price was based upon a preliminary valuation and
our estimates and assumptions are subject to change upon the finalization of the valuation.
Intangible assets include amounts recognized for the fair value of existing technology,
maintenance agreements, trade name and trademarks, distributor agreements and non-compete
agreement. These intangible assets have a weighted-average useful life of approximately five
years.
In-process research and development (IPR&D) represents incomplete H3C research and development
projects that had not reached technological feasibility and had no alternative future use as of
the acquisition dates. Technological feasibility is established when an enterprise has completed
all planning, designing, coding, and testing activities that are necessary to establish that a
product can be produced to meet its design specifications including functions, features, and
technical performance requirements. At the dates of acquisition, H3C had multiple IPR&D efforts
under way for certain current and future product lines. Purchased IPR&D relates primarily to
projects associated with the H3C routers and switch products, which had not yet reached
technological feasibility as of the acquisition date and have no alternative future use.
Of the total estimated purchase price paid to gain full control in 2007, a preliminary estimate of
approximately $148.6 million was allocated to net assets acquired. Net assets were valued at their
respective carrying amounts, which management believes approximate fair value, except for
adjustments to inventory and deferred revenue. Inventory was adjusted by an increase of $11.1
million in the consolidated balance sheet as of June 2, 2007, to adjust inventory to the actual
fair value less direct selling expense. Deferred revenues were reduced by $0.5 million in the
consolidated balance sheet as of June 2, 2007, to adjust deferred revenue to the estimated cost
plus an appropriate profit margin to perform the support and maintenance services.
Approximately $298.2 million of the 2007 purchase price was allocated to acquired identifiable
intangible assets. Existing core technology is comprised of products that have reached
technological feasibility, which includes most of H3C’s technology. The remainder of intangible
assets is associated with maintenance agreements, trademarks, and non-compete agreements. One day
worth of the amortization expense related to the amortizable intangible assets is reflected in the
audited consolidated statements of operations for the year ended June 2, 2007.
Of the total estimated 2007 purchase price, approximately $409.9 million was allocated to goodwill.
Goodwill represents the excess of the purchase price over the fair value of the net assets
acquired. Goodwill amounts are not amortized, but rather are tested for impairment at least
annually. In the event that we determine that the value of the goodwill has become impaired, an
accounting charge for the amount of the impairment will be incurred in the quarter in which such
determination is made.
66
Table of Contents
TippingPoint
On January 31, 2005, we completed our acquisition of 100 percent of the outstanding common shares
of TippingPoint Technologies, Inc. for consideration of $430.0 million. This amount excludes the
cost of integration, as well as other costs related to the transaction. TippingPoint is a
provider of networked-based intrusion prevention systems. The acquisition enabled us to expand
our portfolio of secure, converged voice and data networking solutions.
The TippingPoint acquisition was accounted for as a purchase, and accordingly, the assets
purchased and liabilities assumed are included in the consolidated balance sheet as of May 31,
2006 and 2005. The operating results of TippingPoint are included in the consolidated financial
statements since the date of acquisition.
The purchase price categories are shown below (in millions):
Cash paid for common stock |
$ | 389.5 | ||
Fair value of outstanding stock options assumed |
36.1 | |||
Acquisition direct costs |
4.4 | |||
Total purchase price |
$ | 430.0 | ||
In accordance with SFAS No. 141, “Business Combinations,” the purchase price was allocated to the
tangible and intangible assets acquired and liabilities assumed, including in-process research and
development, based on their estimated fair values, while the associated deferred stock compensation
was recorded based on intrinsic value. The fair values assigned to tangible and intangible assets
acquired and liabilities assumed are based on management’s estimates and assumptions, and other
information compiled by management, including valuations that utilize established valuation
techniques appropriate for the high technology industry. Goodwill recorded as a result of this
acquisition is not deductible for tax purposes. In accordance with SFAS No. 142, goodwill is not
amortized but will be reviewed at least annually for impairment. Purchased intangibles with finite
lives will be amortized on a straight-line basis over their respective estimated useful lives. The
total purchase price has been allocated as follows (in millions):
Net tangible assets assumed |
$ | 37.4 | ||
Amortizable intangible assets: |
||||
Existing technology |
39.1 | |||
Maintenance agreements |
19.0 | |||
Other |
11.8 | |||
Total amortizable intangible assets |
69.9 | |||
In-process research and development |
5.1 | |||
Deferred compensation on unvested stock options |
9.4 | |||
Goodwill |
308.2 | |||
Total purchase price |
$ | 430.0 | ||
During the three months ended August 31, 2005, we revised the purchase price allocation by
increasing net tangible assets assumed and reducing goodwill by $1.3 million. This adjustment
related to the revision of an estimate for a contingent liability assumed in the acquisition and
has been incorporated into the purchase price allocation above. As of February 28, 2006 the
purchase price has been finalized.
Intangible assets include amounts recognized for the fair value of existing technology,
maintenance agreements, trade name and trademarks, and non-competition agreements. These
intangible assets have a weighted-average useful life of approximately five years.
67
Table of Contents
IPR&D represents incomplete TippingPoint research and development projects that had not reached
technological feasibility and had no alternative future use as of the acquisition date.
Technological feasibility is established when an enterprise has completed all planning,
designing, coding, and testing activities that are necessary to establish that a product can be
produced to meet its design specifications including functions, features, and technical
performance requirements. At the time of acquisition, TippingPoint had multiple IPR&D efforts
under way for certain current and future product lines. The value assigned to IPR&D was
determined by considering the importance of each project to our overall development plan,
estimating costs to develop the purchased IPR&D into commercially viable products, estimating the
resulting net cash flows from the projects when completed and discounting the net cash flows to
their present value based on the percentage of completion of the IPR&D projects. Purchased IPR&D
relates primarily to projects associated with the TippingPoint UnityOne® products and Software
Management System product, which had not yet reached technological feasibility as of the
acquisition date and have no alternative future use. We utilized the multi-period excess earnings
method to value the IPR&D, using a discount rate of 20 percent. At the time of acquisition, it
was estimated that these development efforts would be completed over the next twelve months at an
estimated cost of approximately $10 million. As of February 28, 2006, these projects had been
completed.
Pro forma Results of Operations
The following unaudited pro forma financial information presents the consolidated results of
operations of 3Com and H3C as if the acquisition of full control of H3C had occurred as of the
beginning of the periods presented below. Preliminary adjustments, which reflect the
amortization of purchased intangible assets, in-process research and development and charges to
cost of sales for inventory write-ups, have been made to the consolidated results of operations.
We also eliminate the inter-company activity between the parties in the consolidated results. The
unaudited proforma financial information is not intended, and should not be taken as
representative of our future consolidated results of operations or financial condition or the
results that would have occurred had the acquisition occurred as of the beginning of the earliest
period.
| Fiscal Year | ||||||||
| (in millions, except per share amounts) | 2007 | 2006 | ||||||
Net sales |
$ | 1,267.5 | $ | 1,146.8 | ||||
Net loss |
(201.3 | ) | (102.2 | ) | ||||
Basic and diluted net loss per share |
$ | (0.51 | ) | $ | (0.26 | ) | ||
Our 2006 consolidated statements of cash flows reflect $110.4 million of the line item businesses
acquired in purchase transactions, net of cash acquired. This reflects acquired cash of $138.4
million on January 31, 2006 offset by the purchase price payment of $28.0 million for an additional
2 percent ownership of H3C.
