The Daily Magic Formula Stock for 05/06/2008 is Foundry Networks Inc. According to the Magic Formula Investing Web Site, the ebit yield is 12% and the EBIT ROIC is >100 %.
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Foundry Networks, Inc., a Delaware corporation founded in 1996, designs, develops, manufactures, markets and sells switching and routing solutions designed for wired and wireless local area networks (LANs), metropolitan area networks (MANs), wide area networks (WANs), in addition to other infrastructure products for both enterprise networks and the Internet. We sell a wide variety of fixed configuration switches and modular platforms, referred to as chassis.
Our platforms are designed to operate within Layer 2 through 7 of the Open System Interconnect (OSI) model for data networking as described below:
Transport Set â€”
â€˘ Layer 1: Physical â€” This is the level of the actual hardware. It defines the physical characteristics of the network such as connections, voltage levels and timing.
â€˘ Layer 2: Data â€” In this layer, the appropriate physical protocol is assigned to the data. Also, the type of network and the packet sequencing is defined.
â€˘ Layer 3: Network â€” The way that the data will be sent to the recipient device is determined in this layer. Logical protocols, routing and addressing are handled here.
â€˘ Layer 4: Transport â€” This layer maintains flow control of data and provides for error checking and recovery of data between the devices. Flow control means that the Transport layer looks to see if data is coming from more than one application and integrates each applicationâ€™s data into a single stream for the physical network.
Application Set â€”
â€˘ Layer 5: Session â€” Layer 5 establishes, maintains and ends communication with the receiving device.
â€˘ Layer 6: Presentation â€” Layer 6 takes the data provided by the Application layer and converts it into a standard format that the other layers can understand.
â€˘ Layer 7: Application â€” This is the layer that actually interacts with the operating system or application whenever the user chooses to transfer files, read messages or perform other network-related activities.
We design, develop, manufacture, market and sell networking platforms that address three primary areas of the data networking market. This includes:
Layer 2/3 Switches â€” These platforms are designed to connect users in an enterprise network allowing them to share information, printers and storage devices. We offer a variety of platforms to allow customers to design a network to meet their needs. This includes the EdgeIron, FastIron and BigIron product families. Our Layer 2 and Layer 3 switches provide the intelligence, speed and cost effectiveness required to support the increasing use of bandwidth-intensive and Internet-based applications.
Layer 4-7 Switches â€” These platforms are designed for application traffic management, allowing customers to enable specific features to improve the performance of specific applications or improve the performance of a server farm. This includes our ServerIron and SecureIron switch family. Our high-performance Internet traffic management systems with network intelligence capabilities allow enterprises and service providers to build highly available network infrastructures that efficiently direct the flow of traffic.
Metro and Internet Routers â€” These platforms are designed to handle internet traffic within Service Provider networks. These are Ethernet based routers designed to run a common protocol known as Multi-Protocol Label Switching (MPLS). This category includes our NetIron router families. Our Metro and internet routers are designed to deliver the capabilities and performance needed to provide efficient and reliable routing services to Internet data centers around the world.
Our networking products have been deployed in key enterprise, service provider, and High Performance Computing (HPC) markets that include government agencies, education, healthcare, entertainment, automotive, energy, retail, financial services, aerospace, technology, transportation, and e-commerce. For enterprise customers, we provide a complete end-to-end solution with our FastIron Â® , SecureIron Â® , FastIron Edge Â® , FastIron Workgroup Â® , IronPoint tm , NetIron tm , BigIron Â® , ServerIron Â® , and EdgeIron tm product lines. Our enterprise products are designed for wireless access, wiring closet, VoIP, data center, WAN access and campus solutions. Our products support a wide array of interfaces such as wireless, 10/100/1000 Ethernet, 1 GbE (copper and fiber), 10GbE (10GbE) and Packet over SONET so that our customers can leverage their existing infrastructures. Our service provider markets include Metro service providers, Internet service providers, web hosting and Internet data centers, application service providers, and Internet exchanges. For service providers, we offer our BigIron switches, NetIron Â® Metro and Internet routers, and ServerIron web switches. Our switching and routing products can be managed with our IronView Â® Network Manager software products. We sell our products through a direct sales force, integrators and resellers. By providing high levels of performance and intelligence capabilities at competitive price points, we provide comprehensive solutions to address the enterprise and service provider markets.
Market Trends and Business Drivers
According to the 2007 Ethernet Switch Five Year Forecast Report, published by the independent research firm, Dellâ€™Oro, the Ethernet switch market is expected to grow steadily over the next three years. In addition, Dellâ€™Oro has projected that 10GbE switch port shipments will represent the strongest growth segment of the Ethernet switch market. Although 10GbE port shipments are expected to grow in 2008-2010, our revenues may grow at a slower rate, or not at all, due to pricing pressures from increased competition and rapid technological change.
Foundry was an early leader in bringing 10GbE products to market. Since the introduction of our first 10GbE switch product, we have continued to bring new 10GbE products and solutions to market. Our 10GbE customers include the education, health-care, government, manufacturing and entertainment industries, as well as service providers across the globe. 10GbE is the highest-speed Ethernet available today. 10GbE offers the potential to unify and simplify networking on a global scale with all the benefits and cost efficiencies of Ethernet.
In addition to the need for high-performance, high-reliability, and high-availability networking solutions, todayâ€™s enterprises and service providers are facing business drivers that place new demands on their networks. These drivers include convergence, mobility and security.
Convergence â€” Although convergence primarily refers to using the same network for data, voice, and video, it also refers to the demands placed on networks that support mission-critical applications such as Enterprise Resource Management (ERP), Customer Relationship Management (CRM), financial reporting, accounting, and other business processes. As businesses seek to accommodate network user needs, adding bandwidth alone is not an adequate solution. Not only have the types of traffic proliferated, but different applications require different levels of network service. This need is addressed by application switching, also known as Layer 4-7 switching. Application switches extend their features and functions by examining data in Layers 4 through 7 of the OSI model. Not only does a Layer 4-7 switch provide benefits such as optimization of computing resources, it can also provide critical protection from external threats such as denial of service (DoS) attacks and address costly nuisances such as unwanted email solicitations, sometimes called â€śspam email.â€ť This business driver fuels demand for additional features and functions that networks can perform. Supplying these features and functions has the potential to be a significant differentiator in the market.
Mobility â€” Wireless networking has rapidly gained acceptance in the market place. Wireless networking provides many benefits, including coverage of areas that would be difficult to cable and simplification of changes when personnel move within an organization. On the horizon is the larger opportunity of mobility. Whereas wireless networking focused on lowering the total cost of ownership, mobility seeks to enhance return on investment. With advanced features and functions, mobility will enable businesses to achieve productivity gains by seamlessly extending productivity tools to multiple locations. This business driver fuels demand for integration in wired and wireless networking. A company that has expertise in switch and routing potentially has a competitive advantage over providers of wireless devices to the extent that it can offer a superior integrated solution.
Security â€” In todayâ€™s business environment, perimeter defenses such as firewalls and intrusion detection are no longer adequate to address security needs. Security measures must now take into account internal threats, network admission control, anomaly detection (non-business-related network usage such as music file sharing), and compliance with policies and regulations. This business driver fuels demand for secure and highly reliable networking that can support additional security features and functions.
Our objective is to be a leading provider of next-generation, high-performance network solutions. We intend to achieve this objective by providing a broad suite of cost-effective, high performing network switching and routing products. Key elements of our strategy include:
Continue to Deliver Products that Meet the Needs of the High-End Switching Market. We intend to continue to broaden our high-end enterprise and service provider switch portfolio to meet customer needs for greater bandwidth, more flexible interfaces, advances in Internet networking protocols, convergence, mobility, and enhanced security. We intend to continue to offer value-added feature sets that provide for reliability, redundancy, ease of use and management of the network, yielding a lower total cost of ownership.
We have introduced products that address five strategic data networking areas, and we intend to continue to enhance our product portfolio in these areas:
â€˘ 10-Gigabit Ethernet â€” Our 10GbE solutions have achieved commercial success in the marketplace. 10GbE addresses the key concerns facing data networking businesses today â€” the continued need for additional bandwidth while building a reliable network. Our 10GbE offerings include the EdgeIron, FastIron, BigIron, ServerIron and NetIron product families. The FastIron SuperX family of modular switches began shipment in 2006 as an edge aggregation switch for both the traditional enterprise and VoIP market segments. The BigIron RX modular switch began shipment in July 2005 as an enterprise core router, high performance computing core switch, and as a data center and infrastructure router for service providers. The introduction of these products is central to our strategy of offering high performance 10 GbE capable switches and routers from the enterprise edge to the Internet core.
