UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-Q

 

 

Commission file number 0-26339

 

JUNIPER NETWORKS, INC.

(Exact name of registrant as specified in its charter)

 

 

 

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 filings requirements for the past 90 days.  Yes þ     No 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. (Check one):

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

 

There were approximately 565,750,000 shares of the Company’s Common Stock, par value $0.00001, outstanding as of April 30, 2006.

 

 

Table of Contents

 

 

Juniper Networks, Inc.

 

Condensed Consolidated Statements of Operations

 

 

See accompanying Notes to the Condensed Consolidated Financial Statements

Juniper Networks, Inc.

 

 

 

 

See accompanying Notes to the Condensed Consolidated Financial Statements

Juniper Networks, Inc.

 

Condensed Consolidated Statements of Cash Flows

 

 

See accompanying Notes to the Condensed Consolidated Financial Statements

Juniper Networks, Inc.

 

Notes to the Condensed Consolidated Financial Statements

(Unaudited)

 

 

Description of Business

 

Juniper Networks, Inc. (“Juniper Networks” or the “Company”) designs and sells products and services that together provide its customers with secure and assured Internet Protocol (“IP”) networking solutions. The Company is organized into the following three operating segments: Infrastructure, Service Layer Technologies (“SLT”), and Service. The Company’s Infrastructure segment primarily offers scalable router products that are used to control and direct network traffic. The Company’s SLT segment offers solutions that meet a broad array of its customers’ priorities, from securing the network and the data on the network, to maximizing existing bandwidth and acceleration of applications across a distributed network. Together, its secure networking solutions help enable its customers to convert networks that provide commoditized and best efforts services into more valuable assets that provide differentiation, value and increased reliability and security to end users. The Company’s Service segment delivers world-wide services, including technical support, professional services, as well as a number of education and training programs, to customers of the Infrastructure and SLT segments. The Company sells products and services through its direct sales force and through its strategic distribution relationships and value-added resellers.

 

Basis of Presentation

 

The Condensed Consolidated Financial Statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments, including normal recurring accruals, considered necessary for a fair presentation have been included. The results of operations for the three months ended March 31, 2006 are not necessarily indicative of the results that may be expected for the year ended December 31, 2006. The information included in this Quarterly Report on Form 10-Q should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Risk Factors,” “Quantitative and Qualitative Disclosures About Market Risk” and the Consolidated Financial Statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

 

Stock-Based Compensation

 

On January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment, (“SFAS 123R”) which requires the measurement and recognition of compensation expense for all stock-based payment awards made to employees and directors including employee stock options, restricted stock units (“RSUs”) and employee stock purchases under the Company’s Employee Stock Purchase Plan based on estimated fair values. SFAS 123R supersedes the previous accounting under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), as allowed under Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), for periods beginning in 2006. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS 123R. The Company has applied the provisions of SAB 107 in conjunction with its adoption of SFAS 123R.

 

The Company adopted SFAS 123R using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of the Company’s fiscal year 2006. The Company’s Condensed Consolidated Financial Statements as of and for the three months ended March 31, 2006 reflect the impact of SFAS 123R. In accordance with the modified prospective

 

Juniper Networks, Inc.

 

Notes to the Condensed Consolidated Financial Statements — (Continued)

transition method, the Company’s Condensed Consolidated Financial Statements for periods prior to 2006 have not been restated to reflect, and do not include, the impact of SFAS 123R.

 

SFAS 123R requires companies to estimate the fair value of stock-based payment awards on the date of grant using an option-pricing model. The Company uses the Black-Scholes-Merton option-pricing model to determine the fair-value of stock based awards under SFAS 123R, consistent with that used for pro forma disclosures under SFAS 123. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the Company’s consolidated statement of operations.

 

Stock-based compensation expense recognized during the period is based on the fair value of the actual awards vested or expected to vest. Stock-based compensation expense recognized in the Company’s consolidated statement of operations for the three months ended March 31, 2006 included compensation expense for stock-based payment awards granted prior to, but not yet vested as of, December 31, 2005 based on the grant date fair value estimated in accordance with the provisions of SFAS 123 and compensation expense for the stock-based payment awards granted subsequent to December 31, 2005 based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. In conjunction with the adoption of SFAS 123R, the Company changed its accounting policy of attributing the fair value of stock-based compensation to expense from the accelerated multiple-option approach provided by APB 25, as allowed under SFAS 123, to the straight-line single-option approach. Compensation expense for all stock-based payment awards expected to vest that were granted on or prior to December 31, 2005 will continue to be recognized using the accelerated attribution method. Compensation expense for all stock-based payment awards expected to vest that were granted or modified subsequent to December 31, 2005 is recognized on a straight-line basis. SFAS 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. In the Company’s pro forma information required under SFAS 123 for the periods prior to 2006, the Company accounted for forfeitures as they occurred.

 

Prior to the adoption of SFAS 123R, no stock-based compensation expense had been recognized in the Company’s consolidated statement of operations, other than those related to acquisitions. As a result of adopting SFAS 123R, pre-tax stock-based compensation expense recorded for the three months ended March 31, 2006 of $23.1 million was related to employee stock options, RSUs, and employee stock purchases under the Company’s Employee Stock Purchase Plan. Pre-tax stock-based compensation expense of $3.4 million for the three months ended March 31, 2005, which the Company recorded under APB 25, was related to options assumed from acquisitions. The pre-tax compensation expense was $18.8 million higher than the expense that would have been recorded had the Company continued to account for stock-based compensation under APB 25. Net income for the three months ended March 31, 2006 was $13.5 million lower than would have been reported had the Company continued to account for stock-based compensation under APB 25. Unamortized deferred compensation associated with stock options assumed from past acquisitions of $15.6 million has been reclassified to additional paid-in capital in the Company’s consolidated balance sheet upon the adoption of SFAS 123R. Additional information is discussed in Note 6.

 

In accordance with SFAS 123R, beginning in the three months ended March 31, 2006, the Company has presented tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options as financing cash flows. Prior to the adoption of SFAS 123R, tax benefits of stock option exercises were presented as operating cash flows. Tax benefits, related to tax deductions in excess of the compensation cost recognized, of $56.1 million presented as financing cash flows for the first quarter of 2006 would have been classified as operating cash flows if the Company had not adopted SFAS 123R.

 

Juniper Networks, Inc.

 

Notes to the Condensed Consolidated Financial Statements — (Continued)

 

The following table illustrates the pro forma net income and earnings per share, net of related tax effect, had the Company applied the fair value recognition provisions of SFAS 123 to employee stock benefits, including shares issued under the stock option plans and under the Employee Stock Purchase Plan (in millions, except per share amounts):

 

 

As previously disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005, the Company determined that the calculation of the pro forma stock-based compensation expense disclosed under SFAS 123 for 2004, as reported, inadvertently did not include the proper fair value for options assumed in the acquisition in 2004. Accordingly, the amount of pro forma stock-based compensation expense reported in the table above has been revised to reflect the proper fair value for options assumed from the 2004 acquisition. For the three months ended March 31, 2005, the previously reported pro forma net income was $52.2 million, the previously reported pro forma basic net income per share was $0.10, and the previously reported pro forma diluted net income per share was $0.09. This revision has no impact on the Company’s previously reported consolidated results of operations or financial condition.