Roving Planet Acquisition
On December 5, 2006, the Company acquired certain assets and liabilities of Roving Planet, Inc.
(“Roving Planet”) to support our strategy of extending our appliance-based intrusion prevention
system (“IPS”) business to include network access control (“NAC”) features. Under the terms of the
definitive agreement the Company acquired the Roving Planet assets for $8.0 million in cash, plus
assumption of liabilities of approximately $0.2 million.
The consolidated financial statements include the operating results of Roving Planet from the date
of acquisition, as part of the Company’s SCN operating segment. Pro forma results for the Roving
Planet acquisition have not been presented because the effects of the acquisitions were not
material to the Company’s financial results.
The Company’s methodology for allocating the purchase price for purchase acquisitions to
in-process research and development, purchased intangible assets and goodwill is determined through
established valuation techniques. In-process research and development is expensed upon acquisition
because technological feasibility has not been established and no future alternative uses exist.
68
Table of Contents
Based upon these established valuation techniques the Company assigned the purchase price for the
acquisition in the following manner (in millions):
| 2007 | ||||||||
| Preliminary Purchase | Useful Life for Purchased | |||||||
| Price Allocation | Intangible Assets | |||||||
In-process research and development |
$ | 1.7 | — | |||||
Purchased core technology |
3.1 | 3 years | ||||||
Goodwill |
3.2 | — | ||||||
Other |
0.2 | — | ||||||
Total acquisition value |
$ | 8.2 | — | |||||
The purchase price and related allocation are preliminary and may be revised as a result of
adjustments made to the purchase price, additional information regarding liabilities assumed,
including revisions of preliminary estimates of fair values made at the date of purchase.
Note 4: Restructuring Charges
In recent fiscal years, we have undertaken several initiatives involving significant changes in our
business strategy and cost structure.
In fiscal 2001, we began a broad restructuring of our business to enhance the focus and cost
effectiveness of our business units in serving their respective markets. These restructuring
efforts continued through fiscal 2004. We took the following specific actions in fiscal 2001,
2002, 2003, and 2004 (the “Fiscal 2001, 2002, 2003, and 2004 Actions”):
| § | announced the integration of the support infrastructure of two of our business units to leverage a common infrastructure in order to drive additional costs out of the business; | ||
| § | organized around independent businesses that utilized shared central services; | ||
| § | outsourced the manufacturing of certain high volume desktop, mobile and server connectivity products in a contract manufacturing arrangement; | ||
| § | entered into an agreement to outsource certain information technology (IT) functions; | ||
| § | outsourcing of our remaining manufacturing operations in Dublin, Ireland; | ||
| § | reduced our workforce; and | ||
| § | continued efforts to consolidate and dispose of excess facilities. |
During fiscal 2005 (the “Fiscal 2005 Actions”), we took the following additional measures to reduce
costs:
| § | Reductions in workforce; and | ||
| § | continued efforts to consolidate and dispose of excess facilities. |
During fiscal 2006 (the “Fiscal 2006 Actions”), we took the following additional measures to reduce
costs:
| § | Reductions in workforce; and | ||
| § | continued efforts to consolidate and dispose of excess facilities. |
During fiscal 2007 (the “Fiscal 2007 Actions”), we took the following additional measures to reduce
costs:
| § | Further reductions in workforce; and | ||
| § | continued efforts to consolidate and dispose of excess facilities. |
Restructuring charges related to these various initiatives were $3.5 million in fiscal 2007, $14.4
million in fiscal 2006, and $23.9 million in fiscal 2005. Such charges were net of credits of
$13.3 million in fiscal 2007, $0.1 million in fiscal 2006, and $7.6 million in fiscal 2005, related
primarily to revisions of previous estimates of employee separation expenses, lease obligation
costs and values on held for sale properties.
Accrued liabilities associated with restructuring charges are included in the caption “Accrued
liabilities and other” in the accompanying consolidated balance sheets. These liabilities are
classified as current because we expect to satisfy such liabilities in cash within the next 12
months.
69
Table of Contents
Fiscal 2007 Actions
Activity and liability balances related to the fiscal 2007 restructuring actions are as follows (in
thousands):
| Employee | Facilities- | Other | ||||||||||||||
| Separation | related | Restructuring | ||||||||||||||
| Expense | Charges | Costs | Total | |||||||||||||
Balance as of June 1, 2006 |
$ | — | $ | — | $ | — | $ | — | ||||||||
Provisions |
12,134 | (7,501 | ) | 247 | 4,880 | |||||||||||
Payments and non-cash charges |
(10,804 | ) | 7,765 | (247 | ) | (3,286 | ) | |||||||||
Balance as of May 31, 2007 |
$ | 1,330 | $ | 264 | $ | — | $ | 1,594 | ||||||||
Employee separation expenses include severance pay, outplacement services, medical and other
related benefits. The
reduction in workforce affected employees involved in research and development, sales and
marketing, customer support,
and general and administrative functions. Through May 31, 2007, the total reduction in workforce
associated with actions
initiated during fiscal 2007 included approximately 233 employees who had been separated or were
currently in the
separation process and approximately 15 additional employees who had been notified but had not yet
worked their last day.
We believe that the all remaining actions will be completed by the end of fiscal 2008.
Fiscal 2006 Actions
Activity and liability balances related to the fiscal 2006 restructuring actions are as follows (in
thousands):
| Employee | Facilities- | |||||||||||
| Separation | related | |||||||||||
| Expense | Charges | Total | ||||||||||
Balance as of June 1, 2005 |
$ | — | $ | — | $ | — | ||||||
Provisions |
9,558 | 1,635 | 11,193 | |||||||||
Payments and non-cash charges |
(4,681 | ) | (744 | ) | (5,425 | ) | ||||||
Balance as of May 31, 2006 |
4,877 | 891 | 5,768 | |||||||||
Provisions |
(688 | ) | (136 | ) | (824 | ) | ||||||
Payments and non-cash charges |
(4,189 | ) | (619 | ) | (4,808 | ) | ||||||
Balance as of May 31, 2007 |
$ | — | $ | 136 | $ | 136 | ||||||
Employee separation expenses include severance pay, outplacement services, medical and other
related benefits. The reduction in workforce affected employees involved in research and
development, sales and marketing, customer support, and general and administrative functions.
Through May 31, 2007, the total reduction in workforce associated with actions initiated during
fiscal 2006 included approximately 227 employees who had been separated or were currently in the
separation process and approximately 41 additional employees who had been notified but had not yet
worked their last day.
We believe that the all remaining actions will be completed by the end of fiscal 2008.