â€˘ Mobility â€” Our IronPoint tm family of wireless products have been designed to meet mobility requirements and support a diverse set of environments. The IronPoint Access Point is a cost-effective solution that allows enterprise networks to quickly and easily enable safe and secure wireless access. The IronPoint Access Point can also be connected to the IronPoint-FES Wireless Switch for enhanced management, mobility and security.
â€˘ Voice-over-IP (VoIP) â€” An increasing number of enterprises are migrating to converged environments in which voice, video, and data are carried by the same network to take advantage of valuable business benefits such as reduced costs and increased productivity. A converged network needs a network foundation that provides superior performance, high availability and secure, guaranteed voice quality. Our strategy is to provide high-performance networking products and the tools necessary to configure and optimize a converged environment. Our adherence to industry and international standards allows customers to successfully use a wide variety of IP phones from industry providers such as Avaya Inc., Cisco Systems, Inc., Mitel Networks Corp., Nortel Networks, Shoretel Inc., and Siemens AG. Our FastIron SuperX and FastIron Edge switch support legacy and industry standard 802.3af Power over Ethernet, automated Quality of Service (QoS), redundant and hot swappable power supplies, wireless mobility, and a range of VoIP security features. These provide customers the technology needed to power new devices such as IP phones, optimize network performance, and manage network resources. We intend to further develop and expand our networking and management offerings for converged environments so that customers will have more options for efficiencies and productivity.
â€˘ Security â€” As networking has become an essential part of nearly all businesses, agencies, and organizations, security has become an integral part of designing and deploying todayâ€™s networks and data centers. Securing this infrastructure against debilitating attacks from malicious users is necessary to ensure sustained business operations. Mobility, convergence, and Web-centric applications are rendering centralized security models less effective. Today, organizations require distributed, network-wide, security architectures to protect against threats from outside the network and to minimize vulnerabilities inside the network. Our security offerings are both embedded into our standard switching platforms and complimented by a stand-alone security platform offered within the SecureIron product family.
â€˘ Internet Protocol version 6 (IPv6) â€” Although interest in and adoption of IPv6 is gaining momentum in international markets, we believe the widespread adoption of IPv6 in the U.S. commercial sector is likely to take several years. However, the U.S. federal government has made IPv6 a requirement for its installations. We deliver products that meet the requirements of IPv6 using a phased approach. In 2006, we delivered new IPv6 interface modules for the BigIron RX Series, NetIron MLX Series and NetIron XMR Series. We intend to further develop and deliver IPv6 solutions.
Continue to Expand our Metro and Internet Router Capabilities to Address this Market and Deliver a New Level of Price/Performance. We remain committed to the service provider and metro provider markets while growing our enterprise business. We have product offerings and planned enhancements for Multi-Protocol Label Switching, Virtual Private LAN Services (VPLS), traffic engineering (TE) and multiplexing of different services over Virtual LAN (VLAN).
Continue to Leverage our Product Capabilities to Address Emerging Markets. Our strategy is to position ourselves to benefit from the acceptance of Gigabit and 10 Gigabit Ethernet in such environments as metropolitan area networking (MAN), Gigabit Ethernet storage area networking (SAN), VoIP, and content distribution networks. We believe the key advantages of 1 and 10 Gigabit Ethernet, such as price, simplicity and ease of use, will allow this technology to migrate into many new adjacent markets over time. We work with select partners when additional non-networking hardware or software is needed for solutions such as VoIP and SAN. We also intend to explore additional product offerings in adjacent technologies that would benefit our installed customer base by providing ease of management, cost efficiencies, or productivity gains.
Continue to Deliver High-Performance Application Traffic Management Systems. We believe demand for Internet traffic management intelligence capabilities will be an important growth area for web-based businesses, Internet service providers and traditional enterprise networks. We intend to continue improving the performance and functionality of our Internet traffic management products. Our products are designed to enable web-based businesses and Internet service providers to deliver new applications and services to customers, while providing a high degree of service reliability.
Expand Global Sales Organization. We intend to continue the global expansion of our sales organization utilizing a direct sales organization in the United States and abroad, strategic channel partners outside the United States and select integration partners. We intend to increase our worldwide sales force and establish additional channel partner relationships to build a greater worldwide sales presence.
Deliver World Class Service and Support. We intend to expand our service and support infrastructure to meet the needs of our growing customer base. Our goal is to offer a wide range of service and support programs to meet customer needs, including prompt on-site hardware replacement, 24-hour, seven days-a-week web and telephone support, parts depots in strategic global locations, system and network management software updates, and technical documentation updates.
Sales and Marketing
Our sales strategy includes domestic and international field sales organizations, domestic and international resellers, domestic and international integration partners, and marketing programs.
Domestic field sales. Our domestic field sales organization establishes and maintains direct relationships with key accounts and strategic customers. To a lesser extent, our field organization works with resellers and integrators to assist in communicating product benefits to end-user customers and proposing networking solutions. As of December 31, 2007, our domestic sales organization consisted of 301 sales representatives and systems engineers.
Domestic resellers. Our domestic resellers include regional networking system resellers and vertical resellers who focus on specific markets, such as small Internet service providers and the federal government. We provide sales and marketing assistance and training to our resellers, who in turn provide first level support to end-user customers. We intend to leverage our relationship with key resellers to penetrate select vertical markets.
International sales. Product fulfillment and first level support for our international customers are provided by resellers and integrators. As of December 31, 2007, our international field organization consisted of 139 sales representatives and system engineers who conduct sales, marketing, and support activities. Our international sales organization establishes and maintains direct relationships with resellers, integrators, and end-users. Our export product sales represented 35% and 39% of net product revenue in 2007 and 2006, respectively. Information on net product sales to customers attributable to our geographic regions is included in Note 2, â€śSummary of Significant Accounting Policies,â€ť to Consolidated Financial Statements.
Marketing programs. We have numerous marketing programs designed to inform existing and potential customers, the press, industry standard analyst groups, resellers and integrators about the capabilities and benefits of Foundry and our products and solutions. Our marketing efforts also support the sale and distribution of our products through our field organizations and channels. These efforts include advertising, public relations, participation in industry trade shows and conferences, public seminars, Webcasts, participation in independent third-party product tests, presentations, and maintenance of our web site.
Customer Service and Support
Our service and support organization maintains and supports products sold by our field organization to end-users. We provide 24-hour assistance, including telephone and Internet based support. Our customer service offerings also include parts depots in strategic locations globally, implementation support, and pre-sales service. Typically, our resellers and integrated partners are responsible for installation, maintenance, and support services to their customers.
We provide all customers with our standard one or five year hardware and 90-day software warranty. Our standalone switches in the FastIron Edge, FastIron Workgroup, and EdgeIron product lines have a five-year hardware warranty. We also have four levels of customer service offerings to meet specific support needs. Our Titanium service program provides the most comprehensive support and includes on-site support and delivery by a trained technician of a hardware replacement within two to four hours. Our Gold service program is targeted towards customers who have trained internal resources to maintain their network 24x7. Our Gold program is designed to provide all the tools needed by these trained resources to maximize the uptime of their network. Our Silver service program is tailored for customers who typically purchase spares inventory as part of their overall contingency plan. Our Bronze service program is targeted towards budget conscious customers who are looking for basic telephone and web-based support and run a 9 to 5 operation.
We have regional Centers-of-Excellence in Santa Clara and Irvine, California, Denver, Colorado, Chicago, Illinois, Boston, Massachusetts, New York City, New York, and Herndon, Virginia. We also have Centers-of-Excellence in London, Munich, Tokyo and Toronto. These Centers-of-Excellence include executive briefing centers and serve as major customer demonstration centers, regional technical support centers, and equipment depot centers.
Sales to our ten largest customers accounted for 27%, 29% and 30% of net product revenue for 2007, 2006 and 2005, respectively. The loss of continued orders from any of our more significant customers, such as the United States government or individual agencies within the United States government or Mitsui & Co., our reseller in Japan (â€śMitsuiâ€ť), could cause our revenue and profitability to suffer. Sales to United States government and individual agencies accounted for approximately 18%, 17% and 19% of our total revenue in 2007, 2006 and 2005, respectively.
For the years ended December 31, 2007, 2006 and 2005, no single customer accounted for 10% or more of our net product revenue, other than the U.S. Government. As of December 31, 2007 and 2006, ten customers accounted for approximately 38% and 30%, respectively, of our net outstanding trade receivables.