 

Revenue Recognition

 

Juniper Networks sells products and services through its direct sales force or through its strategic distribution relationships and value-added resellers. The Company’s infrastructure and SLT products are integrated with software that is essential to the functionality of the equipment. Additionally, the Company provides unspecified software upgrades and enhancements related to the equipment through its maintenance contracts for most of its products. Accordingly, the Company accounts for revenue in accordance with Statement of Position No. 97-2, Software Revenue Recognition, and all related interpretations. The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery or performance has occurred, the sales price is fixed or determinable and collectibility is reasonably assured. Evidence of an arrangement generally consists of customer purchase orders and, in certain instances, sales contracts or agreements. Shipping terms and related documents, or written evidence of customer acceptance, when applicable, are used to verify delivery or performance. In instances where final acceptance of the product, system, or solution is specified by the customer, revenue is deferred until all acceptance criteria have been met. The Company assesses whether the sales price is fixed or determinable based on payment terms and whether the sales price is subject to refund or adjustment.

 

Juniper Networks, Inc.

 

Notes to the Condensed Consolidated Financial Statements — (Continued)

Collectibility is assessed based on the creditworthiness of the customer as determined by credit checks and the customer’s payment history to the Company.

 

For arrangements with multiple elements, we allocate revenue to each element using the residual method based on vendor specific objective evidence of fair value of the undelivered items. Under the residual method, the amount of revenue allocated to delivered elements equals the total arrangement consideration less the aggregate fair value of any undelivered elements. Vendor specific objective evidence of fair value is based on the price charged when the element is sold separately.

 

For sales to direct end-users and value-added resellers, the Company recognizes product revenue upon transfer of title and risk of loss, which is generally upon shipment. It is the Company’s practice to identify an end-user prior to shipment to a value-added reseller. For the end-users and value-added resellers, the Company has no significant obligations for future performance such as rights of return or pricing credits. A portion of the Company’s sales are made through distributors under agreements allowing for pricing credits and/or rights of return. Product revenue on sales made through these distributors is recognized upon sell-through as reported by the distributors to the Company.

 

The Company records reductions to revenue for estimated product returns and pricing adjustments, such as rebates and price protection, in the same period that the related revenue is recorded. The amount of these reductions is based on historical sales returns and price protection credits, specific criteria included in rebate agreements, and other factors known at the time.

 

Revenue from maintenance contracts is deferred based on vendor specific objective evidence of fair value and recognized ratably over the contractual support period, generally one year. Revenue from training and consulting is recognized as the services are completed or ratably over the contractual period.

 

Goodwill and Purchased Intangible Assets

 

Goodwill is not subject to amortization but is subject to annual assessment, at a minimum, for impairment by applying a fair-value based test. Future goodwill impairment tests could result in a charge to earnings. Purchased intangibles with finite lives are amortized on a straight-line basis over their respective estimated useful lives.

 

Impairment

 

The Company evaluates goodwill, at a minimum, on an annual basis and whenever events and changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Impairment of goodwill is tested at the reporting unit level by comparing the reporting unit’s carrying value, including goodwill, to the fair value of the reporting unit. The fair values of the reporting units are estimated using a combination of the income, or discounted cash flows, approach and the market approach, which utilizes comparable companies’ data. If the carrying value of the reporting unit exceeds the fair value, goodwill is considered impaired and a second step is performed to measure the amount of the impairment loss, if any. Juniper Networks conducted its annual impairment test as of November 1, 2005 and determined that goodwill was not impaired. There were no events or circumstances from that date through March 31, 2006 that would impact this assessment.

 

The Company evaluates long-lived assets held-for-use for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. An asset is considered impaired if its carrying amount exceeds the future net cash flow the asset is expected to generate. If an asset is considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the asset exceeds its fair market value. The Company assesses the recoverability of its long-lived and intangible assets by determining whether the unamortized balances

 

Juniper Networks, Inc.

 

Notes to the Condensed Consolidated Financial Statements — (Continued)

can be recovered through undiscounted future net cash flows of the related assets. The amount of impairment, if any, is measured based on projected discounted future net cash flows.

 

Recent Accounting Pronouncements

 

There have been no material changes to the recent pronouncements as previously reported in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

 

Reclassifications

 

Certain reclassifications have been made to prior year balances in order to conform to the current year’s presentation.

 

 

The following is a summary of the Company’s available-for-sale investments (in millions):

 

 

 

Goodwill

 

Changes in the Company’s goodwill were as follows (in millions):

 

 

Juniper Networks, Inc.

 

Notes to the Condensed Consolidated Financial Statements — (Continued)

 

Purchased Intangible Assets

 

The following table presents details of the Company’s purchased intangibles assets with definite lives (in millions):

 

 

There was no addition to purchased intangible assets during the three months ended March 31, 2006.

 

Amortization expense of purchased intangible assets of $24.6 million and $18.5 million were included in operating expenses and cost of product revenue for the three months ended March 31, 2006 and 2005, respectively. The estimated future amortization expense of purchased intangible assets with definite lives for the next five years is as follows (in millions):

 

 

 

Restricted Cash

 

Restricted cash as of March 31, 2006 consists of escrow accounts required by certain acquisitions completed in 2005 and the Directors & Officers (“D&O”) trust. Juniper Networks established the D&O trust to secure its indemnification obligations to certain directors and officers arising from their activities as such in the event that the Company does not provide or is financially incapable of providing indemnification. During the three months ended March 31, 2006, restricted cash decreased by $6.2 million primarily due to the removal of deposit requirements for standby letters of credits issued for facility leases.

 

Minority Equity Investments

 

As of March 31, 2006 and December 31, 2005, the carrying values of the Company’s minority equity investments in privately held companies were $13.3 million and $13.2 million, respectively.

 

Juniper Networks, Inc.

 

Notes to the Condensed Consolidated Financial Statements — (Continued)

 

Warranties

 

As of March 31, 2006 and December 31, 2005, warranty reserve was $35.8 million and $35.3 million, respectively. Changes in the Company’s warranty reserve were as follows (in millions):

 

 

Deferred Revenue

 

Details of the Company’s deferred revenue are as follows (in millions):

 

 

Restructuring Charges

 

Restructuring charges were based on Juniper Networks’ restructuring plans that were committed to by management. Any changes to the estimates of executing the approved plans will be reflected in the Company’s results of operations. As of March 31, 2006, the Company had restructuring reserves of $1.3 million and $0.7 million pertaining to future facility charges accrued in connection with the discontinuance of the CMTS products and the acquisition of Unisphere Networks, Inc. (“Unisphere”), respectively. The Company expects to pay out these obligations over the life of the related obligations, which extended through 2009.

 

Acquisition Related Accrual

 

In conjunction with various acquisitions, the Company accrued for acquisition related charges primarily related to severance and facility charges. As of March 31, 2006, approximately $6.2 million

 

Juniper Networks, Inc.