70
Table of Contents
Fiscal 2005 Actions
Activity and liability balances related to the fiscal 2005 restructuring actions are as follows (in
thousands):
| Employee | Long-term | Facilities- | Other | |||||||||||||||||
| Separation | Asset | related | Restructuring | |||||||||||||||||
| Expense | Write-downs | Charges | Costs | Total | ||||||||||||||||
Balance as of June 1, 2004 |
$ | — | $ | — | $ | — | $ | — | $ | — | ||||||||||
Provisions |
23,391 | 1,021 | 468 | 768 | 25,648 | |||||||||||||||
Payments and non-cash charges |
(15,186 | ) | (766 | ) | (80 | ) | (755 | ) | (16,787 | ) | ||||||||||
Balance as of May 31, 2005 |
8,205 | 255 | 388 | 13 | 8,861 | |||||||||||||||
Provisions |
1,873 | 221 | 32 | 364 | 2,490 | |||||||||||||||
Payments and non-cash charges |
(8,235 | ) | (221 | ) | (420 | ) | (364 | ) | (9,240 | ) | ||||||||||
Balance as of May 31, 2006 |
1,843 | 255 | — | 13 | 2,111 | |||||||||||||||
Provisions |
(1,395 | ) | (255 | ) | 32 | (13 | ) | (1,631 | ) | |||||||||||
Payments and non-cash charges |
(145 | ) | — | (32 | ) | — | (177 | ) | ||||||||||||
Balances as of May 31, 2007 |
$ | 303 | $ | — | $ | — | $ | — | $ | 303 | ||||||||||
Employee separation expenses include severance pay, outplacement services, medical and other
related benefits. The reduction in workforce affected employees involved in research and
development, sales and marketing, customer support, general and administrative, and manufacturing
functions. Through May 31, 2007, the total reduction in workforce associated with actions initiated
during fiscal 2005 included approximately 397 employees who had been separated or were currently in
the separation process and approximately 3 additional employees who had been notified but had not
yet worked their last day. The provision of $1.9 million recorded in fiscal 2006 relates to
employees separation costs for employees that were not notified or had not worked their last day
until fiscal 2006. For the year ended May 31, 2007, 2006 and 2005, total separation payments
associated with actions initiated during fiscal 2005 were approximately $0.1 million, $8.2 million
and $15.2 million, respectively.
Long-term asset write-downs were associated with assets that no longer support our continuing
operations. The provision of $1.0 million was related to capitalized software licenses with no
future benefit ($0.5 million) and leasehold improvements in vacated facilities ($0.5 million).
Facilities-related charges included write-downs and accelerated depreciation of properties,
including properties that were classified as held for sale prior to fiscal 2005, as well as
expenses related to lease obligations.
Other restructuring costs of $0.4 million and $0.8 million for the years ended May 31, 2006 and
2005, respectively, included payments to suppliers and contract termination fees.
We believe that the all remaining actions will be completed by the end of fiscal 2008.
71
Table of Contents
Fiscal 2001, 2002, 2003 and 2004 Actions
Activity and liability balances related to the fiscal 2001, 2002, 2003 and 2004 restructuring
actions are as follows (in thousands):
| Employee | Long-term | Facilities- | Other | |||||||||||||||||
| Separation | Asset | related | Restructuring | |||||||||||||||||
| Expense | Write-downs | Charges | Costs | Total | ||||||||||||||||
Balance as of May 31, 2004 |
$ | 5,529 | $ | — | $ | 9,819 | $ | 82 | $ | 15,430 | ||||||||||
Provisions |
(2,829 | ) | 12 | 813 | 278 | (1,726 | ) | |||||||||||||
Payments and non-cash charges |
(2,700 | ) | (12 | ) | (1,891 | ) | (355 | ) | (4,958 | ) | ||||||||||
Balance as of May 31, 2005 |
— | — | 8,741 | 5 | 8,746 | |||||||||||||||
Provisions |
— | 90 | 609 | — | 699 | |||||||||||||||
Payments and non-cash charges |
— | (90 | ) | (3,709 | ) | — | (3,799 | ) | ||||||||||||
Balance as of May 31, 2006 |
— | — | 5,641 | 5 | 5,646 | |||||||||||||||
Provisions |
— | — | 1,053 | 16 | 1,069 | |||||||||||||||
Payments and non-cash charges |
— | — | (5,351 | ) | (21 | ) | (5,372 | ) | ||||||||||||
Balance as of May 31, 2007 |
$ | — | $ | — | $ | 1,343 | $ | — | $ | 1,343 | ||||||||||
The reductions in workforce affected employees involved in sales, customer support, product
development, and general and administrative positions. During fiscal 2005, we recorded a net
benefit related to revisions of previous estimates of employee separation expenses.
Facilities-related charges included accelerated depreciation of buildings, write-downs of land and
buildings held for sale, losses on sales of facilities, and lease obligations.
Other restructuring costs included payments to suppliers and contract termination fees.
We believe that the all remaining actions will be completed by the end of fiscal 2008.
Note 5: Investment in Unconsolidated Joint Venture
As described in Note 3 we formed the Huawei-3Com joint venture (H3C) with a subsidiary of Huawei
Technologies, Ltd. (Huawei).
At the time of formation, we contributed cash of $160.0 million, assets related to our operations
in China and Japan, and licenses related to certain intellectual property in exchange for a 49
percent ownership interest. We recorded our initial investment in H3C at $160.1 million, reflecting
our carrying value for the cash and assets contributed. Huawei contributed its enterprise
networking business assets - including Local Area Network (LAN) switches and routers; engineering,
sales, marketing resources and personnel; and licenses to its related
intellectual property - in
exchange for a 51 percent ownership interest. Huawei’s contributed assets were valued at $178.2
million at the time of formation.
Prior to the acquisition we accounted for our investment by the equity method. Under this method,
we recorded our proportionate share of H3C’s net income or loss based on the most recently
available quarterly financial statements. Since H3C follows a calendar year basis of reporting, we
reported our equity in H3C’s net loss for H3C’s fiscal period from April 1, 2005 through January
31, 2006 for the fiscal year 2006, April 1, 2004 through March 31, 2005 for the fiscal year 2005 in
our results of operations for fiscal 2006 and 2005. This represents reporting two months in
arrears.
72
Table of Contents
Summarized information from the balance sheet and statement of operations for H3C for the ten month
period ended January 31, 2006, and for the year ended March 31, 2005 (in thousands):
| January 31, | March 31, | |||||||
| 2006 | 2005 | |||||||
Balance Sheet |
||||||||
Current assets |
$ | 404,068 | $ | 259,369 | ||||
Non-current assets |
132,130 | 149,571 | ||||||
Current liabilities |
210,853 | 109,097 | ||||||
Non-current liabilities |
8,866 | 8,866 | ||||||
Statement of Operations: |
||||||||
Sales |
$ | 399,612 | $ | 297,977 | ||||
Gross profit |
181,553 | 120,498 | ||||||
Income (loss) from operations |
10,132 | (17,064 | ) | |||||
Net income (loss) |
22,487 | (14,125 | ) | |||||
In determining our share of the net loss of H3C certain adjustments are made to H3C’s reported
results. These adjustments are made primarily to recognize the value and the related amortization
expense associated with Huawei’s contributed assets, as well as to defer H3C’s sales and gross
profit on sales of products sold to us that remained in our inventory at the end of the accounting
period. We recorded our equity interest in income (loss) of $11.0 million in fiscal 2006 (prior to
the acquisition of majority ownership on January 27, 2006) for the period April 1, 2005 through
January 31, 2006 and, ($6.9) million in fiscal 2005 for the period April 1, 2004 through March 31,
2005 as our share of H3C’s net income (loss); this income (loss) is included in our results of
operations under the caption “Equity interest in income (loss) of unconsolidated joint venture.”
3Com and H3C are parties to agreements for the sale of certain products between the two companies.