We operate under a modified â€śturn-keyâ€ť process, utilizing strategic manufacturing partners that are ISO 9000 certified and have global manufacturing capabilities. During fiscal year 2007, we obtained ISO 9001:2000 certification for the design, development, support and manufacturing operations of high performance switching, routing, security and web traffic management products and solutions. All designs, documentation, selection of approved suppliers, quality control, and configuration are performed at our facilities. Our manufacturing operations consist of quality assurance for subassemblies and final assembly and test. Our manufacturing process also includes the configuration of products in unique combinations to meet a wide variety of individual customer requirements. We use automated testing equipment and â€śburn-inâ€ť procedures, as well as comprehensive inspection and testing, to ensure the quality and reliability of our products. Our approach to manufacturing provides the flexibility of outsourcing while maintaining quality control of products delivered to customers. Because quality is a priority in our operations, we have a quality council consisting of interdepartmental leaders that meet weekly to monitor quality and to drive continuous improvement. The results of our enhancements are measured by several metrics, including the number of events reported to customer support in relation to systems shipped.
We currently have four manufacturing partners. Celestica, Inc., located in San Jose, California, Flash Electronics, Inc., located in Fremont, California and Shanghai, China, and Proworks Inc, located in San Jose, California, assemble and test printed circuit boards. Sanmina-SCI Corp., located in San Jose, assembles and tests printed circuit boards and our backplane products. Celestica, Inc., Sanmina-SCI Corp., and Flash Electronics, Inc. have global manufacturing facilities providing back-up capability and local content for foreign sales if required. We perform all prototype and pre-production procurement and component qualification with support from our manufacturing partners. Our agreements with our contract manufacturers allow them to procure long lead-time component inventory on our behalf based on a rolling production forecast provided by us. We may be contractually obligated to purchase long lead-time component inventory procured by our contract manufacturers in accordance with our forecasts although we can generally give notice of order cancellation at least 90 days prior to the delivery date. We also have third-party OEMs such as Meru Networks and Accton who manufacture some products that we purchase and resell under the Foundry brand.
We design all ASICs, printed circuit boards and sheet metal, and work closely with semiconductor partners on future component selection and design support. All materials used in our products are subject to a full qualification cycle and controlled by use of an â€śapproved vendor listingâ€ť that must be followed by our sources. We perform extensive testing of all of our products, including in-circuit testing of all printed circuit board assemblies, full functional testing, elevated temperature burn-in and power cycling at maximum and minimum configuration levels.
We currently purchase components from several sources, including certain integrated circuits, power supplies and long-range optics, which we believe are readily-available from other suppliers. Our proprietary ASICs, which provide key functionality in our products, are fabricated in foundries operated by, or subcontracted by, Texas Instruments Inc., Fujitsu Ltd., and Broadcom Corp. In addition, our newer product families integrate customizable network processors from sole source suppliers such as Marvell Technology Group Ltd. and Freescale Semiconductor, Inc.
Research and Development
Our future success depends on our ability to enhance existing products and develop new products that incorporate the latest technological developments. We work with customers and prospects, as well as partners and industry research organizations, to identify and implement new solutions that meet the current and future needs of businesses. Whenever possible, our products are based on industry standards to ensure interoperability. We intend to continue to support emerging industry standards integral to our product strategy.
Our research and development operations involve development activities that utilize both custom and commercial integrated circuits, which enables us to quickly bring new products and features to market. We continue to develop new switching solutions that provide new levels of performance, scalability, and functionality. We had 266 engineers at the end of 2007, compared to 219 engineers at the end of 2006. Our research and development expenses were $77.1 million in 2007, $70.7 million in 2006 and $53.0 million in 2005, or 13%, 15% and 13%, of net revenue in 2007, 2006 and 2005, respectively.
We believe the key competitive factors that affect our markets are technical expertise, pricing, new product innovation, product features, service and support, brand awareness, and distribution. We intend to remain competitive through ongoing investment in research and development efforts to enhance existing products and introduce new products. We will seek to expand our market presence through aggressive marketing and sales efforts. However, our market continues to evolve, and we may not be able to compete successfully against current and future competitors.
The market in which we operate is highly competitive. For instance, Cisco Systems, Inc. (â€śCiscoâ€ť) maintains a dominant position in our market and several of its products compete directly with ours. Purchasers of networking solutions may choose Ciscoâ€™s products because of its longer operating history, broader product line, and strong reputation in the networking market. We believe our technology and the purpose-built features of our products make them unique and allow us to compete effectively against Cisco and other competitors.
In addition to Cisco, we compete against 3Com, Alcatel-Lucent, Enterasys Networks, Extreme Networks, F5 Networks, Inc., Force 10 Networks, Hewlett-Packard, Huawei Technologies, Juniper Networks and Nortel Networks. Some of our current and potential competitors have longer operating histories and substantially greater financial, technical, sales, marketing and other resources, as well as greater name recognition and larger installed customer bases than we do. As a result, we anticipate that we will have to continue to adjust prices on many of our products to stay competitive.
We experience some seasonal trends in the sale of our products. For example, sales to the U.S. government are typically stronger in the third calendar quarter and sales to European customers tend to be weaker in the summer months.
Bobby R. Johnson, Jr. co-founded Foundry and has served as President, Chief Executive Officer and member of the Board of Directors of Foundry since its inception in May 1996. Mr. Johnson was Foundryâ€™s Chairman of the Board of Directors from May 1996 to January 2007. From August 1993 to October 1995, Mr. Johnson co-founded and served as President, Chief Executive Officer and Chairman of the Board of Directors of Centillion Networks, Inc., a provider of local area network switches. From September 1991 to February 1993, Mr. Johnson was Vice President and General Manager of Internetworking Hardware for Network Equipment Technologies, Inc., a wide area networking company. Mr. Johnson holds a B.S. degree with honors from North Carolina State University.
Alfred J. Amoroso has served as a member of the Board of Directors of Foundry since October 2000 and as the Chairman of the Board of Directors since January 2007. Since July 2005, Mr. Amoroso has served as the President, Chief Executive Officer and director of Macrovision Corporation. From September 2004 to July 2005, Mr. Amoroso was an advisor to Warburg Pincus. From July 2002 to August 2004, Mr. Amoroso served as the President, Chief Executive Officer and Vice Chairman of Meta Group, an information technology research and advisory firm. From October 1999 until its merger with IBM in January 2002, Mr. Amoroso served as President, Chief Executive Officer and a director of CrossWorlds Software, Inc. From November 1993 to November 1999, Mr. Amoroso served in a number of general management positions with IBM and served on the Management Committee of the company for a period of time. Before joining IBM, Mr. Amoroso held various positions at Price Waterhouse, now PricewaterhouseCoopers, from 1985 to 1993, including lead technology partner and partner in charge of the worldwide insurance consulting practice. He joined Price Waterhouse upon the sale of his consulting company to them in 1985. Mr. Amoroso holds a B.S. degree in systems engineering and M.S. degree in operations research from Polytechnic Institute of Brooklyn.
C. Nicholas Keating, Jr. has served as a member of the Board of Directors of Foundry since October 2000 and has been a director of Network Equipment Technologies, Inc. (NET), a wide area networking company, since November 2001. In July 2005, he was appointed President and Chief Executive Officer of NET. From July 2000 to April 2005, he served as a member of the Board of Directors of IP Infusion Inc., an Internet protocol software development company. From October 2000 to February 2004, Mr. Keating was the President and Chief Executive Officer of IP Infusion Inc. From February 1999 to January 2001, he was President and Chief Executive Officer of US Search.com Inc., a Web-based supplier of information products and services. From January 1994 to February 1999, he was a business advisor to a number of companies in the networking, software and semiconductor industries. From May 1987 until December 1993, Mr. Keating served as Vice-President of Network Equipment Technologies. In addition to Network Equipment Technologies, Mr. Keating also serves as a trustee of the Asian Art Museum and American University. Mr. Keating holds a B.A. degree and M.A. degree from American University and was a Fulbright Scholar.
J. Steven Young has served as a member of the Board of Directors of Foundry since October 2000. Mr. Young is a co-founder of H&G Capital Partners, a private equity firm, and has served as its Managing Partner since its inception in July 2007. Mr. Young was a co-founder of Sorenson Capital, a private equity firm, and served as its Managing Partner since its inception in February 2003 to July 2007. Mr. Young was a founding partner of Northgate Capital, a funds of funds management company from 1999 to 2002. From February 1999 to January 2003, Mr. Young co-founded and served as the Chairman of the Board of Directors of Found, Inc., an e-infrastructure technology solution provider. From May 1987 to June 2000, Mr. Young was the quarterback of the San Francisco 49ers. Mr. Young holds a B.S. degree and a J.D. degree from Brigham Young University.
