ITEM 1. BUSINESS
GENERAL
Bay Networks, Inc. (the "Company") develops, manufactures, markets and supports a comprehensive line of data networking products and services, including high-speed routers, switches, intelligent hubs, remote and internet access solutions and sophisticated management software providing network design and configuration solutions. These products enable end users to build or enhance their data network systems, including all levels from small local area networks to large enterprise-wide information infrastructures.
In October 1994, SynOptics Communications, Inc. ("SynOptics") and Wellfleet Communications, Inc. ("Wellfleet") effected a strategic combination of the two companies through the merger of a wholly-owned subsidiary of Wellfleet with and into SynOptics (the "Combination"). In connection with the Combination, Wellfleet changed its name to Bay Networks, Inc. On May 15, 1995, the Company acquired Centillion Networks, Inc. a leading provider of Token Ring and Token Ring-to-ATM switching products.
On December 15, 1995, the Company acquired Xylogics, Inc. ("Xylogics"), a technology and market leader in enterprise remote access, offering remote users and offices transparent corporate-wide access to networking resources. On March 13, 1996, the Company acquired all of the outstanding shares of Performance Technology, Inc., a privately held company headquartered in San Antonio, Texas and a leader in developing LAN-to-Internet access technology, providing small offices and small-to-medium-sized businesses easy, secure access to the Internet. On March 31, 1996, the Company acquired substantially all of the net assets of Armon Networking, Ltd., headquartered in Tel Aviv, Israel, a technology developer of RMON-based distributed analysis tools and multi-segment LAN probes. In June 1996, the Company signed a definitive agreement to acquire the Digital Signal Processing (DSP) modem business of Penril DataComm Networks, Inc., a provider of advanced DSP-based modems and remote access products. The closing of the transaction is currently expected to be in the quarter ending December 31, 1996. See Management's Discussion and Analysis of Financial Condition and Results of Operations and Note 2 to the Consolidated Financial Statements included herein.
The Company's products connect and interconnect multiple types of LANs, comprised of computer equipment from the same or different manufacturers, to form an internetworked system. These products connect computers to form LANs, interconnect LANs located in a single facility and, through WAN connections, may connect LANs dispersed around the world. The internetworking of these networks enables computer users operating different types of equipment in different locations to communicate, exchange data and share other computing resources.
The Company is a Delaware corporation incorporated in May, 1986. The Company's principal offices are located at 4401 Great America Parkway, Santa Clara, California 95054.
Trademarks of Bay Networks, Inc. appear in this document. Other trademarks, brand, product, or company names may be the property of others.
RECENT DEVELOPMENTS
On September 3, 1996, the Company signed a definitive agreement to acquire all the outstanding shares of LANcity Corporation ("LANcity"), a provider of advanced cable modem technology, in exchange for $59.0 million. The acquisition is subject to LANcity shareholder approval and is scheduled to close during the quarter ending September 30, 1996. The acquisition will be accounted for as a purchase. Based on preliminary estimates, the Company expects to allocate approximately one-half of the purchase price to in-process research and development, which will be charged to expense upon the closing of the transaction.
NETWORKING SOLUTIONS
Organizations are increasingly seeking to internetwork their disparate, often incompatible, LANs and WANs to share information and computing resources across the organization for applications such as electronic mail, sharing of databases, multi-site engineering and product development, transaction processing and electronic image transfer. Enterprise-wide networks facilitate efficient and rapid data communications among connected work groups, departments and locations and provide for more effective utilization of information and computer resources. In addition, as the computing paradigm migrates to client-server architectures, enterprise-wide networks are the enabler that allows those technologies to be implemented by organizations. The internetworking of LANs and WANs into enterprise-wide networks requires data communications products which efficiently, reliably, and quickly transmit data to appropriate locations on different networks, reconcile incompatible LAN and WAN standards between networks and manage large, complex internetworks.
To meet these internetworking needs, the Company has developed a family of computer networking products including hubs, routers, switches, and network management software. The Company's hub products, which reside at the center of networks and serve as a control and consolidation point for network activity, integrate connectivity, network management and internetworking products into a structured network solution that emphasizes network management scalability and manages complexity across the network.