During the ten months ended January 31, 2006 (date of the 2 percent acquisition) we recorded sales
to H3C of approximately $10.6 million and made purchases of approximately $53.8 million. During
fiscal 2005, we recorded sales to H3C of approximately $13.2 million and made purchases of
approximately $26.9 million.
Note 6: Investments
Available-for-sale securities consist of (in thousands):
| May 31, 2007 | ||||||||||||||||
| Gross | Gross | |||||||||||||||
| Amortized | Unrealized | Unrealized | Estimated | |||||||||||||
| Cost | Gains | Losses | Fair Value | |||||||||||||
Publicly traded corporate equity securities |
$ | 257 | $ | 210 | $ | — | $ | 467 | ||||||||
Total |
$ | 257 | $ | 210 | $ | — | $ | 467 | ||||||||
| May 31, 2006 | ||||||||||||||||
| Gross | Gross | |||||||||||||||
| Amortized | Unrealized | Unrealized | Estimated | |||||||||||||
| Cost | Gains | Losses | Fair Value | |||||||||||||
State and municipal securities |
$ | 22,816 | $ | — | $ | (96 | ) | $ | 22,720 | |||||||
U.S. Government and agency securities |
136,317 | 13 | (486 | ) | 135,844 | |||||||||||
Corporate debt securities |
205,793 | 13 | (1,120 | ) | 204,686 | |||||||||||
Short-term investments |
364,926 | 26 | (1,702 | ) | 363,250 | |||||||||||
Publicly traded corporate equity securities |
309 | 93 | — | 402 | ||||||||||||
Total |
$ | 365,235 | $ | 119 | $ | (1,702 | ) | $ | 363,652 | |||||||
73
Table of Contents
The total cost and carrying value of corporate equity securities consist of (in thousands):
| May 31, 2007 | ||||
| Carrying Value | ||||
Publicly traded corporate equity securities |
$ | 467 | ||
Total corporate equity securities |
$ | 467 | ||
| May 31, 2006 | ||||||||
| Initial Cost | Carrying Value | |||||||
Investments in limited partnership venture capital funds |
$ | 25,498 | $ | 15,794 | ||||
Direct investments in private companies |
12,262 | 91 | ||||||
Total private equity investments |
$ | 37,760 | 15,885 | |||||
Publicly traded corporate equity securities |
402 | |||||||
Total corporate equity securities |
$ | 16,287 | ||||||
Publicly traded corporate equity securities are included in other current assets. Private equity
instruments are included in deposits and other assets.
The following table provides gross realized gains and losses related to our investments (in
thousands):
| Years Ended May 31, | ||||||||||||
| 2007 | 2006 | 2005 | ||||||||||
Gross realized gains |
$ | 3,560 | $ | 5,499 | $ | 3,594 | ||||||
Gross realized losses |
(2,417 | ) | (1,166 | ) | (2,014 | ) | ||||||
Total |
$ | 1,143 | $ | 4,333 | $ | 1,580 | ||||||
Note 7: Inventories
Inventories consist of (in thousands):
| May 31, | ||||||||
| 2007 | 2006 | |||||||
Finished goods |
$ | 61,857 | $ | 69,386 | ||||
Work-in-process |
7,143 | 12,777 | ||||||
Raw materials |
38,988 | 66,656 | ||||||
Total |
$ | 107,988 | $ | 148,819 | ||||
74
Table of Contents
Note 8: Property and Equipment
Property and equipment, net, consists of (in thousands):
| May 31, | ||||||||
| 2006 | 2006 | |||||||
Land |
$ | 1,724 | $ | 6,999 | ||||
Buildings and improvements |
— | 11,122 | ||||||
Machinery and equipment |
231,886 | 202,407 | ||||||
Software |
31,387 | 63,814 | ||||||
Furniture and fixtures |
20,217 | 21,161 | ||||||
Leasehold improvements |
17,201 | 13,667 | ||||||
Construction in progress |
8,599 | 2,883 | ||||||
Total |
311,014 | 322,053 | ||||||
Accumulated depreciation and amortization |
(234,554 | ) | (232,944 | ) | ||||
Property and equipment, net |
$ | 76,460 | $ | 89,109 | ||||
Significant property and equipment transactions
For the Year Ended May 31, 2007. We continue to carry the Hemel Hempstead land as held for use,
which was damaged in December of 2005, on our balance sheet. Based on the size of the experienced
damage, our insurance policy administrator paid us a reimbursement value of approximately $28
million. Furthermore, with no feasible business necessity to keep this property, we are soliciting
offers from prospective buyers to acquire the building and land. Any sale would be contingent on UK
government agencies allowing reconstruction of the building. We believe this process will take more
than one year and as a result we have kept the land classified as held for use. In the first fiscal
quarter we received $16.0 million of proceeds from the sale of our Santa Clara facility.
For the Year Ended May 31, 2006. On December 11, 2005, our Europe, Middle East and Africa
headquarters facility in Hemel Hempstead, United Kingdom was damaged by explosions at a third-party
oil depot facility which occurred approximately one quarter mile from our facility. Approximately
300 employees and contractors worked at our Hemel campus, primarily in our sales, marketing and
product operations groups. The incident occurred during non-business hours and no employee
casualties or injuries were reported. We activated our back-up systems and established business
operations at alternative facilities to ensure business continuity and minimize disruption to our
customers. We believe we have sufficient insurance and recourse against third parties so that any
loss incurred by us in connection with these explosions should not have a material adverse effect
on our results of operations. The building is currently not being used for operations and the
carrying amount of $16.2 million has been reclassified from property and equipment to other
non-current assets and the associated depreciation has been ceased.
For the Year Ended May 31, 2005. In February 2005, we completed the sale of certain properties in
Hemel Hempstead, U.K. that were classified as held for sale. This property, consisting of
approximately 111,000 square feet of office and research and development space, previously had
been used for our administrative and research and development activities. Net proceeds from the
sale resulted in a gain on the sale of $0.1 million that was recorded in restructuring charges in
the third quarter of fiscal 2005.
75
Table of Contents
Note 9: Intangible Assets
Intangible assets consist of (in thousands):
| May 31, 2007 | May 31, 2006 | |||||||||||||||||||||||
| Accumulated | Accumulated | |||||||||||||||||||||||
| Gross | Amortization | Net | Gross | Amortization | Net | |||||||||||||||||||
Existing technology |
$ | 387,233 | $ | (148,641 | ) | $ | 238,592 | $ | 203,946 | $ | (114,235 | ) | $ | 89,711 | ||||||||||
Trademark |
55,500 | — | 55,500 | — | — | — | ||||||||||||||||||
Huawei non-compete
agreement |
33,000 | (61 | ) | 32,939 | — | — | — | |||||||||||||||||
OEM agreement |
23,800 | (22 | ) | 23,778 | — | — | — | |||||||||||||||||
Maintenance contracts |
19,000 | (7,389 | ) | 11,611 | 19,000 | (4,222 | ) | 14,778 | ||||||||||||||||
Other |
21,924 | (13,055 | ) | 8,869 | 15,301 | (7,945 | ) | 7,356 | ||||||||||||||||
Total |
$ | 540,457 | $ | (169,168 | ) | $ | 371,289 | $ | 238,247 | $ | (126,402 | ) | $ | 111,845 | ||||||||||
During fiscal 2007, we recorded approximately $298.2 million and $3.1 million of intangible assets
related to the H3C acquisition and the Roving Planet acquisition, respectively (See Note 3). These
amounts were recognized for the fair value of existing technology, maintenance agreements, trade
name and trademarks, distributor agreements and non-competition agreements. These intangible
assets have a weighted-average useful life of approximately four years.