Alan L. Earhart has served as a member of the Board of Directors of Foundry since August 2003 and has been a retired partner of PricewaterhouseCoopers LLP since 2001. From 1970 to 2001, Mr. Earhart held a variety of positions with Coopers & Lybrand and its successor entity, PricewaterhouseCoopers LLP, an accounting and consulting firm, including most recently as the Managing Partner for PricewaterhouseCoopersâ€™ Silicon Valley office. Mr. Earhart also serves on the Board of Directors of Monolithic Power Systems, Inc. and Network Appliance, Inc. Mr. Earhart holds a B.S. degree in accounting from the University of Oregon.
Celeste Volz Ford joined the Board of Directors of Foundry in April 2007. Ms. Ford is the founder of Stellar Solutions, Inc., a professional aerospace engineering services firm, and has served as its Chief Executive Officer since its inception in 1995. From 1984 to 1995 Ms. Ford served as Vice President, Satellite Business Area of Scitor Corporation, a systems engineering, information technology and program management aerospace expertise company. From 1978 to 1984 Ms. Ford held project management and engineering positions in the aerospace industry. Ms. Ford currently serves on the Board of Directors of Bay Microsystems, Inc. and also serves as Chairman of the Board of California Space Authority. Ms. Ford holds a B.S. degree from the University of Notre Dame and a M.S. from Stanford University.
Principal Components of Our Executive Compensation Program
Our executive compensation program consists of four components:
â€˘ base salary;
â€˘ annual cash bonuses;
â€˘ equity incentive awards (in the form of stock options and restricted stock awards); and
â€˘ other benefits.
In addition, certain Named Executive Officers have change in control severance arrangements with the Company that provide them with specified payments and benefits in the event that their employment is terminated under specified circumstances following a change in control of the Company.
We offer base salaries to our executives, including the Named Executive Officers. We set base salaries to be competitive and to be sufficient to attract and retain key executives. In 2007, base salaries represented approximately 66% to 75% of the targeted cash compensation for our executives.
To determine the appropriate base salary for each executive, our CEO, assisted by our Vice President of Human Resources, formulates recommendations for the Compensation Committee (except with respect to his own base salary) taking into consideration several factors, including the executiveâ€™s responsibilities, experience, skills, past performance, and expected future contributions. These recommendations are then submitted to the Compensation Committee which makes its own independent decisions with respect to base salary adjustments, after considering the base salaries of executives in similar positions at the Peer Group.
In 2007, Messrs. Johnson, Cheng, and Bridges did not receive base salary increases because their responsibilities had not changed significantly from the prior year and the Peer Group data for similar positions did not warrant increases. In 2007, Mr. Fairfax received a base salary increase of $125,000 in recognition of his promotion to CFO and its attendant increase in responsibilities. Mr. Akin received a base salary increase of $50,000 in recognition of his increased responsibilities from the prior year.
The base salaries of the Named Executive Officers during 2007 are reported in the Summary Compensation Table below.
Annual Incentive Awards
Our Executive Performance Incentive Plan (the â€śAnnual Incentive Planâ€ť) provides for annual cash bonuses for our executives, including the Named Executive Officers, based upon the attainment of pre-established annual corporate objectives (the â€śCorporate Performance Objectivesâ€ť), and the achievement of certain individual performance objectives. The Annual Incentive Plan is intended to provide competitive incentive-based cash compensation, reward executive contributions to the achievement of corporate objectives, and acknowledge individual contributions to our growth and success. Each of the Named Executive Officers participates in the Annual Incentive Plan except Mr. Akin who, as our Senior Vice President of Worldwide Sales, is compensated through a separate commissions-based sales incentive plan.
Target Award Levels
The target annual cash bonus opportunity for each executive, including each Named Executive Officer who participated in the Annual Incentive Plan, in 2007 was 40% of his annual base salary, except in the case of our CEO, whose target annual cash bonus opportunity was 50% of his annual base salary. These target award opportunities took into consideration Watson Wyattâ€™s competitive market reviews, which concluded that a 30% target level was below the 50th percentile of our Peer Group. The Compensation Committee determined that increasing the target bonus level percentage better reflected our pay-for-performance compensation philosophy. We maintain the same weighting and target bonus level percentages for all executives who participate in the Annual Incentive Plan at the same level.
Performance Target Levels
The specific target levels for the Corporate Performance Objectives are proposed by our CEO, who then submits them to the Compensation Committee for review and approval. Since 2002, the Corporate Performance Objectives have involved achieving specified target levels of annual revenue, gross margin, and operating income as reported in our published financial statements for the year, but excluding the impact of stock-based compensation expense and excluding or including other items that the Compensation Committee believes to be extraordinary in nature or otherwise appropriate to exclude or include. In 2007, there were no extraordinary items excluded or included in the specified target levels mentioned above. The Compensation Committee approves these target goals as stretch targets that should be challenging to achieve, and historically, they have not always been achieved.
2007 Award Payouts
Under the Annual Incentive Plan for 2007, the actual annual cash bonus payouts for each executive, including each Named Executive Officer who participated in the Annual Incentive Plan, were based primarily with reference to our achievement of the Corporate Performance Objectives, and secondarily with reference to each executiveâ€™s achievement of his or her individual performance objectives. The Corporate Performance Objectives made up 75% of each executiveâ€™s annual cash bonus opportunity (with each objective being weighted equally) and his or her individual performance objectives made up the remaining 25% of the opportunity.
The remaining one-quarter of the annual cash bonus payout was based on each individual executiveâ€™s performance for the year as measured against major management objectives determined by our CEO and communicated to the executive during the year. Our CEO continuously evaluates the individual performance of each executive using their weekly reports, and measures their results against their major management objectives for the year. These objectives vary among executives depending on his or her functional area of responsibility, although in each case they focus primarily on departmental goals and include the following core competencies: expense control, delivery of timely and quality results, teamwork and communication, initiative, dependability, recruitment and retention, and any other measureable departmental or Company specific goals as deemed appropriate. Our CEO submits his annual performance assessment and rating of each executive to the Compensation Committee, making a payout recommendation to the Committee on this individual performance objectives component using the following rating system:
â€˘ An executive with a (1) rating (Outstanding Performer) should receive a 100% bonus payout with respect to this component
â€˘ An executive with a (2) rating (Exceeds Expectations) should receive a 87.5% bonus payout with respect to this component
â€˘ An executive with a (3) rating (Achieving Expectations) should receive a 62.5% bonus payout with respect to this component
â€˘ An executive with a rating below a (3) should not receive any bonus payout with respect to this component
The Compensation Committee made the final determination of the appropriate payout for each executive with respect to the individual performance objective component.
Mr. Akin, our Senior Vice President of Worldwide Sales, does not participate in this Executive Performance Incentive Plan. Mr. Akin is compensated through a separate commission-based sales incentive plan which is directly tied to achieving revenue targets set by the Board of Directors in the Annual Incentive Plan and MBO targets set by the CEO. For 2007, the MBO targets related primarily to the development of the Companyâ€™s field sales force.
The annual cash bonus payouts to the Named Executive Officers for 2007 are reported in the Summary Compensation Table below. Additional information about the target annual cash bonus opportunities of the Named Executive Officers for 2007 are reported in the Grants of Plan-Based Awards Table below.
Equity Incentive Awards
We believe that equity-based incentive compensation is a key component for an effective executive compensation program at growth-oriented technology companies. We believe equity-based compensation aligns the interests of our executives with the interests of our stockholders, since these rewards depend on stock price performance.
We believe that stock options are an effective motivational tool because they generate economic value for the executive only if the market price of our common stock on the exercise date exceeds the option exercise price. We also believe that restricted stock awards and units, which have a more limited upside incentive than stock options, serves as an effective retention tool because these shares have value for executives even if the market price of our common stock does not increase. The CEO and the Compensation Committee determine the allocation between options and restricted stock. It is our philosophy that restricted stock acts as a more valuable retention strategy.
Each equity incentive award is subject to a service-based vesting schedule in order to spread the realization of the economic benefits over future periods, thereby keeping these incentives â€śin frontâ€ť of our executives to motivate performance and help us retain key talent. In addition, each stock option award is granted with an exercise price equal to the closing market price of our common stock on the date of grant. Restricted stock awards are generally issued for the par value of our common stock.
