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Article by DailyStocks_admin    (12-29-07 03:27 AM)

The Daily Magic Formula Stock for 12/29/2007 is Avici Systems Inc. According to the Magic Formula Investing Web Site, the ebit yield is 78% and the EBIT ROIC is >100%.

Dailystocks.com only deals with facts, not biased journalism. What is a better way than to go to the SEC Filings? It's not exciting reading, but it makes you money. We cut and paste the important information from SEC filings for you to get started on your research on a specific company.


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BUSINESS OVERVIEW
Overview
Avici Systems Inc. (referred to as Avici, we, our and the company) provides high-speed core Internet infrastructure equipment that enables networking service providers to transmit large volumes of data, voice and video, across their networks. Our high-performance routing solutions are designed and built to deliver the scalability, reliability, and performance that carriers need to support a wide range of applications while lowering the total cost of building and operating their core data networks.
The Avici core routing product family consists of three chassis platforms and several line cards to provide carriers with flexibility in selecting a product that best fits their needs. We offer customers three different equipment configurations, the Terabit Switch Router (TSR ™ ), the Stackable Switch Router (SSR ™ ), and the Quarter-rack Scalable Router (QSR ™ ), and each chassis is configured with our line cards and proprietary software to support a range of speeds, protocols, and carrier services. All three chassis use the same line cards and software to enable carriers of every size to take advantage of Avici’s proprietary carrier-class technology. Our core routers are designed to provide our customers:



• Carrier-class reliability;
• In-service modular scalability to enable non-disruptive incremental capacity additions to the network;
• Stability and interoperability;
• Advanced security features; and
• High performance across very large IP-based core networks.


Our current strategy is primarily to pursue direct sales of our legacy core routing products principally to our largest customer, AT&T Inc. (“AT&T”), maximize the near-term financial returns from our core routing business, and pursue new market initiatives and product development. Our principal customer is, and has been, AT&T. In the past, we utilized a direct sales force to sell and market our products to incumbent local exchange carriers, inter-exchange carriers, postal telephone and telegraph operators, internet service providers and other service providers globally. In February 2006, we announced a corporate restructuring aimed at driving Avici toward profitability and positive cash flow.
Avici was incorporated in Delaware in 1996 and held its initial public offering in July 2000. We are headquartered in North Billerica, Massachusetts. At December 31, 2006, we had 104 full time employees. In February 2006, we announced a corporate restructuring aimed at driving Avici toward profitability and positive cash flow. Our corporate restructuring resulted in reduction in both full time and contract labor by approximately 45%, with the majority of this reduction occurring at the time of the announcement.
In February 2007, we announced the launch of a new product initiative, Soapstone Networks (“Soapstone”). The positive cash flow that Avici has been able to generate will enable us to fund the development of Soapstone.
Industry Background
Traditional carrier networks were primarily built on technologies to support voice services. These legacy voice networks used circuit switches, which dedicate an individual connection, or part of the network, for the duration of a call even while there are pauses in the conversation. As the amount of data traffic carried over the network infrastructure increased, carriers sought to increase the efficiency of data transmission through their networks by adopting packet switching technologies, such as Asynchronous Transfer Mode (ATM) and Frame Relay. Packet switching technologies enabled carriers to send data from multiple sources on the same connection, substantially reducing the network bandwidth wasted using traditional circuit switch technology.

Internet, telecom, and media networks are converging and carrier IP networks are now expected to support critical services such as voice, video, IPTV, Virtual Private Networks (VPNs), online gaming, security, storage, and other business and residential applications. These types of services are required for carriers to increase revenue and profits. In addition, these applications require significantly high levels of reliability, scale, QoS, and performance.
Today, a maturing Internet has placed new demands on routers. As IP is increasingly used to support more diverse and demanding applications, carriers require routing platforms purpose built for the carrier network. Carriers recognize that they cannot cost effectively support multiple networks—one for landline voice, another for IP traffic, another for wireless, and many more for separate data network. Carriers envision a converged IP network where voice, data, video and wireless services are supported over a single reliable and cost effective network. This vision requires upgrading existing best effort IP networks to a new-real time IP network powered by carrier-grade IP routers to improve the economics of the IP network.
Carrier Requirements for an IP Network
The boundaries that exist between Internet, telecom, and media networks are blurring and the core routers that run carrier networks today must evolve and support a new model of system availability, scale in service to extend network longevity, keep pace with new traffic requirements, and deliver the levels of service and performance to converge these networks over a common IP core. As a result, carriers are demanding solutions with the following attributes:
Carrier-Class Reliability. The equipment that carriers deploy within their networks must offer the highest level of up time and redundancy.
Reduced Network Cost and Complexity. Carriers are demanding modular solutions that scale in service to accommodate new capacity requirements, reduce the number of devices needed and, consequently, reduce the forecasting uncertainty, complexity, and costs of operating large capacity networks.
Faster Service Provisioning. Networks and service demands are changing constantly, and carriers require a cost-effective means of increasing capacity and offering new services on a continual basis.
High Performance. As carriers consolidate existing legacy networks and deliver new services on an IP backbone, they must provide Quality of Service, or the ability to prioritize different traffic types in order to meet customers’ service level agreements for premium services.
Interoperability. Due to economic constraints associated with upgrading an entire network to accommodate new technologies, it is critical that new network equipment support the protocols and devices already deployed in carrier networks.
Industry Segments
Avici has conducted its operations in one industry segment. Please see our financial statements attached hereto in Item 8 for financial information related to our segment.
The Avici Core Router Solution
Products and Technology
Our high-performance core routing family is engineered to provide a carrier network solution that addresses a wide range of network applications across a carrier’s core IP network. Avici routers are designed to deliver scalability, reliability, and performance to IP networks using carrier-proven principles of redundancy, in-service upgradeability, multi-generational investment protection, and quality assurance.