 

Notes to the Condensed Consolidated Financial Statements — (Continued)

remained unpaid, of which $2.8 million was recorded in other long-term liabilities in the condensed consolidated balance sheet.

 

Other Comprehensive Income

 

Other comprehensive income is as follows (in millions):

 

 

Derivatives

 

Derivatives used to mitigate transaction gains and losses generated by certain foreign currency denominated monetary assets and liabilities are carried at fair value with changes recorded in other income (expense). Changes in the fair value of these derivatives are largely offset by re-measurement of the underlying assets and liabilities. These foreign exchange contracts have maturities between one and two months.

 

Derivatives used to hedge certain forecasted foreign currency transactions relating to operation expenses are designated as cash flow hedges and have maturities of less than one year. The effective portion of the derivative’s gain or loss is initially reported as a component of accumulated other comprehensive income and, upon occurrence of the forecasted transaction, is subsequently reclassified into the condensed consolidated statements of operations line item to which the hedged transaction relates. The Company records any ineffectiveness of the hedging instruments, which was immaterial during the three months ended March 31, 2006 and 2005, respectively, in other income (expense) in its condensed consolidated statements of operations.

 

 

The following table presents the calculation of basic and diluted net income per share (in millions, except per share amounts):

 

 

Juniper Networks, Inc.

 

Notes to the Condensed Consolidated Financial Statements — (Continued)

 

Net income for the first three months of 2006 included pre-tax stock-based compensation expense of $23.1 million related to employee stock options, RSUs, employee stock purchases under the Company’s Employee Stock Purchase Plan and acquisitions reflecting the fair value recognition provisions under SFAS 123R. Net income for the first quarter of 2005 included pre-tax stock-based compensation expense of $3.4 million related to past acquisitions. No stock-based compensation expense related to employee stock options and employee stock purchases under the Company’s Employee Stock Purchase Plan was included in the results of operations in the first quarter of 2005 as the Company adopted SFAS 123R using the modified prospective method and, therefore, did not restate its operating results prior to 2006 as if SFAS 123R were applied to the earlier period. See Note 6 for additional information.

 

Employee stock options to purchase approximately 46,226,139 shares and 26,855,000 shares in the three months ended March 31, 2006 and 2005, respectively, were outstanding, but were not included in the computation of diluted earnings per share because the exercise prices of those stock options were greater than the average share price of the common shares and, therefore, the effect would have been anti-dilutive.

 

 

  Stock Option Plans

 

Amended and Restated 1996 Stock Plan

 

The Company’s Amended and Restated 1996 Stock Plan (the “1996 Plan”) provides for the granting of incentive stock options to employees and non-statutory stock options to employees, directors and consultants. Incentive stock options are granted at an exercise price of not less than the fair value per share of the common stock on the date of grant. Non-statutory stock options may be granted at an exercise price of not less than 85% of the fair value per share on the date of grant; however, no non-statutory stock options have been granted for less than fair market value on the date of grant. Vesting and exercise provisions are determined by the Board of Directors (the “Board”) of the Company, or a committee of the Board of Directors. Options granted under the 1996 Plan generally become exercisable over a four-year period beginning on the date of grant. Options granted under the 1996 Plan have a maximum term of ten years. Options granted to consultants are in consideration for the fair value of services previously rendered, are not contingent upon future events and are expensed in the period of grant. As of March 31, 2006, the Company had authorized 164,623,039 shares of common stock for issuance under the 1996 Plan.

 

The 1996 Plan also provides for the sale of restricted shares of common stock to employees and consultants. Shares issued to consultants are for the fair value of services previously rendered and are not contingent upon future events. Shares sold to employees are made pursuant to restricted stock purchase agreements containing provisions established by the Board or a committee of the Board. These provisions give Juniper Networks the right to repurchase the shares at the original sales price upon termination of the employee. This right expires at a rate determined by the Board, generally at the rate of 25% after one year and 2.0833% per month thereafter.

 

Since its adoption in 1996, the 1996 Plan has permitted the Company to make grants of restricted stock. In the case of such an award, the entire number of shares subject to a restricted stock award would be issued at the time of grant. Such shares could be subject to vesting provisions based on time or other conditions specified by the Board or an authorized committee of the Board. The Company would have the right to repurchase unvested shares subject to a restricted stock award if the grantee’s service to the Company terminated prior to full vesting of the award. Until repurchased, such unvested shares would be considered outstanding for dividend, voting and other purposes.

 

Juniper Networks, Inc.

 

Notes to the Condensed Consolidated Financial Statements — (Continued)

 

On November 3, 2005, the Board adopted an amendment to the 1996 Plan to add the ability to issue RSUs under the 1996 Plan. Unlike restricted stock awards, RSUs represent an obligation of the Company to issue unrestricted shares of common stock to the grantee only when and to the extent that the vesting criteria of the award are satisfied. As in the case of restricted stock awards, vesting criteria for RSUs can be based on time or other conditions specified by the Board or an authorized committee of the Board. However, until vesting occurs, the grantee is not entitled to any stockholder rights with respect to the unvested shares.

 

2000 Nonstatutory Stock Option Plan

 

In July 2000, the Board adopted the Juniper Networks 2000 Nonstatutory Stock Option Plan (the “2000 Plan”). The 2000 Plan provides for the granting of non-statutory stock options to employees, directors and consultants. Non-statutory stock options may be granted at an exercise price of not less than 85% of the fair value per share on the date of grant; however, no non-statutory stock options have been granted for less than fair market value on the date of grant. Vesting and exercise provisions are determined by the Board or a committee of the Board. Options granted under the 2000 Plan generally become exercisable over a four-year period beginning on the date of grant and have a maximum term of ten years. Options granted to consultants are in consideration for the fair value of services previously rendered, are not contingent upon future events and are expensed in the period of grant. As of March 31, 2006, the Company had authorized 90,901,437 shares of common stock for issuance under the 2000 Plan.

 

Plans Assumed Upon Acquisition

 

In connection with past acquisitions, the Company assumed options under the stock plans of the acquired companies, exchanged those options for Juniper Networks’ options and authorized the appropriate number of shares of common stock for issuance pursuant to those options. During the three months ended March 31, 2006, 333 shares of restricted common stock have been repurchased at an average price of $0.35 per share in connection with employee terminations. There were 18,862 shares of restricted shares subject to repurchase as of March 31, 2006.

 

Stock Award Activity

 

In the first quarter of 2006, the Company granted 2.7 million RSUs to its employees under the 1996 Plan. Such awards generally vest over a period of three or four years from the date of grant. RSUs do not have the voting rights of common stock and the shares underlying the RSUs are not considered issued and outstanding. The Company expenses the cost of the RSUs, which is determined to be the fair market value of the shares at the date of grant, ratably over the period during which the restrictions lapse. In addition to RSUs, the Company also granted 7.0 million employee stock options under the 1996 Plan and the 2000 Plan. No restricted stock was issued under the 1996 Plan in the three months ended March 31, 2006 and 2005.

 

Juniper Networks, Inc.