We monitor the equity incentive awards granted to our executives each year, as part of our annual assessment of the number of shares of our common stock granted to our employees as equity awards, in order to limit our compensation expense for financial reporting purposes and the potential dilution of our stockholderâ€™s interests. In particular:
â€˘ Each year, we budget the number of shares of our common stock available for equity incentive awards to executives. In determining the size of this pool, we consider factors such as the number of executives eligible for awards, competitive compensation practices, expected average award sizes based on expected performance, and the compensation expense for financial reporting purposes of granting equity incentive awards; and
â€˘ For 2007, we budgeted the number of shares of our common stock available for equity incentive awards to all employees, including our executives, with reference to the Institutional Shareholder Services determined average annual dilution rate not to exceed 6.11% as measured over a three-year period from 2006 through 2008. For these purposes, we define the â€śannual dilution rateâ€ť as the gross number of shares of common stock subject to new equity awards granted during a fiscal year, expressed as a percentage of the total number of outstanding shares of our common stock at year-end. For purposes of calculating the number of shares of our common stock awarded in a year, each share of our common stock subject to a stock option grant is counted on a one-for-one basis and each share of our common stock subject to a restricted stock award is counted based on a multiplier which is determined using our annual stock price volatility. By using this approach, we are placing more weight on our restricted stock awards given their higher intrinsic value. For 2007, this multiplier was two. For details of this dilution calculation, please see Proposal No. 3 in our Proxy Statement filed with the SEC on April 28, 2006 in connection with our 2006 Annual Meeting of Stockholders with respect to the Approval of the 2006 Stock Incentive Plan. For the two-year period of 2006 and 2007, our actual dilution rate was 6.38%, primarily reflecting retention awards made to existing employees, including some of the Named Executive Officers, and, to a more limited extent, awards made to newly-hired employees as our workforce grew approximately 36%, from 719 to 981 employees. We have no policy that sets or limits the target proportion of equity incentive awards to our executives relative to awards to all employees.
During July 2007, each of our executives, including the Named Executive Officers (except for our CEO), received a restricted stock award (with a three-year annual service-based vesting schedule). To determine the appropriate size and the composition of restricted stock and stock options for each executiveâ€™s equity incentive award, our CEO, assisted by our Vice President of Human Resources, formulated recommendations for the Compensation Committee (except with respect to the his own award) taking into consideration several factors, including the executiveâ€™s past performance and expected future contribution, the retention value of the executiveâ€™s outstanding unvested equity incentive awards, our growth and performance outlook, and the equity incentive awards provided to executives in similar positions in the Peer Group. These recommendations are then submitted to the Compensation Committee which then makes its own independent award decisions.
The grant date fair value of the equity incentive awards granted to the Named Executive Officers in 2007 and in prior years is reported in the Summary Compensation Table below. Additional information on the equity incentive awards granted to the Named Executive Officers in 2007, including the number of shares subject to each award and the full grant date fair value of each award, is reported in the Grants of Plan-Based Awards Table below.
MANAGEMENT DISCUSSION FROM LATEST 10K
During 2007, we benefited from a continuation of a broad enterprise upgrade cycle, which began in late 2004, as customers continued preparing their network infrastructure for Voice over Internet Protocol (VoIP), wireless applications, and the adoption of 10GbE in the network core to accommodate higher levels of traffic. In addition, we experienced renewed service provider interest in our new router product offerings, the XMR and MLX family of MPLS routers.
The networking market has been characterized by rapid advances in technology and related product performance, which has generally resulted in declining average selling prices over time. Our revenue has generally been favorably affected by increases in units sold as a result of market expansion, increases in market share and the release of new products. However, our revenue growth has been hindered by declining prices and competitive pressures. The market for data networking products continues to be dominated by Cisco, with over 50% share of the networking market. We continue to invest in our core market and adjacent markets in which we believe the competitive landscape looks attractive and the growth prospects are promising. However, we are continually assessing any adverse impact that the current macroeconomic environment may have on our growth prospects for 2008.
2007 Financial Performance
â€˘ 2007 marked the seventh year that we have operated profitably in the eight years since our initial public offering.
â€˘ Our total net revenue for 2007 increased 28% to $607.2 million from $473.3 million in 2006 due to the increased breadth and depth of the solutions we are now delivering to both the service provider and enterprise markets and the expansion of our sales organization.
â€˘ Net income in 2007 was $81.1 million, or 13% of total net revenue, compared to $38.7 million, or 8% of total net revenue, in 2006. Our profitability in 2007 was reduced by stock-based compensation expense of $46.0 million and increased professional and legal fees associated with the restatement of our prior period financial statements of $5.7 million.
â€˘ Our balance sheet remains debt-free, with cash and investments of $965.7 million, an increase of $79.2 million from 2006. During 2007, we generated $105.9 million of cash from operations, received $54.7 million of cash from net issuances of common stock and spent $82.9 million to repurchase 4.4 million shares of our common stock at an average price of $18.93 per share.
â€˘ In the fourth quarter of 2007 our annualized revenue per employee increased to approximately $688,000 from $647,000 in the fourth quarter of 2006.
Stock Option Investigation and Tender Offer
In the second quarter of fiscal 2007, we completed the restatement of our historical financial statements as a result of our independent stock option investigation and review of historical stock compensation practices and regained compliance with the listing standards of the Nasdaq Global Select Market.
In fiscal 2007, we amended certain options granted under the 1996 Stock Plan and the 2000 Non-Executive Stock Option Plan that we determined for financial accounting purposes had original exercise prices per share that were less than the fair market value per share of the common stock underlying the option on the optionâ€™s grant date. Employees subject to taxation in the United States and Canada had the opportunity to increase their strike price on affected options to the appropriate fair market value per share on the date of grant so as to avoid unfavorable tax consequences under United States Internal Revenue Code Section 409A and applicable Canadian tax law. In exchange for increasing the exercise price of these options, we committed to make a cash payment to employees participating in the offer so as to make employees whole for the incremental exercise price as compared to their original option exercise price. Pursuant to Internal Revenue Service and Securities Exchange Commission rules, the amendment of United States non-officer employee option agreements were executed through a tender offer. Canadian employee option agreements were amended by contractual agreement as allowed by Canadian law. On August 2, 2007, the date that the tender offer closed, we amended options to purchase 3.7 million shares of our common stock. Our Board of Directors also approved the amendment of options to purchase 0.6 million shares of our common stock for certain officers who were not allowed under IRS regulation to participate in the tender offer. Based on the above arrangements, we committed to make aggregate cash payments of $6.3 million and cancelled and regranted 1,104,858 options to purchase common stock. The cash payments will be returned to us if and when the underlying options to which they relate are exercised by our employees. During 2007, we recorded approximately $4.9 million in stock-based compensation expense, and we expect to record over the remaining vesting period approximately $4.1 million in additional stock-based compensation expense, in connection with these amended option grants.
We have revised the grant measurement dates following our stock option investigation for certain stock option grants exercised in 2006. When the revised measurement dates resulted in grant date fair market values in excess of the grant exercise prices, the Internal Revenue Service and the State of California have determined that the grantee has incurred a tax obligation under Section 409A of the Internal Revenue Code and respective state statutes. On February 9, 2007, the Board of Directors authorized us to assume these Section 409A and applicable state tax obligations on behalf of our employees, and instructed management to participate in Internal Revenue Service and State of California sponsored programs designed to facilitate company payments of these taxes for our non-executive employees. In addition, our Board of Directors has approved the reimbursement of Section 409A taxes our executives have incurred on certain 2006 stock option exercises. The taxes we have assumed for both our executive and non-executive employees plus an amount to compensate these employees for the gross-up or income tax effect of our payments has been recorded as bonus compensation in the amount of $3.1 million in the first quarter of 2007.
Critical Accounting Policies and Use of Estimates
Managementâ€™s discussion and analysis of financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenue and expenses during the period reported. By their nature, these estimates and judgments are subject to an inherent degree of uncertainty. Management bases its estimates and judgments on historical experience, market trends, current economic conditions, and other factors that are believed to be reasonable under the circumstances. The results of these estimates form the basis for judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Management believes the following critical accounting policies reflect the more significant judgments and estimates that can have a significant effect on our results of operations and the value of certain assets and liabilities on our consolidated financial statements. These and other significant accounting policies are further described in Note 2, â€śSummary of Significant Accounting Policies,â€ť to Consolidated Financial Statements.
We generate the majority of our revenue from sales of stackable and chassis-based networking equipment, with the remainder of our revenue primarily coming from customer support fees. We generally sell directly to end-users and value-added resellers. We apply the principles of SEC Staff Accounting Bulletin (â€śSABâ€ť) 104, Revenue Recognition and recognize revenue when persuasive evidence of an arrangement exists, delivery or performance has occurred, the sales price is fixed or determinable, and collectibility is reasonably assured. It is our practice to identify an end-user prior to shipment to a value-added reseller.
Product revenue is generally recognized upon transfer of title and risk of loss, which is generally upon shipment, unless an acceptance period or other contingency exists, in which case revenue is recognized upon the earlier of customer acceptance or expiration of the acceptance period, or upon satisfaction of the contingency.
Support revenue is recognized ratably over the term of the support arrangement, in accordance with Financial Accounting Standards Board (â€śFASBâ€ť) Technical Bulletin 90-1, Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts.