Avici has developed a modular network architecture that eliminates many of the constraints of traditional routers. Our core routing platforms support traffic expansion by scaling, in-service, from gigabits to terabits of capacity through the non-disruptive addition of line cards and chassis. Unlike traditional routers, every port can be used to support customer traffic, and no ports or external switching hubs are needed for interconnection or scaling. Our routing platforms provide carriers with a stable, scalable, and reliable foundation to support traffic growth and lower cost requirements. Our routers can also perform both the core and aggregation/hub functions in a single platform, thereby eliminating the need for a separate aggregation layer. Our routing technologies provide internal hardware and software redundancy to deliver carrier-grade 99.999+% system availability to support SLAs on services such as IPTV, video, VPNs and Voice over IP (VoIP). Because Avici products can deliver such high levels of reliability, carriers are able to remove duplicate routers and simplify their Points of Presence (PoP). Avici routers also enable the IP network to recover quickly from service disruptions, a critical requirement for supporting real time services.
Our products provide these benefits through our proprietary technologies, including our application-specific integrated circuits, or ASICs, Velociti ™ switch fabric and distributed system design, IPriori ™ system software, Composite Links ™ , and Non Stop Routing (NSR ™ ) technologies. We incorporate all of these proprietary technologies into each of our three available product platforms—the Terabit Switch Router (TSR), Stackable Switch Router (SSR), and Quarter-rack Scalable Router (QSR). The TSR, SSR, and QSR offer customers differing combinations of speed, capacities and numbers of available ports in order to allow them to tailor their network infrastructure to meet their traffic needs.
ASIC-based Packet Routing Technology
We have consolidated all data-flow and control processes, including packet input and output framing, forwarding, scheduling, and switching into our application specific integrated circuits, or ASICs. We utilize a distributed routing architecture. Each line card has its own ASICs, and, accordingly, the addition of each line card increases the overall capacity of our product.
Velociti Switch Fabric
Our Velociti switch fabric is the mechanism that transfers data from an input line card to specific output cards in our products. This direct communication provides high-speed data transfer and, as additional capacity is needed, enables cost-effective addition of line cards. The Velociti switch fabric also gives our products a high level of reliability by creating multiple connections between pairs of input and output line cards.
IPriori Carrier System Control Software
Avici’s IPriori system software has been developed to optimize and control switching and routing in all of our products. IPriori is built on a distributed model, which uses multiple processor units to provide increased levels of reliability and scalability, and is specifically designed to address the system requirements arising from scaling to a large number of ports.
Composite Links for Seamless Capacity Additions and Cost-Effective Link Protection
Avici’s proprietary Composite Links technology enables carriers to seamlessly expand capacity in the PoP by enabling multiple physical links or fiber interfaces between two Avici routers to be grouped into a single logical connection. This technology provides greater flexibility to carriers in migrating to higher-speed backbones that leverage multiple generations of fiber infrastructure and speeds. Hardware upgrades can be done without costly downtime by adding or removing router modules without disruption to packet ordering, routing tables or traffic flows. Composite Links also provide carriers with cost-effective link protection through the ability to recover from failures on individual member-link interfaces.