During fiscal 2007, we reclassed $0.9 million of goodwill that no longer has an indefinite life to
intangible assets.
During fiscal 2006, we recorded approximately $132.6 million of intangible assets related to the
H3C acquisition and our consolidation of H3C (See Note 3). These amounts were recognized for the
fair value of existing technology, maintenance agreements, trade name and trademarks, and
non-competition agreements. These intangible assets have a weighted-average useful life of
approximately four years.
During fiscal 2005, we recorded approximately $69.9 million of intangible assets related to the
TippingPoint acquisition (See Note 3). These amounts were recognized for the fair value of existing
technology, maintenance agreements, trade name and trademarks, and non-competition agreements.
These intangible assets have a weighted-average useful life of approximately five years.
Annual amortization expense related to intangible assets is expected to be as follows for each of
the following five succeeding fiscal years (in thousands):
| 2008 | 2009 | 2010 | 2011 | 2012 | ||||||||||||||||
Amortization expense |
$ | 103,431 | $ | 81,240 | $ | 60,337 | $ | 36,206 | $ | 15,163 | ||||||||||
76
Table of Contents
Note 10: Accrued Liabilities and Other
Accrued liabilities and other consist of (in thousands):
| May 31, | ||||||||
| 2007 | 2006 | |||||||
Accrued payroll and related expenses |
$ | 81,791 | $ | 88,305 | ||||
EARP Accrual |
94,563 | 16,960 | ||||||
Accrued rebates and other marketing |
67,446 | 60,301 | ||||||
Deferred revenue |
54,034 | 57,050 | ||||||
Accrued product warranty |
40,596 | 41,791 | ||||||
Income and other taxes payable |
36,365 | 25,759 | ||||||
Advance from customers |
8,300 | — | ||||||
Restructuring |
3,376 | 13,525 | ||||||
Other |
49,167 | 14,345 | ||||||
Total |
$ | 435,638 | $ | 318,036 | ||||
Note 11: Accrued Warranty and Other Guarantees
Most products are sold with varying lengths of warranty ranging from 90 days to limited lifetime.
Allowances for estimated warranty obligations are recorded in the period of sale, based on
historical experience related to product failure rates and actual warranty costs incurred during
the applicable warranty period and are recorded as part of cost of goods sold. Also, on an ongoing
basis, we assess the adequacy of our allowances related to warranty obligations recorded in
previous periods and may adjust the balances to reflect actual experience or changes in future
expectations.
The following table summarizes the activity in the allowance for estimated warranty costs (in
thousands):
| Years Ended May 31, | ||||||||||||
| 2007 | 2006 | 2005 | ||||||||||
Accrued warranty, beginning of period |
$ | 41,791 | $ | 41,782 | $ | 43,825 | ||||||
Cost of warranty claims |
(46,950 | ) | (32,958 | ) | (32,910 | ) | ||||||
Accrual for warranties issued during the period |
46,406 | 28,424 | 30,867 | |||||||||
Adjustments to preexisting warranties |
(651 | ) | — | — | ||||||||
Reserves related to H3C at date of 2 percent acquisition |
— | 4,543 | — | |||||||||
Accrued warranty, end of period |
$ | 40,596 | $ | 41,791 | $ | 41,782 | ||||||
Note 12: Long-Term Debt
On March 22, 2007, H3C Holdings Limited (the “Borrower”), an indirect wholly-owned subsidiary of
3Com Corporation, entered into the Credit and Guaranty Agreement dated as of March 22, 2007 among
H3C Holdings Limited, as Borrower, 3Com Corporation, 3Com Holdings Limited and 3Com Technologies,
as Holdco Guarantors, various Lenders, Goldman Sachs Credit Partners L.P., as Mandated Lead
Arranger, Bookrunner, Administrative Agent and Syndication Agent (“GSCP”), and Industrial and
Commercial Bank of China (Asia) Limited, as Collateral Agent (the “Credit Agreement”). On March 28,
2007, the Borrower borrowed $430 million under the Credit Agreement in the form of a senior secured
term loan to finance a portion of the purchase price for 3Com’s acquisition of 49 percent of H3C
Technologies Co., Limited, or H3C.
On May 25, 2007, the parties amended and restated the Credit Agreement in order to, among other
things, convert the facility into two tranches with different principal amortization schedules and
different interest rates, as further described below (the “A&R Loans”). The parties closed the
A&R Loans on May 31, 2007.
77
Table of Contents
The A&R Loans are subject to the terms and conditions of an Amended and Restated Credit and
Guaranty Agreement dated as of May 25, 2007 and effective as of May 31, 2007 among H3C Holdings
Limited, as Borrower, 3Com Corporation, 3Com Holdings Limited and 3Com Technologies, as Holdco
Guarantors, H3C, as a Guarantor, various Lenders, GSCP, as Mandated Lead Arranger, Bookrunner,
Administrative Agent and Syndication Agent, and Industrial and Commercial Bank of China (Asia)
Limited, as Collateral Agent (the “A&R Credit Agreement”).
As amended, borrowings under the Credit Agreement consist of two tranches with different principal
amortization schedules and different interest rates. The first tranche, the “Tranche A Term
Facility,” matures in 2010 and its aggregate principal amount of $230 million is payable as to 40
percent in year one and then evenly (20 percent per year) over the succeeding three years. The
second tranche, the “Tranche B Term Facility,” matures in 2012 and its $200 million principal
amount is payable primarily in its fourth (10 percent) and fifth (86 percent) years. Moody’s
Investors Service has assigned a Ba2 rating to the A&R Loans and a Ba2 corporate family rating
(stable outlook) to H3C Holdings Limited. Standard & Poor’s Ratings Services assigned the A&R
Loans a ‘BB’ rating (with a recovery rating of ‘1’) and assigned a BB- corporate credit rating
(stable outlook) to H3C Holdings Limited. We are required to maintain a rating from each of these
agencies during the term of the A&R Loans.
Interest on borrowings is payable semi-annually on March 28 and September 28, commencing on
September 28, 2007. All amounts outstanding under the Tranche A Term Facility will bear interest,
at the Borrower’s option, at the (i) LIBOR, or (ii) Base Rate (i.e., prime rate), in each case
plus the applicable margin percentage set forth in the table below, which is based on a
“leverage ratio” of consolidated indebtedness of the Borrower and its subsidiaries to EBITDA (as
defined in the A&R Credit Agreement, and calculated to exclude certain one-time nonrecurring
charges) for the relevant twelve-month period:
| Leverage Ratio | LIBOR + | Base Rate + | ||||||
>3.0:10
|
2.25 | % | 1.25 | % | ||||
< 3.0:1.0 but > 2.0:1.0
|
2.00 | % | 1.00 | % | ||||
< 2.0:1.0 but > 1.0:1.0
|
1.75 | % | 0.75 | % | ||||
< 1.0:1.0
|
1.50 | % | 0.50 | % | ||||
All amounts outstanding under the Tranche B Term Facility will bear interest, at the Borrower’s
option, at the (i) LIBOR plus 3.00 percent or (ii) Base Rate (i.e., prime rate) plus 2.00
percent. We have elected to use LIBOR as the reference rate for borrowings to date, and expect to
do so for the foreseeable future. In addition, the applicable margin for the Tranche A Term
Facility is 2.00 percent at May 31, 2007.