As network demands continue to increase, switching delivers the performance required to support the emerging image processing, animation, modeling, scientific and multimedia applications of the future. The Company's router products choose the optimal path to interconnect LANs or to route data to the WAN. These products enhance network segmentation and security, improve reliability (since alternative paths can be used) and increase bandwidth utilization (since the best path between source and destination is chosen by a router).
Organizations are experiencing a shift from departmental-only to enterprise-wide remote access and the need for applications and network infrastructure that are remote access-ready as a result of increased business mobility, the move to telecommuting, reduced cost of ownership of both product and WAN services, and widespread adoption of remote access standards. Remote and internet access products extend the backbone network beyond the branch office, bringing remote users closer to the enterprise and permit connection to the corporate LAN so users can work anywhere -- at home, in a hotel or in a remote office -- at any time. Users can access electronic mail, databases and file servers as if they were directly included within the network.
PRODUCTS
The Company's product lines include a broad family of internetworking products, including routers, hubs, switches, remote and internet access solutions, and network management technologies. These products encompass LAN and WAN components, which allow the Company to offer a solution to communicate network data worldwide, managed from a single network management software platform which supports the Company's product lines.
The Company's product strategy is focused on weaving LAN connectivity, management and internetworking solutions into a flexible network fabric capable of supporting large, diverse enterprise networks. The center of this strategy is the intelligent hub, which acts as a central control point for network connections, management and growth. The intelligent hub incorporates the hardware and software required to connect computing devices to structured networks using various cabling types and media-access methods, switches, bridges and routers that enable the internetworking of various network segments into enterprise networks. Integrated network management software products facilitate network operation by diagnosing and solving network problems. The categories of the Company's product lines are described below.
Connectivity Products, which include intelligent hubs and related host modules and transceivers, enable computing devices to communicate over networks. Intelligent hubs provide integrated connectivity and centralized management by supporting ethernet, token ring and fiber distributed data interface ("FDDI") protocols, or any combination of the three in the same hub. Transceivers provide an interface between the
computing devices and cabling systems and are implemented either as units external to the computer or as integrated circuits on network cards.
Network Management Products distribute management intelligence throughout geographically dispersed networks and enable network administrators to monitor and control the network. The open, standards-based network management products are comprised principally of intelligent modules which resides within hubs, sophisticated management software which resides on intelligent modules and advanced software application programs which reside on network management computer consoles. Through a combination of hardware and software components, intelligent network management modules gather network information close to the source of data activity, reduce it into meaningful information within the hub, and forward the data to a central network management console attached to the network. The actual management of data takes place in the hub, relieving the burden on central network management resources and enabling networks to grow along with the expansion of the business.
Using the Simple Network Management Protocol ("SNMP"), which ensures compatibility with other management systems that may already be in place in a particular networking environment, the Company's network management products address a wide variety of diverse environments. The Optivity network management system works with DOS and UNIX network management platforms from International Business Machines Corporation, Hewlett-Packard Company, Inc., Novell, Inc. and Sun Microsystems, Inc. Additionally, the Company offers application software products which automate operational functions and facilitate design and management of a network. The flexibility of these software products enable them to interface in an array of multi-vendor environments.
Internetworking Products are modular devices integrated into intelligent hubs or stand-alone devices which provide links between independent LAN segments and control the flow of data on the LAN. The devices connect data traffic between linked networks and forward packets of data destined for other locations throughout the network. The Company's internetworking product lines include local and remote bridges, local and remote routers, and switches. Bridges, which are protocol-independent, are the simplest method of connecting LAN segments. Bridges sort through all traffic on a network, and decide whether to send it to the remainder of the network.
As networks grow in both size and complexity, routers provide additional intelligence in connecting individual networks. Unlike bridges, routers actually examine the protocol of the data packets which permits protocol filtering and security control. The Company offers a family of scalable and highly flexible router products that concurrently provide bridging and multi-protocol routing functions in modular and stackable forms. The Backbone Node ("BN") products are designed to satisfy the throughput and/or availability requirements of the most demanding enterprise internetworks. The Backbone Node provides complete fault resiliency with redundant processor interconnects, power supplies, and software image storage in combination with its symmetric multiprocessor architecture.
The Company also offers a modular, stackable router, which is designed to provide seamless integration of multiple units stacked together, performing as a single router. This modular product offers scalability for expanding sites requiring remote, regional or departmental access to the corporate network.