When sales arrangements contain multiple elements (e.g., hardware and support), we apply the provisions of EITF Issue No. 00-21, Revenue Arrangements with Multiple Deliverables (â€śEITF 00-21â€ť) , to determine the separate units of accounting that exist within the arrangement. If more than one unit of accounting exists, the arrangement consideration is allocated to each unit of accounting using either the relative fair value method or the residual fair value method as prescribed by EITF 00-21. Revenue is recognized for each unit of accounting when the revenue recognition criteria described above have been met for that unit of accounting. The application of EITF 00-21 involves significant judgment. For example, we use judgment to determine whether objective and reliable evidence of fair value exists for undelivered item(s) in an arrangement. The timing of revenue recognition varies based on this determination.
We provide a provision for estimated customer returns at the time product revenue is recognized. Our provision is based primarily on historical sales returns and our return policies. Our resellers generally do not have a right of return, and our contracts with original equipment manufacturers only provide for rights of return in the event our products do not meet specifications or there is an epidemic failure, as defined in the contracts. If the historical data used by us to calculate estimated sales returns does not reasonably approximate future returns, revenue in future periods could be affected.
Results of Operations
We offer products in two configuration platforms, a fixed configuration stackable and a flexible configuration chassis. A stackable has a fixed configuration that cannot be altered. A chassis uses a modular platform that can be populated and reconfigured with various management and line card modules as frequently as desired by the customer. For example, customers can use our chassis products at the edge of their network or reconfigure the chassis for use in the backbone or core of their network. In many cases, large customers tend to deploy a larger percentage of chassis based products due to the size and complexity of their networks and the need for long-term flexibility. Our selling prices and gross margins on chassis-based products are generally higher than our stackable products because of the flexible configuration offered by chassis-based products.
We manage our business based on four geographic regions: the Americas (primarily the United States); Europe, the Middle East, and Africa (â€śEMEAâ€ť); Japan; and Asia Pacific. Because some of our customers, such as the United States government and multinational companies, span various geographic locations, we determine revenue by geographic region based on the billing location of the customer.
Net product revenue in 2007 increased 31% from 2006 primarily due to increased sales of our LAN switching and WAN router product families attributable to the increased customer acceptance of products delivered to the enterprise and service provider markets and the expansion of our sales organization to 440 at December 31, 2007 from 368 at December 31, 2006. Net product revenue from our chassis-based products improved due to greater volume shipments of our RX, SuperX, and XMR/MLX platforms for the enterprise and service provider markets. The mix shift from stackable to chassis during 2007 was driven primarily by the higher frequency of deployments within large enterprise accounts. Revenue for the RX, SuperX and XMR/MLX platforms, along with the associated accessories, increased $132.8 million to $291.4 million in 2007 compared from $158.6 million in 2006. The increases were offset by a $20.5 million decrease in revenue for our older â€śJetCoreâ€ť based BigIron and FastIron platforms in 2007 compared to 2006. Sales to the United States government accounted for approximately 18% of total net revenue for 2007, up from 17% in 2006, and increased in terms of absolute dollars by approximately 33% to $108.9 million in 2007 from $81.6 million in 2006.
Net product revenue in 2006 increased 17% from 2005 due to a general improvement in both the enterprise and service provider markets coupled with increased customer acceptance of our switching and routing platforms and the expansion of our sales organization. During the course of 2006 we grew our sales personnel from 297 at December 31, 2005 to 368 at December 31, 2006. Net product revenue from our chassis-based products increased 24% in 2006 as compared to 2005 due to customer acceptance of our new RX, SuperX platforms for the enterprise market and XMR/MLX platforms for the service provider market. Revenue for 2006 reflects our first full year of sales of our XMR and MLX product offerings. Sales to the United States government accounted for approximately 17% of total net revenue for 2006, down from 19% for 2005, but increased in terms of absolute dollars by 7% to $81.6 million in 2006 from $76.6 million in 2005.
Service revenue consists primarily of revenue from customer support contracts. The increase in absolute dollars in 2007 and 2006 was due to a larger installed base of our networking equipment each year as customers purchased new support contracts with their new equipment purchases and renewed maintenance contracts on existing equipment. We added approximately 1,290 new customers in 2007 and 1,410 new customers in 2006.
For the years ended December 31, 2007, 2006 and 2005, no single customer accounted for 10% or more of our net product revenue other than the United States government.
Our cost of product revenue consists primarily of material, labor, freight, warranty costs, provisions for excess and obsolete inventory, and manufacturing overhead which includes stock-based compensation. The slight increase in product gross margins in 2007 compared to 2006 was due to improved pricing and a reduction in our provision for excess and obsolete inventory as a result of higher provisions in 2006 due to product transitions to newer platforms. The increase was also due to the shift in sales from our lower margin stackable products to our higher margin chassis products. The average selling price per unit increased 5% in 2007 as compared to 2006. Our gross margin benefited by $1.9 million or 0.5% and $2.9 million or 1.0% from the sale of fully reserved inventory during the years ended December 31, 2007 and 2006, respectively. These increases in product gross margin were offset by an increase in average cost of 4% in 2007 as compared to 2006.
The decrease in product gross margins in 2006 compared to 2005 was primarily due to an increase in material and labor cost, which includes an increase of $1.7 million from stock-based compensation expense. The average material cost per unit increased 5% in 2006 as compared to 2005, while the average selling price increased only 3% in 2006 as compared to 2005. In 2006, the XMR/MLX and RX platforms were in the early stages of the product life cycle, which resulted in higher material costs.
Our cost of service revenue consists primarily of costs of providing services under customer support contracts including maintaining adequate spares inventory levels at service depots. These costs include materials, labor, and overhead which includes stock-based compensation. The decreases in service gross margin percentage in 2007 compared to 2006 was due to the expansion of our customer support infrastructure to support a larger and more diverse customer base. As we support a larger installed base of multi-national enterprise and service provider customers, it has become necessary to make further investments in our international support infrastructure, logistics capabilities and inventory.
Service gross margins remained flat at 82% in 2006 compared with 2005 primarily due to higher service revenues offsetting the increased investment in our service infrastructure. Service gross margins typically experience variability due to the timing of technical support service initiations and renewals and additional investments in our customer support infrastructure.
Our gross margins may be adversely affected by increased price competition, component shortages, increases in material or labor costs, excess and obsolete inventory charges, changes in channels of distribution, or customer, product and geographic mix. See also â€śRisk Factors â€” Our gross margins may decline over time and the average selling prices of our products may decrease as a result of competitive pressures and other factors.â€ť
Research and development expenses consist primarily of salaries and related personnel expenses, stock-based compensation expense, prototype materials expense, depreciation of equipment used in research and development activities and the cost of facilities. Research and development expenses for the year ended December 31, 2007 increased $6.4 million, as compared to the year ended December 31, 2006, largely as a result of a $9.8 million increase in salaries and related personnel expense. The increase in salaries and related personnel expense was due to increased salary costs, which largely resulted from growth in our research and development headcount, and special one-time bonuses of $3.4 million that we recorded in the quarter ended March 31, 2007, of which $1.6 million related to the suspension of our ESPP and $1.8 million related to our assumption and reimbursement of employee 409A taxes associated with exercises of certain stock options in 2006 with revised measurement dates. The increase in payroll related expense was partially offset by a decrease in prototype material spending of $2.7 million, which resulted from the fact that our RX, XMR/MLX product families were introduced in late 2005 and early 2006, and a decrease in stock-based compensation expense of $1.0 million. Our research and development headcount increased from 219 at the end of 2006 to 266 at the end of 2007.
Research and development expenses in 2006 increased $17.6 million compared to 2005 primarily due to an increase in stock-based compensation expense of $15.8 million, and to a lesser extent, an increase in personnel from 204 engineers at the end of 2005 to 219 engineers at the end of 2006, resulting in increased salary related costs of $4.6 million. The increase was offset by a $1.8 million decrease in prototype material expenditures following the introduction of our XMR/MLX product families in late 2005 and early 2006.
We believe that investments in research and development, including the retention, recruiting and hiring of engineers and spending on prototype development costs are critical to our ability to remain competitive in the marketplace and, excluding charges of $3.4 million for the one-time bonuses in fiscal year 2007, we expect our spending on research and development will grow in absolute dollars in fiscal year 2008.