 

Notes to the Condensed Consolidated Financial Statements — (Continued)

 

A summary of the Company’s stock award activity and related information for the three-months ended March 31, 2006 is set forth in the following table (share data presented in thousands):

 

 

 

 

A summary of the Company’s vested or expected to vest stock and exercisable options as of March 31, 2006 is set forth in the following table (share data presented in thousands):

 

 

Aggregate intrinsic value represents the difference between the Company’s closing stock price on the last trading day of the fiscal period, which was $19.12 as of March 31, 2006, and the exercise price multiplied by the number of related options. Total intrinsic value of options exercised was $70.4 million for the three months ended March 31, 2006.

 

Juniper Networks, Inc.

 

Notes to the Condensed Consolidated Financial Statements — (Continued)

 

The following schedule summarizes information about stock options outstanding under all option plans as of March 31, 2006:

 

 

As of March 31, 2006, approximately 65.1 million options were exercisable at a weighted average exercise price of $18.88 per option. As of March 31, 2005, approximately 44.3 million options were exercisable at a weighted average exercise price of $13.81 per option.

 

The Company had 2.6 million RSUs outstanding as of March 31, 2006, which were excluded from the options outstanding balance in the preceding tables. The total weighted-average grant date fair value was $50.6 million.

 

The following schedule summarizes information about the Company’s RSUs as of March 31, 2006 (share data presented in thousands):

 

 

None of these RSUs was vested as of March 31, 2006. The grant of these RSUs has been deducted from the shares available for grant under the Company’s stock option plans.

 

Total fair value of options vested during the three months ended March 31, 2006 was $31.7 million. As of March 31, 2006, approximately $137 million of total unrecognized compensation cost related to stock options and RSUs is expected to be recognized over a weighted-average period of 1.4 years and 2.5 years, respectively.

 

No non-vested restricted stock was granted during the three months ended March 31, 2006. Forfeitures and vesting of the non-vested restricted stock were immaterial during the three months ended March 31, 2006. Total non-vested restricted stock outstanding at March 31, 2006 was immaterial.

 

Juniper Networks, Inc.

 

Notes to the Condensed Consolidated Financial Statements — (Continued)

 

Employee Stock Purchase Plan

 

In April 1999, the Board approved the adoption of Juniper Networks’ 1999 Employee Stock Purchase Plan (the “ESPP”). The ESPP permits eligible employees to acquire shares of the Company’s common stock through periodic payroll deductions of up to 10% of base compensation. Each employee may purchase no more than 6,000 shares in any twelve-month period, and in no event, may an employee purchase more than $25,000 worth of stock, determined at the fair market value of the shares at the time such option is granted, in one calendar year. The ESPP is implemented in a series of offering periods, each six months in duration. The price at which the common stock may be purchased is 85% of the lesser of the fair market value of the Company’s common stock on the first day of the applicable offering period or on the last day of the respective offering period. On December 16, 2005, the Board amended the Company’s ESPP to eliminate the ability of a participant under the ESPP to increase the rate of his/her payroll deductions during any offering period (as defined in the ESPP). This change was effective beginning with the offering period commencing on February 1, 2006. For the first three months of 2006, pre-tax compensation expense related to the stock issued under ESPP was $2.7 million.

 

Valuation of Stock-Based Compensation

 

SFAS No. 123R requires the use of a valuation model to calculate the fair value of stock-based awards. The Company has elected to use the Black-Scholes-Merton option-pricing model, which incorporates various assumptions including volatility, expected life, and risk-free interest rates. The expected volatility is based on the historical volatility of the Company’s common stock over the most recent period commensurate with the estimated expected life of the Company’s stock options, adjusted for other relevant factors including implied volatility of market traded options on the Company’s common stock. The expected life of an award is based on historical experience and on the terms and conditions of the stock awards granted to employees, as well as the potential effect from options that had not been exercised at the time.

 

In 2006, the Company began granting stock option awards that have a contractual life of seven years from the date of grant. Prior to 2006, stock option awards generally had a ten year contractual life from the date of grant. As a result, the expected term assumption used in the first three months of 2006 reflects the shorter contractual life of the new option awards granted during the period.

 

Juniper Networks, Inc.

 

Notes to the Condensed Consolidated Financial Statements — (Continued)

 

The assumptions used and the resulting estimates of weighted-average fair value per share of options granted and for employee stock purchases under the ESPP during those periods are as follows:

 

 

Stock Repurchase Activity

 

In the three months ended March 31, 2006, the Company repurchased 10,071,100 common shares at an average price of $18.51 per share as part of its Common Stock Repurchase Program. As of March 31, 2006, a total of 12,939,700 common shares had been repurchased since the inception of the program, equating to approximately $250 million at an average price of $19.32 per share.

 

 

The Company’s chief operating decision maker (“CODM”) and senior management team (together “management”) allocate resources and assess performance based on financial information by categories of products and by service.

 

The Infrastructure segment includes products from the E-, M- and T-series router product families as well as the circuit-to-packet products and session border control products. Previously the session border control products were included in SLT. The SLT segment includes Security products and Application Acceleration products. Security products consist of firewall and virtual private network (“VPN”) systems and appliances, secure sockets layer VPN appliances, intrusion detection and prevention appliances, and the J-series router product family. Application Acceleration products consist of application front end platforms and wide area network (“WAN”) optimization platforms.

 

The Service segment delivers world-wide services to customers of the Infrastructure and the SLT segments.

 

The Company’s primary financial measure or management operating income, used by the management in assessing performance and allocating resources to the segments, includes certain cost of revenues, research and development expenses, sales and marketing expenses, and general and administrative expenses. Direct costs, such as standard costs, research and development, and product marketing expenses, are applied directly to each operating segment. Indirect costs, such as manufacturing overhead and other cost of sales, are allocated based on standard costs. Indirect operating expenses,

 

Juniper Networks, Inc.

 

Notes to the Condensed Consolidated Financial Statements — (Continued)

such as sales, marketing, business development, and general and administrative expenses are allocated to each operating segment based on factors including headcount and revenue. Financial information for each operating segment used by management to make financial decisions and allocate resources is as follows (in millions):

 

 

 

 

The Company attributes sales to geographic region based on the customer’s ship-to location. The following table shows net revenue by geographic region (in millions):

 

 

Siemens and Lucent individually accounted for 15% and 10% of the Company’s net revenues for the three months ended March 31, 2006, respectively. Siemens and Ericsson individually accounted for 13% and 12% of the Company’s net revenues for the three months ended March 31, 2005, respectively. The revenue attributed to each significant customer was derived from the sale of products and services in all three operating segments.

 

Juniper Networks, Inc.

 

Notes to the Condensed Consolidated Financial Statements — (Continued)

 

The Company tracks assets by physical location. The majority of the Company’s assets, including property and equipment, were attributable to its U.S. operations as of March 31, 2006 and 2005.

 

 

The Company recorded tax provisions of $34.8 million and $35.8 million for the three months ended March 31, 2006 and 2005, respectively. The Company’s effective tax rate was approximately 32% for each period. The Company’s income taxes currently payable for federal and state purposes have been reduced by the tax benefit from employee stock option transactions. These benefits totaled $56.1 million for the three months ended March 31, 2006 and were reflected as an increase to additional paid-in capital.