Non-Stop Routing (NSR) Technology
Our products have been designed and manufactured to be highly reliable in the core of carrier networks. Avici’s NSR technology provides nodal reliability by protecting against failure of the route controller, the brain of the router, thus enabling carriers to achieve 99.999+% system availability in a single router. This functionality is achieved by having a second route controller take over routing functions in the event the primary controller fails. Many of today’s IP networks also use two core routers within a POP to increase reliability. Avici NSR can provide potential cost savings by enabling carriers to end the costly practice of deploying redundant routers to increase router reliability.
Strategy
In February 2006, we announced a plan to restructure the business and realign our cost structure to execute a focused strategy aimed at driving Avici toward profitability and positive cash flow.
In February 2007, we announced the launch of Soapstone, a new product initiative.
The Soapstone software-based solution we are developing is designed to manage the complexities between carrier service offerings and applications, and the underlying transport equipment and technologies. Soapstone’s mission is to enable carriers to bring orderly, predicable, business-driven behavior to their IP networks, regardless of vendor or technology composition.
The Soapstone solution is based on key industry standards such as service-oriented architecture (SOA), telemanagement forum (TMF), international telecommunications union (ITU) and next generation networks (NGN) among others, and utilizes open application programming interfaces (APIs) between the network and operational support systems (OSS). It maps the abstract service needs expressed by the business plane into a simple configuration command set that can be applied to an array of technologies and equipment. With this capability, even the simplest network devices can provide support for complex service provisioning and SLA management.
The key elements of our strategy are to:
Focus on Major Customer. We restructured the core routing business to focus on becoming profitable and cash flow positive by pursuing direct sales principally to our major customer, AT&T. We are focused on dynamically responding to our customer’s volume and service requirements, given changing dynamics in a multi-network, multi-vendor environment and limited visibility into future volume requirements.
Develop and Market Soapstone Solution. Carrier networks are undergoing unprecedented transformations as they migrate to the NGN (Next Generation Network) model. In order to increase their service offerings and grow revenues, they will have to support multiple access networks and devices at the lowest cost possible. The complexity of today’s networks creates a need for a product that will form a common control framework for over-IP, IP, over-Ethernet and optical technologies and allow for seamless service migration among them. We are developing the Soapstone solution to deliver a network abstraction layer that decouples the services from the network infrastructure.
Selectively Pursue Indirect Sales Channels for Soapstone. The Soapstone solution will be targeted to the service provider market. We will seek distribution partners to capture new carrier opportunities.
Sales, Marketing, and Customer Service and Support
Historically, we sold and marketed our products through our direct sales force, sales agents, systems integrators, and distribution partners. Subsequent to our restructuring, announced in February 2006, we have primarily sold and marketed our core router products through a downsized domestic sales force.

In the past, we also marketed, sold, and supported our products through systems integrators, sales agents, and distribution partners, including Nortel Networks and Huawei Technologies. In May 2003, we entered into a strategic relationship with Huawei Technologies for sales and support of our products in Greater China. The term of the agreement was two years and expired during 2005. In January 2004, we entered into a worldwide three-year strategic agreement with Nortel Networks to market, sell, and support our products. The term of the agreement is three years and expired in January 2007. During 2005, we entered into a Supply Agreement with Alcatel Teletas to provide Turk Telekom with Avici equipment for its IP/MPLS network. The Alcatel Teletas arrangement was terminated in October 2006.
In the future, we plan to market our Soapstone solution both directly and through strategic indirect channel partners.
Customers
AT&T is our primary customer. Our agreement with AT&T has no minimum purchase commitment level and remains in effect until December 31, 2009. The agreement describes the conditions under which AT&T may purchase equipment and services from us. AT&T has deployed our TSR product in sixteen locations within its North American IP backbone network.
AT&T accounted for 94%, 94% and 60% of our gross revenue in 2006, 2005 and 2004 respectively. In 2004, Huawei and Nortel accounted for 27% and 12%, respectively, of our gross revenue.
Research and Development
We have a team of skilled engineers responsible for product design and development, quality assurance, and documentation. Our engineers have significant experience in optical networking, hardware and software. As part of the restructuring of the business announced in February 2006, our development resources were reduced and partially redeployed to focus on the Soapstone initiative. We have also utilized offshore and outsourced development resources. We have made, and will continue to make, although at a reduced level, substantial investments in research and development. Research and development expenses were $30.1 million, $36.2 million, $32.4 million, and $46.5 million for the years ended December 31, 2006, 2005, 2004, and 2003, respectively.
Competition
The market for data networking equipment is intensely competitive, subject to rapid technological change and significantly affected by new product introductions and other market activities of industry participants. This market historically has been dominated by Cisco Systems, which as a result of its leadership position in the market has been able to develop and promote a broad product line of routers. We also compete with other established companies such as Juniper Networks. For new technology initiatives such as our Soapstone product, we will face competition from large equipment and software companies, as our product will serve as an abstraction layer that will bridge IT/OSS and network centric domains. We may experience reluctance by our prospective customers to replace or expand their current solutions, which may be supplied by competitors, with our products. Competitors have significantly broader product lines and market presence than we do and may bundle their products with other products that we do not offer. In addition, we have faced significant competition and pricing pressure in the core router market.
In order for our Soapstone solution to compete effectively, we must deliver a technologically advanced product that is superior in meeting the needs of carriers, namely a product which:






• hides complexity of transport elements from services, control functions, and OSS;
• provides common API for specifying resources and their SLAs;
• interoperates with existing solutions and equipment vendors;
• enables seamless migration of legacy services onto NGN while supporting new NGN-based service offerings; • mediates between resource requests from services/control and OSS and available resources of the IP network; and
• creates a cost-effective solution for our target customers.
In addition, we will be required to leverage our Soapstone differentiators to extend customer acceptance.
Many of our current and potential competitors have greater selling and marketing, technical, manufacturing, financial and other resources, more customers, greater market recognition, and more established relationships and alliances in the industry. As a result, these competitors may be able to develop, enhance and expand their product offerings more quickly, adapt more swiftly to new or emerging technologies and changes in customer demands, devote greater resources to the marketing and sale of their offerings, pursue acquisitions and other opportunities more readily, and adopt more aggressive pricing policies than us.
Intellectual Property
We presently have 20 patents granted in the United States and over 50 United States and foreign patent applications pending. Our success and ability to compete are dependent on our ability to develop and maintain the proprietary aspects of our technology and operate without infringing on the proprietary rights of others. We rely on a combination of patent protection, copyrights, trademarks, trade secret laws, contractual restrictions on disclosure, and other methods to protect the proprietary aspects of our technology. These legal protections afford only limited protection for our technology. We cannot be certain that patents will be granted based on our pending or any other applications, or that, even if issued, the patents will adequately protect our technology. We seek to protect our source code for our software, documentation and other written materials under trade secret and copyright laws, and we seek to limit disclosure of our intellectual property by requiring employees, consultants, and any third-party with access to our proprietary information to execute confidentiality agreements with us.
While we rely on patent, copyright, trade secret and trademark law to protect our technology, we also believe that factors such as the technological and creative skills of our personnel, new product developments and enhancements, and reliable product maintenance are essential to establishing and maintaining a technology leadership position. We cannot assure you that others will not develop technologies that are similar or superior to our technology.
Our success will depend upon our ability to obtain necessary intellectual property rights and protect our intellectual property rights. We cannot be certain that we will be able to obtain the necessary intellectual property rights or that other parties will not contest our intellectual property rights.
Manufacturing
We outsource the manufacture and assembly of our products to contract manufacturers. We primarily use Celestica Corporation and Sanmina-SCI Corporation, both of which provide comprehensive manufacturing services, including assembly, test and control and procurement of material, on our behalf. We design product tests that are conducted using our test equipment by the contract manufacturer. We believe that the outsourcing of our manufacturing enables us to conserve the working capital that would be required to purchase capital equipment, allows us to adjust manufacturing volumes to meet changes in demand and enables us to more quickly deliver products. Because we outsource our manufacturing, compliance with U.S. federal, state and local environmental laws has not had a material effect on our results or costs.

Employees
As of December 31, 2006, we had 104 full time employees. Our future success will depend in part on our ability to attract, retain and motivate highly qualified personnel, for whom competition is intense. Our employees are not represented by any labor union. We believe our relations with our employees are good. Additionally, as of December 31, 2006, we utilized on-shore and off-shore contract labor, approximating 66 full time equivalent employees.
Financial Information about Geographic Areas
See section (m) of Note 1 to Consolidated Financial Statements at Item 8 incorporated herein by reference.
Additional Information
Our Internet address is www.avici.com. On our Investor Relations web site, located at www.avici.com, we post the following filings as soon as reasonably practicable after they are electronically filed with or furnished to the Securities and Exchange Commission: our annual report on Form 10-K, our quarterly reports on Form 10-Q, our current reports on Form 8-K, our proxy statement on Form 14A related to our annual stockholders’ meeting and any amendments to those reports or statements filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. All such filings on our Investor Relations web site are available free of charge.


CEO BACKGROUND

William J. Leighton, Ph.D. has served as our Chief Executive Officer since November 2004 and as a Director since May 2004. Before joining the Company, Dr. Leighton spent 27 years employed by AT&T. From May 2003 to March 2004, Dr. Leighton served as Vice President of Research at AT&T Labs. Prior to that, Dr. Leighton was Vice President of Technology and Services Strategy at AT&T Labs.