A default rate shall apply on all obligations in the event of default under the A&R Loans at a rate
per annum of 2 percent above the applicable interest rate.
The Borrower’s principal asset is 100 percent of the shares of H3C. Covenants and other
restrictions under the A&R Credit Agreement generally apply to the Borrower and its subsidiaries,
which we refer to as the “H3C Group.” 3Com’s SCN segment is not generally subject to the terms of
the A&R Credit Agreement, other than through parental guarantees. Required payments under the loan
are generally expected to be serviced by cash flows from the H3C Group and the loan is secured by
assets at the H3C level, as well as the parental guarantees (which are expected to be released
after H3C effects a successful capital reduction).
The A&R Loans may be prepaid in whole or in part without premium or penalty. The Borrower will be
required to make mandatory prepayments using net proceeds from H3C Group (i) asset sales, (ii)
insurance proceeds and (iii) equity offerings or debt incurrence. In addition, the Borrower will be
required to make annual prepayments in an amount equal to 75 percent of “excess cash flow” of the
H3C Group. This percentage will decrease to the extent that the Borrower’s leverage ratio is lower
than specified amounts. Any excess cash flow amounts not required to prepay the loan may be
distributed to and used by the Company’s SCN segment, provided certain conditions are met.
H3C and all other existing and future subsidiaries of the Borrower (other than PRC subsidiaries or
small “excluded subsidiaries”) will guarantee all obligations under the A&R Loans and are referred
to as “Guarantors.” Additionally, 3Com Corporation, 3Com Holdings Limited and 3Com Technologies,
will also guarantee all obligations under the A&R Loans until H3C effects a successful capital
reduction; these entities are referred to as “Parent Guarantors” and are not considered
“Guarantors.” The loan obligations will be secured by (1) first priority security interests in all
assets of the Borrower and the Guarantors, including their bank accounts, and (2) a first priority
security interest in 100 percent of the capital stock of the Borrower and H3C and the PRC
subsidiaries of H3C.
78
Table of Contents
The Borrower must maintain a minimum debt service coverage, minimum interest coverage, maximum
capital expenditures and a maximum total leverage ratio. Negative covenants restrict, among
other things, (i) the incurrence of indebtedness by the Borrower and its subsidiaries, (ii) the
making of dividends and distributions to 3Com’s SCN segment, (iii) the ability to make investments
including in new subsidiaries, (iv) the ability to undertake mergers and acquisitions and (v) sales
of assets. Also, cash dividends from the PRC subsidiaries to H3C, and H3C to the Borrower, will be
subject to restricted use pending payment of principal, interest and excess cash flow prepayments.
Standard events of default apply.
Payments of principal on the A&R Loans are due as follows on September 28, for fiscal years ending
May 31 (in thousands):
| Tranche A | Tranche B | |||||||
2008 |
$ | 92,000 | $ | 2,000 | ||||
2009 |
46,000 | 2,000 | ||||||
2010 |
46,000 | 2,000 | ||||||
2011 |
46,000 | 2,000 | ||||||
2012 |
— | 20,000 | ||||||
2013 |
— | 172,000 | ||||||
Note 13: Borrowing Arrangements and Commitments
During fiscal 2005, our revolving credit facility was allowed to expire according to its terms in
November 2004, and we entered into a new arrangement to facilitate the issuance of standby letters
of credit and bank guarantees required in the normal course of business. Since we provide
collateral for any standby letters of credit and bank guarantees issued under this agreement, the
availability of additional issuances is restricted by the amount of cash and short-term investments
that we can provide as collateral. As of May 31, 2007, these facilities were backed by collateral
of $5.9 million provided to the respective banks.
We lease certain of our facilities under operating leases. Leases expire at various dates from
2008 to 2012, and certain leases have renewal options with rentals based upon changes in the
Consumer Price Index or the fair market rental value of the property. We also sublet certain of
our leased and owned facilities to third party tenants. The sublease agreements expire at various
dates from 2008 to 2011.
Future operating lease commitments and future rental income as of May 31, 2007 are as follows (in
thousands):
| Future Lease | Future Rental | |||||||
| Fiscal year | Payments | Income | ||||||
2008 |
$ | 27,671 | $ | 2,341 | ||||
2009 |
15,486 | 838 | ||||||
2010 |
3,647 | 541 | ||||||
2011 |
383 | 70 | ||||||
2012 |
42 | — | ||||||
Total |
$ | 47,229 | $ | 3,790 | ||||
Rent expense was approximately $27.7 million in fiscal 2007, $16.3 million in fiscal 2006, and
$16.5 million in fiscal 2005. Rental income, which includes rents received for both owned and
leased property, was $5.5 million in fiscal 2007, $6.8 million in fiscal 2006, and $6.0 million in
fiscal 2005, and is recorded as an offset to operating expenses.
In September 2006 we sold all of our remaining venture portfolio and generated cash of
approximately $1.3 million with a loss on sale of investments of $0.7 million. In August 2006, we
sold certain limited partnership interests and generated cash of approximately $17.0 million with a
gain on sale of investment of $2.4 million and eliminated our future capital call requirements.
79
Table of Contents
Note 14: Stock Based Compensation Plans
In December 2004, the FASB issued SFAS No. 123(R) “Share-Based Payment”, which requires all
stock-based compensation expense to employees (as defined in SFAS No. 123(R)), including grants of
employee stock options, restricted stock awards, restricted stock units, and employee stock
purchase plan shares to be recognized in the financial statements based on their fair values. We
adopted SFAS No. 123(R) on June 3, 2006 using the modified prospective transition method and
accordingly, prior period amounts have not been restated. In order to determine the fair value of
stock options and employee stock purchase plan shares, we use the Black-Scholes option pricing
model and apply the single-option valuation approach to the stock option valuation. In order to
determine the fair value of restricted stock awards and restricted stock units we use the closing
market price of 3Com common stock on the date of grant. We recognize stock-based compensation
expense on a straight-line basis over the requisite service period of the awards for options
granted following the adoption of SFAS No. 123(R) for time vested awards. We recognize
compensation expense for performance based restricted stock in the fiscal quarter when an event
makes the probability that performance will more than likely be achieved. For unvested stock
options outstanding as of May 31, 2006, we will continue to recognize stock-based compensation
expense using the accelerated amortization method prescribed in FASB Interpretation No. 28,
“Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans”.
Estimates of the fair value of equity awards in future periods will be affected by the market price
of our common stock, as well as the actual results of certain assumptions used to value the equity
awards. These assumptions include, but are not limited to, the expected volatility of the common
stock price, the expected term of options granted, and the risk free interest rate.
As noted above, the fair value of stock options and employee stock purchase plan shares is
determined by using the Black-Scholes option pricing model and applying the single-option approach
to the stock option valuation. The options generally vest on an annual basis over a period of four
years. We estimate the expected option term by analyzing the historical term period from grant to
exercise and also consider the expected term for those options that are still outstanding. The
expected term of employee stock purchase plan shares is the average of the remaining purchase
periods under each offering period. For equity awards granted after May 31, 2006, the volatility
of the common stock is estimated using the historical volatility. We believe that historical
volatility represents the best information currently available for projecting future volatility.