 

The Internal Revenue Service (IRS) has concluded an audit of the Company’s federal income tax returns for fiscal years 1999 and 2000. During 2004, the Company received a Notice of Proposed Adjustment (“NOPA”) from the IRS. While the final resolution of the issues raised in the NOPA is uncertain, the Company believes it has made adequate provisions in the accompanying Condensed Consolidated Financial Statements for any adjustments that the IRS has proposed with respect to these tax returns.

 

In conjunction with the IRS income tax audit, certain of the Company’s US payroll tax returns are currently under examination for fiscal years 1999 — 2001, and the Company received a second NOPA in the amount of $11.7 million for employment tax assessments primarily related to the timing of tax deposits related to employee stock option exercises. The Company responded to this NOPA in February 2005, and intends to dispute this assessment with the IRS. An initial appeals conference was held on January 31, 2006. The Company does not believe that a liability can be reasonably estimated at this time. In the event that this issue is resolved unfavorably to the Company, there exists the possibility of a material adverse impact on the Company’s results of operations for the period in which an unfavorable outcome becomes probable and reasonably estimable.

 

 

Commitments

 

The following table summarizes the Company’s principal contractual obligations as of March 31, 2006 (in millions):

 

 

Operating Leases

 

Juniper Networks leases its facilities under operating leases that expire at various times, the longest of which expires in 2016. Future minimum payments under the non-cancelable operating leases, net of committed subleases, totaled $204.1 million as of March 31, 2006. Rent and related expenses paid to a related party was $1.1 million and $1.1 million for the quarters ended March 31, 2006 and 2005, respectively.

 

Juniper Networks, Inc.

 

Notes to the Condensed Consolidated Financial Statements — (Continued)

 

Senior Notes

 

As of March 31, 2006, the Company’s Zero Coupon Convertible Senior Notes (“Senior Notes”), due on June 15, 2008, had a carrying value of $399.9 million.

 

Purchase Commitments

 

The Company does not have firm purchase commitments with its contract manufacturers. In order to reduce manufacturing lead times and ensure adequate component supply, the contract manufacturers place non-cancelable, non-returnable (“NCNR”) orders, which were valued at $107.8 million as of March 31, 2006, based on the Company’s build forecasts. The Company does not take ownership of the components and the NCNR orders do not represent firm purchase commitments pursuant to Juniper Networks’ agreements with the contract manufacturers. The components are used by the contract manufacturers to build products based on purchase orders the Company has received from its customers or its forecast. The Company may incur a liability for products built by the contract manufacturer if the components go unused for specified periods of time and, in the meantime, the Company may be assessed carrying charges. As of March 31, 2006, the Company had accrued $23.1 million based on its estimate of such charges.

 

Other Contractual Obligations

 

As of March 31, 2006, other contractual obligations consisted primarily of the escrow amount of $33.7 million in connection with past acquisitions for indemnity obligations expiring between May 2006 and June 2007. Earn-out and bonus obligations of $8.2 million will be payable to certain former employees of acquired companies over a one or two year period and recorded as compensation expense when incurred.

 

In addition, the 1.6 million shares of the Company’s common stock with a fair value of $35.2 million, established as of the acquisition date, held in escrow associated with an acquisition for indemnity obligations is not included in the preceding table. One-half of the indemnity obligations will expire in July 2006 and the remaining one-half will expire in January 2007.

 

Legal Proceedings

 

The Company is subject to legal claims and litigation arising in the ordinary course of business, such as employment or intellectual property claims, including the matters described below. The outcome of any such matters is currently not determinable. Although the Company does not expect that any such legal claims or litigation will ultimately have a material adverse effect on its consolidated financial position or results of operations, however, an adverse result in one or more matters could negatively affect the Company’s results in the period in which they occur.

 

IPO Allocation Case

 

In December 2001, a class action complaint was filed in the United States District Court for the Southern District of New York against the Goldman Sachs Group, Inc., Credit Suisse First Boston Corporation, FleetBoston Robertson Stephens, Inc., Royal Bank of Canada (Dain Rauscher Wessels), SG Cowen Securities Corporation, UBS Warburg LLC (Warburg Dillon Read LLC), Chase (Hambrecht & Quist LLC), J.P. Morgan Chase & Co., Lehman Brothers, Inc., Salomon Smith Barney, Inc., Merrill Lynch, Pierce, Fenner & Smith, Incorporated (collectively, the “Underwriters”), the Company and certain of the Company’s officers. This action was brought on behalf of purchasers of the Company’s common stock in the Company’s initial public offering in June 1999 and its secondary offering in September 1999.

 

Specifically, among other things, this complaint alleged that the prospectus pursuant to which shares of common stock were sold in the Company’s initial public offering and its subsequent secondary offering

 

Juniper Networks, Inc.

 

Notes to the Condensed Consolidated Financial Statements — (Continued)

contained certain false and misleading statements or omissions regarding the practices of the Underwriters with respect to their allocation of shares of common stock in these offerings and their receipt of commissions from customers related to such allocations. Various plaintiffs have filed actions asserting similar allegations concerning the initial public offerings of approximately 300 other issuers. These various cases pending in the Southern District of New York have been coordinated for pretrial proceedings as In re Initial Public Offering Securities Litigation, 21 MC 92. In April 2002, plaintiffs filed a consolidated amended complaint in the action against the Company, alleging violations of the Securities Act of 1933 and the Securities Exchange Act of 1934. Defendants in the coordinated proceeding filed motions to dismiss. In October 2002, the Company’s officers were dismissed from the case without prejudice pursuant to a stipulation. On February 19, 2003, the court granted in part and denied in part the motion to dismiss, but declined to dismiss the claims against the Company.

 

In June 2004, a stipulation for the settlement and release of claims against the issuers, including the Company, was submitted to the Court for preliminary approval. The terms of the settlement, if approved, would dismiss and release all claims against participating defendants (including the Company). In exchange for this dismissal, Directors and Officers insurance carriers would agree to guarantee a recovery by the plaintiffs from the underwriter defendants of at least $1.0 billion, and the issuer defendants would agree to an assignment or surrender to the plaintiffs of certain claims the issuer defendants may have against the underwriters. On August 31, 2005, the Court granted preliminary approval of the settlement. The settlement is subject to a number of conditions, including final court approval. If the settlement does not occur, and litigation continues, the Company believes it has meritorious defenses and intends to defend the case vigorously.

 

Federal Securities Class Action Suit

 

During the quarter ended March 31, 2002, a number of essentially identical shareholder class action lawsuits were filed in the United States District Court for the Northern District of California against the Company and certain of its officers and former officers purportedly on behalf of those stockholders who purchased the Company’s publicly traded securities between April 12, 2001 and June 7, 2001. In April 2002, the court granted the defendants’ motion to consolidate all of these actions into one; in May 2002, the court appointed the lead plaintiffs and approved their selection of lead counsel and a consolidated complaint was filed in August 2002. The plaintiffs allege that the defendants made false and misleading statements, assert claims for violations of the federal securities laws and seek unspecified compensatory damages and other relief. In September 2002, the defendants moved to dismiss the consolidated complaint. In March 2003, the court granted defendants motion to dismiss with leave to amend. The plaintiffs filed their amended complaint in April 2003 and the defendants moved to dismiss the amended complaint in May 2003. In March 2004, the court granted defendants motion to dismiss, without leave to amend, and entered final judgment against plaintiffs. Plaintiffs appealed. In December 2005, after complete briefing and oral argument, the United States Court of Appeals for the Ninth Circuit affirmed the district court’s dismissal and final judgment. The deadline for plaintiffs to appeal the Ninth Circuit’s decision to the United States Supreme Court has expired. The matter is now closed.