William J. Stuart has served as our Senior Vice President of Finance, Chief Financial Officer, Treasurer and Secretary since August 2006. Prior to joining the Company, Mr. Stuart was a General Partner of Still River Funds, a venture capital firm focused on investments in the information technology, communications and life sciences industries, from September 2001 to August 2006. Prior to that, Mr. Stuart served as Vice President of Business Development of ADC Telecommunications, Inc. from October 2000 to September 2001 and as Chief Financial Officer of Broadband Access Systems, Inc. from October 1999 until it was acquired by ADC Telecommunications, Inc. in September 2000. Prior to that, Mr. Stuart held CFO and VP level positions at NetCore Systems, Telco Systems, AccessLine Technologies and AT&T Paradyne. Mr. Stuart serves on the board of directors of ThinkEngine Networks, Inc.
T.S. Ramesh has served as our Vice President of Finance and Principal Accounting Officer since May 2006. Mr. Ramesh also served as our acting Chief Financial Officer from May 2006 through August 2006. From April 2003 until May 2006, Mr. Ramesh served as the Company’s Controller. Prior to joining the Company, Mr. Ramesh held various senior positions in accounting and finance between 1999 and 2003 at Sycamore Networks, InteQ Corporation and Wang Global, which was acquired by Getronics. Prior to that, Mr. Ramesh was a manager with PricewaterhouseCoopers LLP.
William Ingram has served as a Director since November 2003. Mr. Ingram is currently an independent consultant. Mr. Ingram served as Vice President and General Manager of AudioCodes, Inc., a telecommunications equipment company from July 2006 to March 2007. Prior to that, Mr. Ingram served as the President and Chief Executive Officer of Nuera Communications, a provider of Voice-over-Internet Protocol infrastructure solutions, from September 1996 until it was acquired by AudioCodes, Inc. in July 2006. Prior to joining Nuera in 1996, Mr. Ingram was the Chief Operating Officer of PCSI-Clarity Products Division, a provider of wireless data communications products, President of Ivie Industries, a computer security and hardware manufacturer, and President of KevTon, an electronics manufacturing company.

Richard T. Liebhaber has served as a Director since June 1997. Mr. Liebhaber was a Consulting Managing Director at Veronis, Suhler & Associates, Inc., a provider of financial advisory services to the communications industry, from June 1995 to August 2001. Prior to that, Mr. Liebhaber served as Executive Vice President of MCI Communications Corporation, a telecommunications provider, from December 1985 to May 1995. Mr. Liebhaber also serves on the board of directors of ILOG S.A., a software company, JDS Uniphase Corporation, a provider of optical communications products, and Cogent Communications, Inc., an internet service provider.
Robert P. Schechter has served as a Director since June 2003. Mr. Schechter is currently Chairman, President and Chief Executive Officer of NMS Communications, Inc., a provider of telecommunications equipment. Prior to joining NMS in 1995, Mr. Schechter spent eight years at Lotus Development Corporation as Senior Vice President of Finance and Operations and Chief Financial Officer, and most recently as Senior Vice President of the International Business Group. Prior to that, Mr. Schechter was a partner with Coopers & Lybrand in Boston. Mr. Schechter also serves on the boards of directors of Moldflow Corporation, a developer of plastics molding products, MapInfo Corporation, a software and consulting company, and Unica Corporation, a provider of marketing management software.


SHARE OWNERSHIP

William J. Leighton owns 192,794 amount and nature of beneficial ownership, William J. Stuart owns 35,000 amount and nature of beneficial ownership, T.S. Ramesh owns 45,250 amount and nature of beneficial ownership, William Ingram owns 16,357 amount and nature of beneficial ownership, Richard T. Liebhaber owns 59,793 amount and nature of beneficial ownership, Robert P. Schechter owns 16,357 amount and nature of beneficial ownership.


MANAGEMENT DISCUSSION FROM LATEST 10K

Overview
Avici Systems provides high-speed data networking equipment that enables networking service providers to transmit high volumes of information across their networks.
The Avici Terabit Switch Router (TSR ™ ), which was introduced in 1999, is purpose-built for the stresses of carrier core routing in large IP networks, and has been deployed at AT&T Corp. (AT&T) since 1999. During 2001, we introduced the Avici Stackable Switch Router (SSR ™ ), a rack-mountable scalable router for service providers with smaller core networks. During the fourth quarter of 2002, we introduced the Avici Quarter-rack Scalable Router (QSR ™ ), which provides customers with one of the smallest footprint, highest density routers commercially available.
On February 16, 2006, Avici announced a plan to restructure its business and realign its cost structure to execute a focused strategy aimed at driving Avici toward profitability and positive cash flow. The restructuring plan included a workforce reduction and employee retention plan, charges related to excess inventory and inventory related costs, asset impairment and other costs. Through March 31, 2007, the Company expects to record total restructuring charges of approximately $10.8 million, of which $8.2 million is cash based. In 2006 Avici recorded $10.7 million of these charges, and expects to record the remaining $0.1 million, all of which are workforce related and cash based in the first quarter of 2007. In connection with this announcement in February 2006, Avici also indicated that, in consultation with its investment bankers, it would evaluate strategic alternatives that may include a further restructuring of the business.
In February 2007 we announced our decision to launch a new product initiative (“Soapstone”) that leverages our deep knowledge of carrier-world transport elements and our leadership role in industry forums. The product initiative is designed to enable carriers to bring orderly, predictable, business-driven behavior to their networks, regardless of vendor or technology composition.
Since our inception, we have incurred significant losses. As of December 31, 2006, we had an accumulated deficit of $417.4 million. Although we recorded our first net income in 2006 and strive to continue such profitability, there is no certainty that profitability will continue.
Revenues
We expect that substantially all of our revenue in the next twelve months will continue to depend on product sales and service revenue from our current customers, primarily AT&T. Under existing procurement agreements, our customers are not committed to purchase any minimum quantities of products from us. In September 2004, we amended our original procurement agreement with AT&T to extend through December 31, 2009. The agreement describes the conditions under which AT&T may purchase equipment and services from us and provides AT&T with the ability, but not the obligation to purchase equipment and services from us. The agreement has no minimum purchase commitment. We do not anticipate recording any material revenue in the next twelve months associated with Soapstone.