The risk-free interest rate used in the Black-Scholes option pricing model is based on the
historical U.S. Treasury zero-coupon bond issues with terms corresponding to the expected terms of
the equity awards. In addition, an expected dividend yield of zero is used in the option valuation
model because we do not expect to pay any cash dividends in the foreseeable future. In accordance
with SFAS No. 123(R), we are required to estimate forfeitures at the time of grant and revise those
estimates in subsequent periods based upon new information. In order to determine an estimated
pre-vesting option forfeiture rate, we used historical forfeiture data, which currently yields an
expected forfeiture rate of 27 percent. This estimated forfeiture rate has been applied to all
unvested options and restricted stock outstanding as of May 31, 2006 and to all options and
restricted stock granted since May 31, 2006. Therefore, stock-based compensation expense is
recorded only for those options and restricted stock that are expected to vest.
The Company’s policy is to issue new shares, or reissue shares from treasury stock, upon settlement
of share based payments.
The following table summarizes the incremental effects of the share-based compensation expense
resulting from the application of SFAS No. 123(R) to the stock options, restricted stock and
employee stock purchase plan:
| (In thousands, except per share data) | May 31, 2007 | |||
Cost of sales |
$ | 1,576 | ||
Sales and marketing |
5,756 | |||
Research and development |
4,621 | |||
General and administrative |
8,142 | |||
Incremental share-based compensation effect of SFAS No. 123(R) on net loss |
$ | 20,095 | ||
80
Table of Contents
As of May 31, 2007, total unrecognized stock-based compensation expense relating to unvested
employee stock options, restricted stock and employee stock purchase plan, adjusted for estimated
forfeitures, was $20.1 million. This amount is expected to be recognized over a weighted-average
period of 2.7 years. If actual forfeitures differ from current estimates, total unrecognized
stock-based compensation expense will be adjusted for future changes in estimated forfeitures.
Prior to June 1, 2006, we accounted for stock options using the intrinsic value method, pursuant to
the provisions of Accounting Principles Board (“APB”) No. 25. Under this method, stock-based
compensation expense was measured as the difference between the option’s exercise price and the
market price of the Company’s common stock on the date of grant.
Pro forma information required under SFAS No. 123 for the prior fiscal years, as if we had applied
the fair value recognition provisions of SFAS No. 123 to awards granted under our equity incentive
plans, was as follows:
| (In thousands, except per share amounts) | May 31, 2006 | May 31, 2005 | ||||||
Net loss as reported |
$ | (100,675 | ) | $ | (195,686 | ) | ||
Add: Stock-based compensation included in
reported net loss |
9,846 | 2,841 | ||||||
Deduct: Total stock-based compensation
determined under the fair value-based
method, net of related tax effects |
(25,496 | ) | (16,203 | ) | ||||
Adjusted net loss |
$ | (116,325 | ) | $ | (209,048 | ) | ||
Net loss per share-basic and diluted: |
||||||||
As reported |
$ | (0.26 | ) | $ | (0.51 | ) | ||
Adjusted |
$ | (0.30 | ) | $ | (0.55 | ) | ||
There were 1.4 million shares of common stock issued under the employee stock purchase plan
during the year ended May 31, 2007. Employee stock purchases normally occur only in the quarters
ended November 30 and May 31.
Share-based compensation recognized in the year ended May 31, 2007 as a result of the adoption of
SFAS No. 123(R) as well as pro forma disclosures according to the original provisions of SFAS No.
123 for periods prior to the adoption of SFAS No. 123(R) use the Black-Scholes option pricing model
for estimating the fair value of options granted under the company’s equity incentive plans. The
Black-Scholes option pricing model was developed for use in estimating the fair value of traded
options that have no vesting restrictions and are fully transferable. Option valuation models
require the input of highly subjective assumptions, including the expected stock price volatility.
The underlying weighted-average assumptions used in the Black-Scholes model and the resulting
estimates of fair value per share were as follows for options granted during the years ended May
31, 2007, May 31, 2006 and May 31, 2005:
| 2007 | 20061 | 20051 | ||||||||||
Employee stock options: |
||||||||||||
Volatility |
42.7 | % | 41.9 | % | 53.2 | % | ||||||
Risk-free interest rate |
4.7 | % | 4.3 | % | 3.5 | % | ||||||
Dividend yield |
0.0 | % | 0.0 | % | 0.0 | % | ||||||
Expected life (years) |
4.0 | 4.0 | 4.0 | |||||||||
Fair value per option |
$ | 1.67 | $ | 1.52 | $ | 1.89 | ||||||
Employee Stock Purchase Plan: |
||||||||||||
Volatility |
39.2 | % | 38.1 | % | 39.2 | % | ||||||
Risk-free interest rate |
5.1 | % | 4.4 | % | 2.6 | % | ||||||
Dividend yield |
0.0 | % | 0.0 | % | 0.0 | % | ||||||
Expected life (years) |
0.5 | 0.5 | 0.5 | |||||||||
Fair value per option |
$ | 1.10 | $ | 1.20 | $ | 1.04 | ||||||
1 – Assumptions used in the calculation of fair value according to the provisions of SFAS No.
123.
81
Table of Contents
As of May 31, 2007, our outstanding stock options as a percentage of outstanding shares were
approximately 13 percent. Stock option detail activity for the period June 1, 2006 to May 31, 2007
was as follows (shares in thousands):
| Number of | Weighted-Average | |||||||
| shares | Exercise Price | |||||||
Outstanding, May 31, 2004 |
56,885 | $ | 7.18 | |||||
Granted |
10,002 | 4.22 | ||||||
TippingPoint options assumed |
13,886 | 1.31 | ||||||
Exercised |
(4,273 | ) | 2.01 | |||||
Canceled |
(13,141 | ) | 6.90 | |||||
Outstanding, May 31, 2005 |
63,359 | 5.83 | ||||||
Granted |
21,974 | 4.22 | ||||||
Exercised |
(5,467 | ) | 2.07 | |||||
Canceled |
(18,445 | ) | 5.83 | |||||
Outstanding, May 31, 2006 |
61,421 | $ | 5.71 | |||||
Granted |
24,285 | 4.71 | ||||||
Exercised |
(2,527 | ) | 3.00 | |||||
Canceled |
(30,899 | ) | 5.94 | |||||
Outstanding, May 31, 2007 |
52,280 | $ | 5.23 | |||||
Exercisable |
22,174 | $ | 6.20 | |||||
Weighted-average grant-date fair value
of options granted |
$ | 1.67 | ||||||
Additional information about employee options outstanding and exercisable at December 31, 2006 is
included in the following table:
| Outstanding Options as of May 31, 2007 | Exercisable as of May 31, 2007 | |||||||||||||||||||
| Range of | Number of | Weighted-Average | Weighted-Average | Number of | Weighted-Average | |||||||||||||||
| Exercise Prices | Shares | Exercise Price | Remaining Contractual Life | Shares Exercise Price | ||||||||||||||||
| (in thousands) | (in years) | (in thousands) | ||||||||||||||||||
$0.00 - $4.00 |
11,101 | $ | 2.87 | 5.5 | 5,360 | $ | 2.33 | |||||||||||||
4.01 - 5.00 |
21,172 | 4.47 | 5.7 | 4,421 | 4.52 | |||||||||||||||
5.01 - 6.00 |
12,664 | 5.52 | 4.8 | 5,238 | 5.51 | |||||||||||||||
6.01 - 7.00 |
1,363 | 6.21 | 2.4 | 1,242 | 6.21 | |||||||||||||||
7.01 - 8.00 |
403 | 7.35 | 2.6 | 354 | 7.36 | |||||||||||||||
8.01 - 22.00 |
5,577 | 11.84 | 2.6 | 5,559 | 11.85 | |||||||||||||||
Total |
52,280 | $ | 5.23 | 5.0 | 22,174 | $ | 6.20 | |||||||||||||
As of May 31, 2007, there were approximately 22.2 million options exercisable with a
weighted-average exercise price of $6.20 per share. By comparison, there were approximately 32.5
million options exercisable as of May 31, 2006 with a weighted-average price of $6.96 per share.