Sales and marketing expenses consist primarily of salaries and related personnel expenses, stock-based compensation expense, commissions and related expenses for personnel engaged in marketing, sales and customer service functions, as well as trade shows and seminars, advertising, promotional expenses, recruiting expenses, travel related expenses, cost of facilities and expenses for maintaining customer evaluation inventory at customer sites. Sales and marketing expenses for the year ended December 31, 2007 increased $31.2 million, as compared to the year ended December 31, 2006, largely as a result of a $30.4 million increase in payroll, fringe benefits and commission expenses. Commission expense increased $14.7 million for the year ended December 31, 2007 due to the increase in revenue. The increase in payroll and fringe benefits expenses was due to increased salary costs, which largely resulted from growth in our sales and marketing headcount, and special one-time bonuses of $3.2 million that we recorded in the quarter ended March 31, 2007, of which $2.4 million related to the suspension of our ESPP and $0.8 million related to our assumption and reimbursement of employee 409A taxes associated with exercises of certain stock options in 2006 with revised measurement dates. The increase in payroll costs was partially offset by a decrease in stock-based compensation expense of $2.8 million. Travel related expenses increased by $2.1 million and recruiting expenses increased by $0.7 million for year ended December 31, 2007, as compared to the year ended December 31, 2006. The increases were offset by a decrease in advertising costs by $0.8 million for the year ended December 31, 2007, as compared to 2006. Our sales and marketing headcount increased from 428 at the end of 2006 to 512 at the end of 2007.
Sales and marketing expenses increased $23.3 million in 2006 primarily due to an increase in stock-based compensation expense of $18.9 million. In addition, the expansion of our worldwide sales force and increased variable performance-based compensation resulted in a $16.9 million increase in sales personnel costs. The sales and marketing headcount grew from 370 at the end of 2005 to 428 at the end of 2006. The increases were offset by decreases in marketing expenses and the expense associated with the evaluation and demonstration inventory units in the field. Excluding stock-based compensation expense, marketing and customer support expenses decreased by $7.9 million in 2006 due primarily to lower advertising, trade show, seminar costs, and technical support cost allocated to service cost of sales. The expense associated with the evaluation and demonstration inventory units in the field decreased by $5.3 million in 2006 compared to 2005.
We expect that sales and marketing expenses, excluding charges of $3.2 million for one-time bonuses in fiscal year 2007, will continue to grow in absolute dollars and will be higher as a percentage of net revenue for fiscal year 2008.
General and administrative expenses consist primarily of salaries and related expenses for executive, finance and administrative personnel, stock-based compensation expense, facilities, bad debt, legal fees, accounting fees, and other general corporate expenses. General and administrative expenses for the year ended December 31, 2007 increased $1.1 million compared to 2006, primarily due to increases in payroll expenses, accounting fees and consulting service fees, partially offset by decreases in legal costs, bad debt expenses and rent expense. Salaries and related expenses increased $3.8 million, largely as a result of growth in our general and administrative headcount and special one-time bonuses of $0.7 million that we recorded in the quarter ended March 31, 2007, of which $0.3 million related to the suspension of our ESPP and $0.4 million related to our assumption and reimbursement of employee 409A taxes associated with exercises of certain stock options in 2006 with revised measurement dates.
MANAGEMENT DISCUSSION FOR LATEST QUARTER
Results of Operations
We offer products in two configuration platforms, a fixed configuration stackable and a flexible configuration chassis. A stackable has a fixed configuration that cannot be altered. A chassis uses a modular platform that can be populated and reconfigured with various management and line card modules as frequently as desired by the customer. For example, customers can use our chassis products at the edge of their network or reconfigure the chassis for use in the backbone or core of their network. Our selling prices and gross margins on chassis-based products are generally higher than our stackable products because of the flexible configuration offered by chassis-based products.
Net product revenue increased 38% and 31% in the three and nine months ended September 30, 2007, respectively, compared to the same periods in 2006 primarily due to increased sales of our LAN switching and WAN router product families, and expansion of our sales organization from 349 sales personnel in the third quarter of 2006 to 397 in the third quarter of 2007. Net product revenue from our chassis-based products improved due to greater volume shipments of our RX, SuperX, and XMR/MLX platforms for the enterprise and service provider markets. Revenue for the RX, SuperX and XMR/MLX platforms, along with the associated accessories, increased by $35.8 million and $98.7 million in the three and nine months ended September 30, 2007, respectively, compared to the same periods in 2006. The increases were offset by a $3.7 million and $19.0 million decrease in revenue for our older â€śJetCoreâ€ť based BigIron and FastIron platforms for the three and nine months ended September 30, 2007, respectively, compared to the same period in 2006. Sales to the United States government accounted for approximately 22% of total net revenue for the third quarter of 2007, up from 20% in the third quarter of 2006 and grew approximately 44% in absolute dollars. Sales to the United States government for the nine months ended September 30, 2007 and 2006 accounted for approximately 17% of total net revenue, but grew approximately 26% in absolute dollars. The increase in our overall product sales is mainly attributed to the greater volume of shipments for the three and nine months ended September 30, 2007, compared to the same periods in 2006.
Other than the United States government, no individual customer accounted for more than 10% of our net product revenue for the three and nine months ended September 30, 2007 and 2006.
Service revenue consists primarily of revenue from customer support contracts. Although we sell service contracts with terms ranging from one to five years, most service contracts are purchased with a one year term. The 13% and 15% increases in service revenue in the three and nine months ended September 30, 2007, respectively, compared to the same periods in 2006, were due to service contract initiations on new product sales and renewals from our growing installed base of networking equipment. Our customer base grew by approximately 1,200 new accounts from September 30, 2006 to September 30, 2007.
Our cost of product revenue consists primarily of material, labor, freight, warranty costs, provisions for excess and obsolete inventory, and manufacturing overhead, which includes stock-based compensation. The increase in product gross margins as a percentage of net product revenue in the three and nine months ended September 30, 2007, compared to the same periods in 2006, was primarily due to the shift in sales from our lower margin stackables products to our higher margin chassis products, improved pricing and lower manufacturing costs achieved in our new product families as shipments achieved greater volume.
Our cost of service revenue consists primarily of costs of providing services under customer support contracts including maintaining adequate spares inventory levels at service depots. These costs include materials, labor, and overhead which includes stock-based compensation. The decreases in service gross margin percentage in the three and nine months ended September 30, 2007, over the same periods in 2006 were due to the expansion of our customer support infrastructure to support a larger and more diverse customer base. As we support a larger installed base of multi-national enterprise and service provider customers, it has become necessary to make further investments in our international support infrastructure, logistics capabilities and inventory. Service gross margins typically experience variability due to the timing of technical support service initiations and renewals and additional investments in our customer support infrastructure.
Our gross margins may be adversely affected by increased price competition, component shortages, increases in material or labor costs, excess and obsolete inventory charges, changes in channels of distribution, or customer, product and geographic mix. See also â€śRisk Factors â€” Our gross margins and average selling prices of our products have decreased in the past and may continue to decrease as a result of competitive pressures and other factors.â€ť
Research and development expenses consist primarily of salaries and related personnel expenses, stock-based compensation expense, prototype materials, depreciation of equipment used in research and development activities and the cost of facilities. Research and development expenses for the three and nine months ended September 30, 2007 increased $1.7 million and $3.8 million, respectively, compared to the same periods in 2006. Payroll expense increased $1.9 million and $5.7 million in the three and nine months ended September 30, 2007, respectively, which was partially offset by a decrease in prototype material spending of $0.2 million and $2.2 million for the three and nine months ended September 30, 2007, respectively, compared to the same periods of 2006. In the three months ended September 30, 2007, the payroll expense increase was primarily due to increased salary costs due to increased headcount and salary adjustments and an increase in stock-based compensation expense of $1.0 million. In the nine months ended September 30, 2007, the payroll expense increase was due to increased salary costs, partially offset by a decrease in stock-based compensation expense of $1.7 million. Included in the increased salary costs for the nine months ended September 30, 2007 were special one-time bonuses recorded in the quarter ended March 31, 2007 of $3.4 million, of which $1.6 million related to the suspension of our ESPP and $1.8 million related to our assumption of employee 409A taxes associated with 2006 exercises of stock option grants with revised measurement dates. Our research and development headcount increased from 212 in the third quarter of 2006 to 239 in the third quarter of 2007. The decreases in prototype material were due to the introduction of the RX, XMR/MLX in late 2005 and early 2006.