 

State Derivative Claim Based on the Federal Securities Class Action Suit

 

In August 2002, a consolidated amended shareholder derivative complaint purportedly filed on behalf of the Company, captioned In re Juniper Networks, Inc. Derivative Litigation, Civil Action No. CV 807146, was filed in the Superior Court of the State of California, County of Santa Clara. The complaint alleges that certain of the Company’s officers and directors breached their fiduciary duties to the Company by engaging in alleged wrongful conduct including conduct complained of in the securities litigation described above. The Company is named solely as a nominal defendant against whom the plaintiffs seek no recovery. After having their previous complaints dismissed with leave to amend, Plaintiffs lodged a third

amended complaint in August 2004. Defendants demurred to the third amended complaint. On November 18, 2004, the Court sustained defendants’ demurrer without leave to amend and entered an order of final judgment against plaintiffs. Plaintiffs appealed to the California Court of Appeal, Sixth District. The appeal hearing was held in April 2006. Subsequent to the hearing, the Plaintiff’s requested the appeal to be dismissed and the Court of Appeal granted the request. The matter is now closed.

 

Toshiba Patent Infringement Litigation

 

On November 13, 2003, Toshiba Corporation filed suit in the United States District Court in Delaware against the Company, alleging that certain of the Company’s products infringe four Toshiba patents, and seeking an injunction and unspecified damages. The Company filed an answer to the complaint in February 2004. Toshiba amended its complaint to add two patents, and the Company answered the amended complaint in July 2004. A Markman hearing was held in April 2006 and trial is scheduled for August 2006.

 

IRS Notices of Proposed Adjustments

 

The Internal Revenue Service (IRS) has concluded an audit of the Company’s federal income tax returns for fiscal years 1999 and 2000. During 2004, the Company received a Notice of Proposed Adjustment (NOPA) from the IRS. While the final resolution of the issues raised in the NOPA is uncertain, the Company does not believe that the outcome of this matter will have a material adverse effect on its consolidated financial position or results of operations. The Company is also under routine examination by certain state and non-US tax authorities. The Company believes that it has adequately provided for any reasonably foreseeable outcome related to these audits.

 

In conjunction with the IRS income tax audit, certain of the Company’s US payroll tax returns are currently under examination for fiscal years 1999 — 2001, and the Company received a second NOPA in the amount of $11.7 million for employment tax assessments primarily related to the timing of tax deposits related to employee stock option exercises. The Company responded to this NOPA in February 2005, and intends to dispute this assessment with the IRS. An initial appeals conference was held on January 31, 2006. The Company does not believe that a liability can be reasonably estimated at this time. In the event that this issue is resolved unfavorably to the Company, there exists the possibility of a material adverse impact on the Company’s results of operations for the period in which an unfavorable outcome becomes probable and reasonably estimable.

 

 

The Company reimburses its CEO, Mr. Scott Kriens, for ordinary operating costs relating to his use of a personal aircraft for business purposes up to a maximum amount per year. The Company incurred $0.1 million in related expenses for the three months ended March 31, 2006, and 2005, respectively.

 

This Quarterly Report on Form 10-Q (“Report”), including the “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, contains forward-looking statements regarding future events and the future results of the Company that are based on current expectations, estimates, forecasts, and projections about the industry in which the Company operates and the beliefs and assumptions of the management of the Company. Words such as ‘expects,’ ‘anticipates,’ ‘targets,’ ‘goals,’ ‘projects,’ ‘intends,’ ‘plans,’ ‘believes,’ ‘seeks,’ ‘estimates,’ variations of such words, and similar expressions are intended to identify such forward-looking statements. These forward-looking statements are only predictions and are subject to risks, uncertainties and assumptions that are difficult to predict. Therefore, actual results may differ materially and adversely from those expressed in any forward-looking statements. Factors that might cause or contribute to such differences include, but are not limited to, those discussed in this Report under the section entitled “Risk Factors” in Item 1A of Part II and elsewhere, and in other reports the Company files with the Securities and Exchange Commission (“SEC”), specifically the most recent Annual Report on Form 10-K. The Company undertakes no obligation to revise or update publicly any forward-looking statements for any reason.

 

The following discussion is based upon our Condensed Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingencies. On an on-going basis, we evaluate our estimates, including those related to sales returns, warranty costs, allowance for doubtful accounts, impairment of long-term assets, especially goodwill and intangible assets, contract manufacturer exposures for carrying and obsolete material charges, assumptions used in the valuation of stock-based compensation, and litigation. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

 

Overview of the Results of Operations

 

To aid in understanding our operating results for the three months ended March 31, 2006 and 2005, we believe an overview of the significant events that affected those periods and a discussion of the nature of our operating expenses is helpful.

 

Business Overview

 

We design and sell products and services that together provide our customers with secure and assured Internet Protocol (“IP”) networking solutions. Our purpose-built, high performance IP platforms enable customers to support many different services and applications at scale. Service providers, enterprises, governments and research and education institutions worldwide rely on Juniper Networks to deliver products for building networks that are tailored to the specific needs of their users, services and applications. Our portfolio of networking and security solutions supports the complex scale, security and performance requirements of many of the world’s most demanding networks. We sell our products and services through direct sales organization, value-added resellers and distributors to end-users in the service provider and enterprise markets. Our operations are organized into three operating segments: Infrastructure, Service Layer Technologies (“SLT”) and Service.

 

Our Infrastructure segment primarily offers scalable router products that are used to control and direct network traffic. This control is made more important by the fact that the size and complexity of IP networks are increasing at a time when service providers are looking to differentiate themselves through value-added service offerings.

Our SLT segment offers solutions that meet a broad array of our customer’s priorities, from protecting the network itself, and protecting data on the network, to maximizing existing bandwidth and acceleration of applications across a distributed network. Together, our secure networking solutions help enable our customers to convert networks that provide commoditized, best efforts services into more valuable assets that provide differentiation and value and increased reliability and security to end users.

 

Our Service segment delivers world-wide services, including technical support, professional services, as well as a number of education and training programs, to customers of the Infrastructure and SLT segments.

 

During the first quarter of 2006, we focused on product innovation and our customers’ needs. Consistent with this focus, we re-aligned our session border control products from the SLT segment to the Infrastructure segment. New products released during this period included the Secure Services Gateway (“SSG”) Series, a new line of high-performance firewall/virtual private network (“VPN”) platforms with integrated local-area and wide-area network routing interfaces.