Prior to our restructuring, we sought to increase our worldwide presence through indirect sales channels established through agreements with system integrators and distribution partners. In April 2003, we entered into a strategic relationship with Huawei. The agreement had no minimum purchase commitment and expired in April 2005. In January 2004, we entered into a worldwide three-year strategic agreement with Nortel Networks (“Nortel”) to market, sell and support Avici’s carrier-class core routers as part of its converged network solutions based on Internet Protocol (IP) technology. The agreement has no minimum purchase commitment and expired in January 2007. The relationships with Nortel and Huawei did not produce the results we anticipated when entering into these relationships. Our current strategy does not include the development of and investment in distribution channels in the core router business.
Common Stock Warrant Discount—Product
In January 2004, in connection with a three-year strategic OEM agreement with Nortel, Avici issued a warrant to purchase 800,000 shares of Avici common stock at an exercise price of $8.03 per share. The agreement provides Nortel with the ability, but not the obligation, to purchase equipment and services from Avici for its own use or for resale. The warrant is nonforfeitable and has a term of approximately seven years from the date of issuance and is exercisable after seven years. The right to exercise the warrant may be accelerated if Nortel achieves certain performance milestones or at the discretion of Avici, upon a change in control. The fair value of the warrant was calculated to be approximately $6.3 million using the Black-Scholes valuation model, and was being recorded as a reduction of revenue on a straight-line basis over three years. The unamortized balance was deemed impaired and was fully written off in the first quarter of 2006, as further described below under Restructuring and Impairment Charges. The unamortized balance of $2.1 million at December 31, 2005 is recorded as a Contract Distribution Right in the accompanying balance sheet.
Cost of Revenue
Cost of Revenue—Product includes material cost, provision for warranty, rework, depreciation, provision for excess and obsolete inventory and, in first and third quarters of 2006, charges of $1.4 million and $1.7 million, respectively, directly associated with Avici’s restructuring. We outsource our manufacturing operations to contract manufacturers that assemble and test our products in accordance with our specifications. Accordingly, a significant portion of our product cost is material cost paid to these entities. Avici’s cost of revenue also includes overhead costs, primarily for material procurement associated with our manufacturing. Warranty costs and inventory provisions are expensed as cost of revenue-product.
Cost of Revenue—Service includes costs associated with providing customer support and maintenance services.
Research and Development
Research and development expenses consist primarily of salaries and related employee costs, depreciation expense on laboratory equipment and project costs, namely, prototype equipment, materials costs and third-party costs and fees related to the development and prototyping of our proprietary technology. Project costs may vary from period to period depending upon the timing and extent of applicable initiatives. In the future, we expect research and development expenses to decline, resulting from the full-year benefit from the restructuring and re-alignment of Avici’s cost structure, partially offset by additional development related to Soapstone.
Sales and Marketing
Sales and marketing expenses have consisted primarily of salaries and related employee costs, sales commissions, travel, public relations, training and other costs associated with marketing material and tradeshows. In the future, we expect sales and marketing expenses to decline, resulting from the full-year benefit from the restructuring and re-alignment of Avici’s cost structure, partially offset by additional expenses related to Soapstone.