Sales and marketing expenses consist primarily of salaries, stock-based compensation expense, commissions and related expenses for personnel engaged in marketing, sales and customer service functions, as well as trade shows, advertising, promotional expenses and the cost of facilities. Sales and marketing expenses for the three and nine months ended September 30, 2007 increased $8.0 million and $20.9 million, respectively, compared to the same periods of 2006. Sales and marketing department payroll, fringe benefits and commission expenses increased by $8.0 million and $18.6 million for the three and nine months ended September 30, 2007, respectively, compared to the same periods in 2006. Commission expense increased $4.1 million and $10.4 million for the three and nine months ended September 30, 2007, respectively, due to the increase in sales revenue as compared to the same periods in 2006. The payroll and fringe benefits expenses increased as a result of the increase in our sales and marketing headcount from 407 employees in the third quarter of 2006 to 467 in the third quarter of 2007. Included in the payroll and fringe benefits increase for the nine months ended September 30, 2007 were special one-time bonuses recorded in the quarter ended March 31, 2007 of $3.2 million, of which $2.4 million related to the suspension of our ESPP and $0.8 million related to our assumption of employee 409A taxes associated with 2006 exercises of stock option grants with revised measurement dates. The increases in payroll costs were partially offset by a decrease in stock-based compensation expense of $3.4 million for the nine months ended September 30, 2007, as compared to the same period of 2006. Travel related expenses increased by $1.1 million for the nine months ended September 30, 2007, as compared to the same period in 2006. In addition, the carrying costs associated with the level of evaluation and demonstration inventory at customer sites increased by $0.8 million for the nine months ended September 30, 2007, as compared to the same period of 2006.
General and administrative expenses consist primarily of salaries and related expenses for executive, finance and administrative personnel, stock-based compensation expense, facilities, bad debt, legal fees, accounting fees, and other general corporate expenses. General and administrative expenses for the three and nine months ended September 30, 2007 decreased $0.4 million and $0.9 million, respectively, compared to the same periods of 2006, primarily due to decreases in legal costs and bad debt expenses, partially offset by increases in accounting and consulting service fees and payroll expenses. Legal costs decreased by $2.1 million and $4.3 million for the three and nine months ended September 30, 2007, respectively, compared to the same periods of 2006, primarily due to lower patent litigation expenses in 2007. Bad debt expenses decreased by $0.9 million and $1.3 million for the three and nine months ended September 30, 2007, respectively, compared to the same periods in 2006, primarily due to lower account receivables write offs in 2007. Consulting services fees increased $0.9 million and $1.1 million for the three and nine months ended September 30, 2007, respectively, as compared to the same periods in 2006, primarily due to increased costs relating to our upgrade of our ERP system. In the three months ended September 30, 2007, payroll expenses increased $0.7 million as compared to the same period of 2006. Headcount increased from 74 at the end of September 30, 2006 to 82 at the end of September 30, 2007. In the nine months ended September 30, 2007, payroll expenses increased $2.0 million due to increased salary costs, partially offset by a decrease in stock-based compensation expense for the nine months ended September 30, 2007 of $0.7 million. Included in the increased salary costs for the nine months ended September 30, 2007 were special one-time bonuses recorded in the quarter ended March 31, 2007 of $0.7 million, of which $0.3 million related to the suspension of our ESPP and $0.4 million related to our assumption of employee 409A taxes associated with 2006 exercises of stock option grants with revised measurement dates. Accounting fees increased $1.8 million for the nine months ended September 30, 2007 as compared to the same period in 2006 due to increased costs relating to the extension of our fiscal year 2006 audit.
Other charges, net, consist primarily of litigation settlement charges and charges relating to professional fees and other costs associated with the investigation of stock option grants to our employees.
â€˘ Litigation settlement charges of $5.4 million were recognized in the nine months ended September 30, 2006 in connection with settlement agreements reached separately, with Lucent and Alcatelâ€”Lucent. Litigation settlement charges pertained primarily to the accrual of costs incurred and payable to Lucent and Alcatelâ€”Lucent related to past periods.
â€˘ For the three months ended September 30, 2007 and 2006, costs of $0.1 million and $4.2 million were incurred, respectively, for the independent review of our stock option practices and for the nine months ended September 30, 2007 and 2006, costs of $5.7 million and $4.5 million were incurred, respectively, related to this review. The remaining costs associated with the review should not be material going forward.
Interest and Other Income, Net
We earn interest income on funds maintained in interest-bearing money market and investment accounts. We recorded interest and other income of $11.4 million and $9.1 million for the three months ended September 30, 2007 and 2006, respectively. We recorded interest and other income of $32.3 million and $24.5 million for the nine months ended September 30, 2007 and 2006, respectively. These increases were primarily due to increased average investment balances and higher interest rates. Our total cash and investments increased $105.5 million, or 13%, from September 30, 2006 to September 30, 2007. In the nine months ended September 30, 2007, we recorded an expense of $0.4 million in interest and other income, net related to the extension of the exercise date for stock options held by certain former employees who were not permitted to exercise their stock options until the completion of our restatement of our financial statements and our public reporting obligations to the U.S. Securities and Exchange Commission had been met. As of September 30, 2007, there are no remaining costs associated with the extension of these exercise dates. We believe our interest income will gradually decline over the next several quarters as a result of the recent Federal Reserve interest rate reductions and as we continue to execute on our share repurchase program.
Provision for Income Taxes
Our interim effective income tax rate is based on our best estimate of our annual effective income tax rate. The effective income tax rates for the three months ended September 30, 2007 and 2006 were 38% and 36%, respectively. The effective income tax rates for the nine months ended September 30, 2007 and 2006 were 38% and 40%, respectively. These rates reflect applicable federal and state tax rates, offset by federal and state research and development tax credits, export sales incentives, and tax-exempt interest income. The higher effective tax rate for the three months ended September 30, 2007 compared to the prior year was primarily due to decreased reserves related to the expired statute of limitations. The lower effective tax rate for the nine months ended September 30, 2007 compared to the prior year was primarily due to the decreased impact of stock-based compensation and the extension of the federal research and development credit, partially offset by reduced export incentive benefits.
When an employee exercises a stock option issued under a nonqualified plan, or has a disqualifying disposition related to a qualified plan, we receive an income tax benefit for the difference between the fair market value of the stock issued at the time of the exercise or disposition and the employeeâ€™s option price, tax effected. As we cannot record the tax benefit for stock-based compensation expense associated with qualified stock options until the occurrence of future disqualifying dispositions of the underlying stock, our future quarterly and annual effective tax rates will be subject to greater volatility and, consequently, our ability to estimate reasonably our future quarterly and annual effective tax rates will be adversely affected.
Subsequent to the adoption of FIN 48 as of January 1, 2007, there was a reduction in unrecognized tax benefits of $1.8 million recorded under FIN 48 resulting from the lapse of the applicable statute of limitations.
Liquidity and Capital Resources
Cash and investments increased $59.2 million from December 31, 2006 to September 30, 2007 primarily due to cash generated from operations of $57.3 million. Cash provided by operating activities was primarily attributable to net income of $52.3 million, plus adjustments for non-cash charges, including $32.7 million of stock-based compensation expense, $3.1 million of inventory provisions and $8.4 million of depreciation and amortization, partially offset by a net increase in operating assets and liabilities of $28.7 million and an increase in deferred tax assets of $3.2 million.
Inventories were $42.9 million and $34.9 million as of September 30, 2007 and December 31, 2006, respectively. During the first three quarters of 2007, we increased our inventory levels to support a broader product offering and larger installed customer base. Inventory turnover was approximately 6.5 and 6.6 as of September 30, 2007 and December 31, 2006, respectively.
Accounts receivable, net of allowance for doubtful accounts and provision for sales returns, increased $38.8 million during the three quarters of 2007. Our accounts receivable and days sales outstanding (â€śDSOâ€ť) are primarily affected by shipment linearity, collections performance, and timing of support contract renewals. DSO, calculated based on annualized revenue for the most recent quarter ended and net accounts receivable as of the balance sheet date, was 63 days and 50 days for the three months ended as of September 30, 2007 and December 31, 2006, respectively.
In July 2007, our Board of Directors approved a share repurchase program authorizing us to purchase up to $200 million of our common stock. The shares may be purchased from time to time in the open market or through privately negotiated transactions at managementâ€™s discretion, depending upon market conditions and other factors, in accordance with SEC requirements. The authorization to repurchase our stock expires on December 31, 2008. During the three months ended September 30, 2007, we repurchased 2.1 million shares of our common stock via open market purchases at an average price of $17.84 per share. The total purchase price of $38.0 million was reflected as a decrease to retained earnings in the three months ended September 30, 2007.
The amount of capital we will need in the future will depend on many factors, including our capital expenditure and hiring plans to accommodate future growth, research and development plans, the levels of inventory and accounts receivable that we maintain, future demand for our products and related cost and pricing, the level of exercises of stock options and stock purchases under our employee stock purchase plan, and general economic conditions. Although we do not have any current plans or commitments to do so, we do from time to time consider strategic investments to gain access to new technologies or the acquisition of products or businesses complementary to our business. Any acquisition or investment may require additional capital. We have funded our business primarily through our operating activities and we believe that our cash and cash equivalents, short-term investments and cash generated from operations will satisfy our working capital needs, capital expenditures, commitments and other liquidity requirements associated with our operations through at least the next 12 months.