 

Of the total net revenue for the first quarter of 2006, 64% attributed to infrastructure products, 20% to SLT products and 16% to Service. From a geographic perspective, 46% of the total revenue was generated in the Americas region, 36% in the Europe, Middle East and Africa (EMEA) region and 18% in the Asia Pacific region.

 

Significant Events

 

Stock Repurchase Activity

 

In the three months ended March 31, 2006, we repurchased and retired 10,071,100 common shares at an average price of $18.51 per share as part of our Common Stock Repurchase Program. As of March 31, 2006, a total of 12,939,700 common shares had been repurchased and retired since the inception of the program, equating to approximately $250 million at an average price of $19.32 per share.

 

Operating Segments

 

The Infrastructure segment includes products from the E-, M- and T-series router product families as well as the circuit-to-packet products and session border control products. The SLT segment includes Security products and Application Acceleration products. Security products consist of firewall and VPN systems and appliances, secure sockets layer VPN appliances, intrusion detection and prevention appliances, and the J-series router product family. Application Acceleration products consist of application front end platforms and wide area network (“WAN”) optimization platforms.

 

Stock-Based Compensation

 

We adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”) effective January 1, 2006, using the modified prospective transition method and, therefore, have not restated prior periods’ results. During the first three months of 2006, we issued to our employees and directors stock options, restricted stock units (“RSUs”) and employee stock purchases under our Employee Stock Purchase Plan. Under SFAS 123R, we recorded stock-based compensation expense of $23.1 million for the three months ended March 31, 2006, compared to $3.4 million for the same period in 2005 when we recognized stock-based compensation expense under the intrinsic value recognition provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”).

 

Nature of Expenses

 

We have an extensive distribution channel in place that we use to target new customers and increase sales. We have made substantial investments in our distribution channel since 2004.

Most of our manufacturing, repair and supply chain operations are outsourced to independent contract manufacturers; accordingly, most of our costs of revenues consist of payments to our independent contract manufacturers for the standard product costs. The independent contract manufacturers produce our products using design specifications, quality assurance programs and standards that we establish. Controls around manufacturing, engineering and documentation are conducted at our facilities in Sunnyvale, California and Westford, Massachusetts. Our independent contract manufacturers have facilities primarily in Canada, China, Malaysia, and the United States. We generally do not own the components and title to products transfers from the contract manufacturers to us and immediately to our customers upon shipment.

 

The contract manufacturers procure components based on our build forecasts and if actual component usage is lower than our forecasts, we may be, and have been in the past, liable for carrying or obsolete material charges.

 

Employee related costs have historically been the primary driver of our operating expenses and we expect this trend to continue. Employee related costs include items such as wages, stock-based compensation, commissions, bonuses, vacation, benefits and travel. We increased our headcount from 3,100 employees as of March 31, 2005 to 4,164 employees as of March 31, 2006 due in part to the acquisitions completed in 2005.

 

Facility and information technology departmental costs are allocated to other departments based on factors including headcount and revenue. These departmental costs have increased in each of the last two years due to increases in headcount and facility leases resulting from acquisitions and additional infrastructure systems to support our growth. Our capital spending decreased by $4.3 million in the three months ended March 31, 2006 compared to the same period in 2005 due to a temporary reduction in our test equipment purchases. We expect our capital spending to increase in the future.

 

Research and development expenses include:

 

 

Several components of our research and development effort require significant expenditures, such as the development of new components and the purchase of prototype equipment, the timing of which can cause quarterly variability in our expenses. We expense our research and development costs as they are incurred. We plan to increase our investment in research and development efforts during 2006 compared to 2005 to further advance our competitive advantage.

 

Sales and marketing expenses include costs for promoting our products and services, demonstration equipment and advertisements. These costs vary quarter-to-quarter depending on revenues, product launches and marketing initiatives. We plan to further develop our distribution channel in 2006 in an effort to expand and grow our presence in new markets, serving both private and public networks with a full portfolio of networking products.

 

General and administrative expenses include professional fees, bad debt provisions and other corporate expenses. Professional fees include legal, audit, tax, accounting and certain corporate strategic services.

 

Critical Accounting Policies and Estimates

 

The preparation of financial statements in accordance with U.S. generally accepted accounting principles requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of net revenue and expenses in the reporting period. We regularly evaluate our estimates and assumptions. We base our estimates and assumptions on current facts, historical experience and various other factors that we believe to be

reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Our actual results may differ materially and adversely from management’s estimates. To the extent there are material differences between our estimates and the actual results, our future operating results will be affected.

 

We believe the following critical accounting policies require us to make significant judgments and estimates in the preparation of our consolidated financial statements:

 

 

Management believes that other than the adoption of SFAS 123R there have been no significant changes during the three months ended March 31, 2006 to the items that we disclosed as our critical accounting policies and estimates in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2005.

 

Stock-Based Compensation Expense

 

Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS 123R, using the modified prospective transition method, and therefore have not restated prior periods’ results in our Condensed Consolidated Financial Statements. In accordance with SFAS 123R, we recognize compensation expense, net of estimated forfeitures, for all stock-based payments granted after January 1, 2006 and prior to but not vested as of January 1, 2006.

 

Under SFAS 123R, stock-based compensation cost is estimated at the grant date based on the award’s fair value as calculated by the Black-Scholes-Merton option-pricing model and is recognized as expense, net of estimated forfeitures, ratably over the requisite service period. Given our employee stock options have certain characteristics that are significantly different from traded options and, because changes in the subjective assumptions can materially affect the estimated value, in our opinion, the existing valuation models may not provide an accurate measure of the fair value of our employee stock options. Although we determine the fair value of employee stock options in accordance with SFAS 123R and SAB 107 using the Black-Scholes-Merton option-pricing model, that value may not be indicative of the fair value observed between a willing buyer and a willing seller in a market transaction.

 

The Black-Scholes-Merton model requires various highly judgmental assumptions including expected option life and volatility. If any of the assumptions used in the Black-Scholes-Merton model or the estimated forfeiture rate changes significantly, stock-based compensation expense may differ materially in the future from that recorded in the current period.

 

Results of Operations

 

The operating results from the companies acquired in the period between May 2005 and December 2005 were included in the condensed consolidated statements of operations for the three months ended March 31, 2006. The increases in cost of revenues and operating expenses in the first quarter of 2006 compared to the same period in 2005 were primarily attributable to additional employees, increases in

stock-based expense from the adoption of SFAS 123R and the inclusion of the operation results from the companies acquired in 2005.

 

Net Revenues

 

The following table shows product and service net revenues (in millions):

 

 

Net Product Revenues

 

Net product revenues increased $81.8 million in the three months ended March 31, 2006 compared to the same period in 2005 primarily as a result of the adoption and expansion of IP networks by our customers in order to reduce total operating costs and to be able to offer multiple services over a single network. Changes in product mix and the addition of the SLT products through various acquisitions also contributed to the net revenue increase.

 

Infrastructure products were $363.0 million for the three months ended March 31, 2006, a $58.9 million increase compared to the same period in 2005. SLT products were $111.1 million for the three months ended March 31, 2006, a $22.9 million increase compared to the same period in 2005. An analysis of the change in revenue by Infrastructure and SLT segments and the change in product units, can be found below in the section titled “Segment Information.”