General and Administrative
General and administrative expenses consist primarily of salaries and related costs for executive, finance, legal, facilities, human resources and information technology personnel as well as professional and compliance related fees. In the future, we expect general and administrative expenses to decline, resulting from the full-year benefit from the restructuring and re-alignment of Avici’s cost structure.
Restructuring and Impairment Charges
On February 16, 2006, Avici announced a plan to restructure its business and realign its cost structure to execute a focused strategy aimed at driving Avici toward profitability and positive cash flow. The restructuring plan included a workforce reduction and employee retention plan (“workforce restructuring”), charges related to excess inventory and inventory related costs, asset impairment and other costs.
The Company expects to record total restructuring charges of approximately $10.8 million, of which $8.2 million is cash based. In 2006 Avici recorded $10.7 million of these charges.
Workforce restructuring
The restructuring plan resulted in the reduction of approximately 45% of the employee base of full-time and contract employees across all business functions and geographic regions. Avici expects to record $5.5 million of employee related charges, all of which are cash based. In 2006, Avici recorded $5.4 million of these charges. Avici expects to pay approximately $1.6 million in the first quarter of 2007.
Inventory and inventory related costs
Due to Avici’s strategic decision to focus on a select customer base, certain inventories and related purchase commitments were determined to be in excess of foreseeable usage. In the first quarter of 2006 Avici recorded a $1.4 million charge to cost of revenue—product to write-down the value of such excess inventory ($1.1 million) and accrue the cost of the non-cancelable inventory purchase commitments ($0.3 million).
In connection with its restructuring, Avici also evaluated certain of its customer relationships and the outcome of this evaluation resulted in Avici agreeing to terminate one of its customer contracts. Avici has not recorded any revenue under this customer contract since all revenue recognition criteria were not met. Under the terms of the termination agreement, the customer will return Avici’s product after a transition period during which Avici will provide product support estimated to cost $0.3 million. In addition, Avici unwound the financial arrangements, reversing remaining accounts receivable and deferred revenue balances and committing to pay $1.4 million. Avici paid $0.7 million in 2006 and will pay the balance upon return of the inventory, scheduled for the third quarter of 2007. Avici has assessed the inventory expected to be received from this customer for recoverability and has adjusted the carrying value accordingly. In 2006 Avici recorded a net charge of $1.7 million in cost of revenue—product as a result of the adjustments relating to this termination agreement. Avici amended the termination agreement in January 2007 and provided incentives to this customer to return the inventory earlier than originally scheduled. Upon such earlier return an additional payment will be made. Avici will record such costs, when it becomes probable an additional loss will be incurred.
Asset impairment
In January 2004, in connection with a three-year strategic OEM agreement with Nortel, Avici issued a warrant to purchase 800,000 shares of Avici common stock as further described in Common Stock Warrant Discount—Product above. The fair value of the warrant was capitalized as contract distribution rights and was being amortized as a reduction of revenue on a straight-line basis over three years. As a result of Avici’s implementation of a revised customer strategy and public announcements by the channel partner of a strategic shift away from wire line data, Avici anticipated minimal future revenue under this agreement. As a result, Avici determined that the unamortized balance of such contract distribution rights ($1.6 million) was impaired and wrote off such balance in the first quarter of 2006.

MANAGEMENT DISCUSSION FOR LATEST QUARTER

Overview
Avici Systems Inc. (referred to as “Avici” or the “Company” or “we” or “us” or “our”) provides high-speed data networking equipment that enables networking service providers to transmit high volumes of information across their networks.
Since inception, we have focused on the development and sale of core router equipment. The Avici Terabit Switch Router (TSR™), which was introduced in 1999, is purpose-built for the stresses of carrier core routing in large IP networks, and has been deployed at AT&T Inc. (AT&T) since 1999. We subsequently introduced the Avici Stackable Switch Router (SSR™) and the Avici Quarter-rack Scalable Router (QSR™), smaller versions of our core routers.
In February 2007 we announced our decision to launch a new product initiative, Soapstone Networks (“Soapstone”). Soapstone is helping network providers of all types connect their physical transport infrastructure to the Next Generation Network (NGN) software infrastructure. Soapstone’s products make the connection simple and easy to use by the NGN infrastructure. The products provide SOA interfaces to clean abstract transport objects that are expressly designed for both wholesale and retail services. The products are designed to work over multiple transport technologies including Carrier Ethernet, MPLS, OTN, and pure optical and to operate in a multi-vendor environment. The Soapstone product initiative is currently in the research and development stage.
On April 18, 2007, we announced that we will be transitioning away from core router development and product sales to focus on Soapstone. We expect the final shipments of our core router products will occur by the end of the fourth quarter of 2007, absent any such shipments shifting into the first quarter of 2008. We will continue to service our products under existing contracts we have in place with our customers. We no longer actively develop or sell core router products, and are no longer resourced to manufacture large volumes of our core router products following our fulfillment of the last orders which is anticipated to be completed in the fourth quarter of 2007. Accordingly, we do not anticipate meaningful product revenue from core router sales in 2008 and as a result expect our total gross revenue to decline significantly in 2008.