During the year ended May 31, 2007 approximately 2.5 million options were exercised at an aggregate
intrinsic value of $4.5 million. The intrinsic value above is calculated as the difference between
the market value on exercise date and the option price of the shares. The closing market value per
share as of June 1, 2007 was $4.69 as reported by the NASDAQ Global Select Market. The aggregate
intrinsic value of options outstanding and options exercisable as of May 31, 2007 was $25.4 million
and $13.6 million respectively. The aggregate intrinsic value is calculated as the difference
between the market value as of June 1, 2007 and the option price of the shares.
82
Table of Contents
Options outstanding that are vested and expected to vest as of May 31, 2007 are as follows:
| Weighted- | ||||||||||||||||
| Weighted- | Average | |||||||||||||||
| Average | Remaining | Aggregate | ||||||||||||||
| Number of | Option | Contractual | Intrinsic Value | |||||||||||||
| Shares | Price | Life (in years) | (in thousands) | |||||||||||||
Vested and expected to vest at May 31, 2007 |
38,248,782 | $ | 5.46 | 4.60 | $ | 21,103 | ||||||||||
Restricted stock awards activity during the year ended May 31, 2007 and restricted stock awards
outstanding as of May 31, 2007, were as follows (shares in thousands):
| Number of | Weighted- | |||||||
| Shares | Average Grant- | |||||||
| (unvested) | Date Fair Value | |||||||
Outstanding, May 31, 2004 |
723 | $ | 4.97 | |||||
Granted |
1,484 | 4.23 | ||||||
Exercised |
(154 | ) | 5.31 | |||||
Canceled |
(316 | ) | 4.90 | |||||
Outstanding, May 31, 2005 |
1,737 | 4.32 | ||||||
Granted |
2,419 | 3.84 | ||||||
Exercised |
(854 | ) | 4.07 | |||||
Canceled |
(1,185 | ) | 3.96 | |||||
Outstanding, May 31, 2006 |
2,117 | $ | 4.07 | |||||
Granted |
2,380 | 4.45 | ||||||
Exercised |
(1,151 | ) | 4.13 | |||||
Canceled |
(943 | ) | 4.30 | |||||
Outstanding, May 31, 2007 |
2,403 | $ | 4.33 | |||||
During the year ended May 31, 2007 approximately 1.2 million restricted award shares with an
aggregate fair value of $4.9 million became vested.
Restricted stock unit activity during the year ended May 31, 2007 and restricted stock units
outstanding as of May 31, 2007, were as follows (shares in thousands):
| Weighted- | ||||||||||||||||
| Average | Aggregate | |||||||||||||||
| Number of | Weighted- | Remaining | Intrinsic | |||||||||||||
| Shares | Average | Contractual | Value (in | |||||||||||||
| (unvested) | Purchase Price | Term (Years) | thousands) | |||||||||||||
Outstanding June 1, 2006 |
— | $ | — | — | $ | — | ||||||||||
Granted |
4,356 | — | — | — | ||||||||||||
Vested |
(836 | ) | — | — | 3,319 | |||||||||||
Forfeited |
(409 | ) | — | — | — | |||||||||||
Outstanding May 31, 2007 |
3,111 | $ | — | 1.19 | $ | 14,591 | ||||||||||
During the year ended May 31, 2007 approximately 0.8 million restricted share units with an
aggregate fair value of $3.3 million became vested.
83
Table of Contents
Employee Stock Purchase Plan. We have an employee stock purchase plan (ESPP) under which eligible
employees may authorize payroll deductions of up to ten percent of their compensation, as defined,
to purchase common stock at a price of 85 percent of the lower of the fair market value as of the
beginning or the end of the six-month offering period. In September 2003, our stockholders
approved an increase of five million shares available for issuance under the ESPP. We recognized
$1.6 million of stock-based compensation expense in the year ended May 31, 2007.
Preferred Shares Rights Plan. In September 1989, the Board of Directors approved a common stock
purchase rights plan, which was amended and restated in December 1994, and again in March 2001.
In November 2002, the Board of Directors approved a Third Amended and Restated Preferred Shares
Rights Plan (the Preferred Shares Rights Plan), which replaced the March 2001 Plan. The Preferred
Shares Rights Plan provides that the preferred share rights (the Rights) will become exercisable
only following the acquisition by a person or a group of 15 percent or more of the outstanding
common stock or ten days following the announcement of a tender or exchange offer for 15 percent
or more of the outstanding common stock (the Distribution Date). After the Distribution Date,
each Right will entitle the holder to purchase for $55.00 (the Exercise Price), one-one thousandth
of a share of our Series A Participating Preferred Stock (or cash, stock or other assets approved
by the Board of Directors) with economic terms similar to that of one share of our common stock.
Upon a person or a group acquiring 15 percent or more of the outstanding common stock, each Right
will allow the holder (other than the acquirer) to purchase common stock or securities of 3Com
having a then current market value of two times the Exercise Price of the Right. In the event
that following the acquisition of 15 percent of the common stock by an acquirer, we are acquired
in a merger or other business combination or 50 percent or more of our assets or earning power is
sold, each Right will entitle the holder to purchase for the Exercise Price, common stock or
securities of the acquirer having a then current market value of two times the Exercise Price. In
certain circumstances, the Rights may be redeemed by us at a redemption price of $0.001 per Right.
If not earlier exchanged or redeemed, the Rights will expire on March 8, 2011.
Stock Reserved for Issuance. As of May 31, 2007 we had reserved common stock for issuance as
follows (in thousands):
Stock option and restricted stock plans for granted shares |
55,391 | |||
Stock option and restricted stock plans for future grants |
14,918 | |||
Employee stock purchase plan |
3,510 | |||
Total shares reserved for issuance |
73,819 | |||
In addition, as of May 31, 2007 we had 0.4 million shares of preferred stock reserved for issuance
under our Preferred Shares Rights Plan.
Stock Repurchase and Option Programs. During the fourth quarter of fiscal 2005, the Board of
Directors approved a new stock repurchase program that authorizes expenditures of up to $100.0
million during a two-year period which expired March 31, 2007, provided that all repurchases are
pre-approved by the Audit and Finance Committee of the Board of Directors. Our prior stock
repurchase program was announced on March 19, 2003 and permitted expenditures up to $100.0 million
through March 2005.
Pursuant to these authorizations, we did not repurchase any shares during fiscal 2007 or fiscal
2006. We repurchased 15.0 million shares of our common stock during fiscal 2005 at a cost of
$73.5 million.
84