 

Net Service Revenues

 

Net service revenues increased $35.8 million in the three months ended March 31, 2006 compared to the same period in 2005 primarily due to the growth in support services business and to increases in professional service revenue. Support service revenue increased by $32.1 million, representing 90% of the increase, primarily due to increased technical support service contract initiations and renewals associated with higher product sales, which have resulted in a larger installed based of equipment being serviced. We recognize revenue from service contracts as the services are completed or ratably over the period of the obligation. A majority of our service revenue is earned from customers who purchase our products and enter into service contracts. These contracts are typically for one-year renewable periods for services such as 24-hour customer support, non-specified updates and hardware repairs. In addition to service contracts, we also provide educational services.

Total Net Revenues

 

The following table shows the total net revenues by geographic region (in millions, except percentages):

 

 

Net revenue in the United States as a percentage of total net revenue increased in the first three months of 2006 compared to the same period in 2005 primarily due to increased sales of our core routers to the service provider market as our customers continue to focus on increasing network performance, reliability and scale. Net revenue in EMEA as a percentage of total net revenue increased in the first three months of 2006 compared to the same period in 2005 primarily due to strength across the region driven by the IPTV demands and next generation network (“NGN”) build-outs. Net revenue in Asia Pacific countries decreased, in absolute dollars and as a percentage of net revenue, in the first three months of 2006 compared to the same period in 2005 primarily due to completion by customers of several network expansion projects and a pause in the build out of their NGN.

 

Siemens and Lucent each accounted for greater than 10% of our net revenues during the three months ended March 31, 2006. Siemens and Ericsson each accounted for greater than 10% of our net revenues during the same period in 2005.

 

Cost of Revenues

 

The following table shows cost of product and service revenues and the related gross margin (“GM”) percentages (in millions, except percentages):

 

 

Cost of product revenues increased $28.4 million in the three months ended March 31, 2006 compared to the same period in 2005, while product gross margin fell by 1 percentage point to 70%. The increase in absolute dollars was primarily due to higher standard costs in connection with the increase in revenue. In addition, a $0.4 million increase in stock-based compensation expense from the adoption of SFAS 123R and the amortization of purchased technologies of $1.4 million contributed to the one percentage point decrease in gross margin for the three months ended March 31, 2006, compared to the same period in 2005.

 

As we have expanded our market share and entered more markets, we have begun to experience increased competition. However, our product revenues and product gross margin increased in absolute dollars and our product gross margins have remained relatively steady compared to the year-ago period in part due to our focus on reducing manufacturing related costs. As of March 31, 2006 and 2005, we employed 140 and 110 people, respectively, in our manufacturing and operations organization who primarily manage relationships with our contract manufacturers, manage our supply chain, and monitor and manage product testing and quality.

Cost of service revenues increased $12.9 million in the three months ended March 31, 2006 compared to the same period in 2005, however service gross margin increased eight percentage points compared to the same period in 2005 primarily by achieving improved economies of scale. In absolute dollars, personnel related expenses consisting primarily of salaries, wages, bonus, and fringe benefit expenses increased $4.6 million due to an increase in headcount from 353 to 483 people. The increase in headcount was attributable, in part, to the acquisitions completed in 2005. Additionally, customer service spares expense and outside services increased by $4.3 million in total due to increased demands resulting from the additional service contracts. The adoption of SFAS 123R resulted in additional stock-based compensation expense of $1.0 million in the period ended March 31, 2006.

 

Operating Expenses

 

The following table shows operating expenses (in millions, except percentages):

 

 

Research and development expenses increased by $35.6 million in the three months ended March 31, 2006 compared to the same period in 2005 primarily due to increases in personnel related expenses,

support costs, and stock-based compensation expense. Personnel related charges, consisting of salaries, bonus, and fringe benefits expenses, increased $16.5 million due to an increase in headcount, from 1,270 to 1,707 people in the engineering organization to support product innovation intended to capture anticipated future NGN infrastructure growth and opportunities in the enterprise market. The increase in headcount was also attributable, in part, to the acquisitions in 2005. Additionally, non-recurring engineering expenses, facilities, information technology, depreciation and equipment expenses increased $7.7 million to support these engineering efforts. The adoption of SFAS 123R resulted in additional stock-based compensation expense of $8.0 million in the period ended March 31, 2006.

 

Sales and marketing expenses increased $37.3 million in the three months ended March 31, 2006 compared to the same period in 2005 primarily due to increases in personnel related expenses, marketing expenses, and stock-based compensation expense. Personnel related charges, consisting of salaries, commissions, bonus, and fringe benefits expenses, increased $16.1 million due to an increase in headcount, from 1,067 to 1,452 people in our worldwide sales and marketing organizations to support additional products and customers. The increase in headcount was also attributable, in part, to the acquisitions in 2005. Additionally, marketing expenses increased $6.8 million as we focused on increasing brand awareness and expanding our presence in the enterprise market. The adoption of SFAS 123R resulted in additional stock-based compensation expense of $6.9 million in the period ended March 31, 2006.

 

General and administrative expenses increased $7.4 million in the three months ended March 31, 2006 compared to the same period in 2005 primarily due to an increase in personnel related expenses, outside professional services, and in stock-based compensation expense. Personnel related charges, consisting of salaries, bonus, and fringe benefits expenses, increased $1.9 million due to an increase in headcount, from 173 to 214 people in our worldwide general and administrative functions to support the overall growth in the business. The increase in headcount was also attributable, in part, to the acquisitions in 2005. Outside professional services, which include accounting, tax, and legal fees, increased as a result of patent litigation expenses in the three months ended March 31, 2006. The adoption of SFAS 123R resulted in additional stock-based compensation expense of $3.3 million in the period ended March 31, 2006.

Special charges of $1.4 million recognized in the three months ended March 31, 2006 pertained to the accrual of acquisition related bonus and earn-out payments.

 

Other Income and Expenses

 

The following table shows other income and expenses (in millions):

 

 

Interest and other income increased by $9.7 million in the three months ended March 31, 2006 compared to the same period in 2005 as a result of higher cash, cash equivalents and investment balances compared to a year ago, as well as increases in interest rates.

 

Interest and other expenses increased by $0.3 million primarily due to increases in foreign exchange losses and increases in other expenses such as bank fees during the three months ended March 31, 2006 compared to the same period in 2005.

 

Provision for Income Taxes

 

We recorded tax provisions of $34.8 million and $35.8 million for the three months ended March 31, 2006 and 2005, and our effective tax rates were approximately 32% for both periods.

 

Segment Information

 

We began to track financial information by our three operating segments during 2005 as our management structure and responsibilities began to measure the business based on product and service profitability. Commencing in 2006, we re-aligned our session border control products from the SLT segment to the Infrastructure segment as we re-prioritized our focus on service provider and enterprise customers. A description of the products and services for each segment can be found in Note 7 to the accompanying Condensed Consolidated Financial Statements.

 

Financial information for each operating segment used by management to make financial decisions and allocate resources is as follows (in millions):