On April 18, 2007, we announced that our Board of Directors had declared a special cash dividend of $2.00 per outstanding share of common stock, or $28.3 million. The dividend was distributed on June 22, 2007 to shareholders of record as of June 11, 2007.
Since our inception, we have incurred significant losses. As of September 30, 2007, we had an accumulated deficit of $384.3 million. Although we recorded our first net income in 2006, there is no certainty that profitability will continue. In particular, we expect that 2008 will be a year of continued transition, as we continue to invest in Soapstone, with the objective of commercial introduction during the year, and continue to provide maintenance and other services under our existing core router customer contracts. Given the early stage of our Soapstone initiative, there can be no assurance that we will generate meaningful revenue or maintain profitability through our Soapstone products once introduced.
Revenue
We expect that substantially all of our revenue in the remainder of 2007 will continue to depend on product sales and service revenue from our current core router customers, primarily AT&T. As a result of our decision to transition away from core router development and product sales, we do not anticipate recording material router product revenue beyond 2007, provided that some revenue from final shipments of our core router products may be recognized in the first quarter of 2008. Accordingly, we expect a significant decline in our product revenue in 2008. We do not anticipate recording any material revenue during the remainder of 2007 associated with Soapstone.
Prior to our restructuring in the first quarter of 2006, we sought to increase our worldwide presence through indirect sales channels established through agreements with system integrators and distribution partners. In April 2003, we entered into a strategic relationship with Huawei. The agreement had no minimum purchase commitment and expired in April 2005. In January 2004, we entered into a worldwide three-year strategic agreement with Nortel Networks (“Nortel”) to market, sell and support Avici’s carrier-class core routers as part of its converged network solutions based on Internet Protocol (IP) technology. The agreement had no minimum purchase commitment and expired in January 2007. The relationships with Nortel and Huawei did not produce the results we anticipated when entering into these relationships.
Common Stock Warrant Discount - Product
In January 2004, in connection with a three-year strategic OEM agreement with Nortel, Avici issued a warrant to purchase 800,000 shares of Avici common stock at an exercise price of $6.03 per share (as adjusted for the $2.00 special cash dividend paid on June 22, 2007 to common stockholders of record on June 11, 2007). The agreement provided Nortel with the ability, but not the obligation, to purchase equipment and services from Avici for its own use or for resale. The warrant is nonforfeitable and has a term of approximately seven years from the date of issuance and is exercisable after seven years. The right to exercise the warrant may have been accelerated if Nortel achieved certain performance milestones or may be accelerated upon a change in control at the discretion of Avici. The fair value of the warrant at grant date was calculated to be approximately $6.3 million using the Black-Scholes valuation model, and was being recorded as a reduction of revenue on a straight-line basis over three years. The unamortized balance was deemed impaired and was fully written off in the first quarter of 2006.
Cost of Revenue
Cost of Revenue - Product includes material cost, provision for warranty, rework, depreciation, provision for excess and obsolete inventory and certain restructuring costs. We outsource our manufacturing operations to contract manufacturers that assemble and test our products in accordance with our specifications. Accordingly, a significant portion of our product cost is material cost paid to these entities. Avici’s cost of revenue also includes overhead costs, primarily for material procurement associated with manufacturing. Warranty costs and inventory provisions are expensed as cost of revenue-product.
Cost of Revenue - Service includes costs associated with providing customer support and maintenance services.

Research and Development
Research and development expenses consist primarily of salaries and labor related costs, depreciation expense on laboratory equipment, project costs and third-party costs and fees related to the development and prototyping of our proprietary technology. During the fourth quarter, we expect research and development expenses to approximate the current levels of spending.
Sales and Marketing
Sales and marketing expenses have consisted primarily of salaries and related employee costs, sales commissions, travel, public relations, training and other costs associated with marketing material and tradeshows. During the fourth quarter, we expect sales and marketing expenses to increase from the current levels of spending primarily related to our Soapstone product initiative.
General and Administrative
General and administrative expenses consist primarily of salaries and related costs for executive, finance, legal, facilities, human resources and information technology personnel as well as professional and compliance related fees. We expect general and administrative expenses to continue at or about the current rate of spending.
Restructuring Expenses and Impairment Charges
On February 16, 2006, Avici announced a plan to restructure its business and realign its cost structure to execute a focused strategy aimed at driving Avici toward profitability and positive cash flow. The restructuring plan included a workforce reduction and employee retention plan, charges related to excess inventory and inventory related costs, asset impairment and other costs.
The Company recorded total restructuring charges of approximately $11.0 million, of which $8.4 million was cash based. In 2006 Avici recorded $10.7 million of these charges and the remaining $0.3 million was recorded in the first quarter of 2007. In the future, Avici does not expect to record any additional charges associated with this restructuring.

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