Switching Products interconnect LANs by supporting multiple parallel communications and eliminating LAN bandwidth congestion. These products offer connectivity to LAN and WAN technologies such as asynchronous transfer mode ("ATM"), FDDI and token ring, as well as a full suite of networking protocols for high-speed LAN and switching environments.
In fiscal 1995, the Company introduced BaySIS (Bay Switched Internetworking Services), a new networking architecture that combines switching technology with traditional shared-media hub and router technology. The resulting switched-internetworking architecture permits the customer to migrate from their existing technology in a controlled, reliable and cost-effective manner.
Remote and Internet Access Products, including Remote Annex analog remote access servers, Nautica ISDN router products and Instant Internet internet access server, which are key to on-line access
to corporate information and services such as the Internet, extend the backbone network beyond the branch office, bringing remote users closer to the enterprise.
The Remote Annex family of products, which are highly scalable and are offered in a variety of configurations, provide users with transparent dial-in access to Ethernet LANS. Users can access electronic mail, data bases and file servers residing on Novell NetWare, TCP/IP and AppleTalk LANs as if they were directly included with the network.
ISDN is a digital telephone connection that accommodates high bandwidth transmissions such as graphics, images or large text files and provides an immediate, high speed, reliable connection to network resources. The Nautica series of ISDN routers support a wide range of routed protocols including Novell IPX/SPX, TCP/SP, Netbios, Microsoft WINS and Banyan Vines as well as the OSPF and RIP2 routing protocols. These products provide bandwidth-on-demand, dial-on-demand, data compression security, configuration and network management features.
Instant Internet provides small offices and small-to-medium-sized businesses easy, secure access to the internet, by providing an all-in-one unit to connect NetWare, Windows '95 and Windows NT users directly to the internet without requiring any time-consuming changes to LAN clients or servers.
SALES CHANNELS
The Company's global market strategy emphasizes the support of sales and service through a network of value added resellers ("VARs"), distributors, networking OEMs and, through its domestic field sales force, directly to major customers. The goal of the multi-channel strategy is to offer the Company flexibility to meet specific needs and furnish the Company with broad coverage of worldwide markets.
Value Added Resellers. VARs integrate the Company's products, along with products sold by other LAN and WAN vendors, into turnkey networking systems that are sold directly to end users. VARs also sell the Company's products as stand-alone units. The Company provides support to the VAR network through its field sales force and customer service organization, so that in addition to sales generated independently, VAR sales are also the result of sales leads generated by the Company's direct marketing efforts. Sales to VARs are made at discounts based on purchase volumes and other incentive programs. VARs may choose to procure the the Company products they resell by purchasing directly from the Company or from its distributors as described below.
Distributors. The Company also sells its products to distributors who typically resell to VARs or other dealers. Distributors must meet certain criteria that are substantially different from those which the Company's VARs must meet. The Company's distributors generally provide a minimal level of systems integration. Distributors purchase at standard discounts based on certain incentive programs. The Company offers additional sales and marketing programs to assist those VARs and dealers who purchase through distributors in promoting, selling and supporting the Company's products.
The Company's VARs and distributors may carry other products which are complementary to, or compete with those of the Company, and these non-exclusive VARs and distributors may choose to give higher priority to products of other suppliers or competitors.
Field Sales Force. The Company's field sales force manages its sales activities through multi-channel distribution strategies. The Company's customers include end-users of large, complex, enterprise-wide networks, who typically provide their own systems integration. The field sales and technical support force also provides training and technical support to the Company's VARs, distributors and end-users.
Marketing. The Company has implemented several marketing programs designed to support the sale of its products through broad-scale reseller distribution (two-tier distributors and direct resellers), generate sales leads for its distribution channels and enhance brand name recognition. The Company's marketing activities include frequent participation in industry trade shows and seminars, advertisements in major trade publications worldwide, publications of technical articles in the trade press, the distribution of sales literature and
product specifications and ongoing communications with its installed base of end-user customers. The Company's reseller and distribution programs include incentives and benefits such as Co-op and reseller marketing programs.
CUSTOMERS AND BACKLOG
The Company's product backlog on June 30, 1996, was approximately $120 million as compared to product backlog on June 30, 1995, of approximately $231 million. The Company includes in its backlog only orders confirmed with a purchase order for products to be shipped within six months. Because of the generally short cycle between order and shipment, and occasional customer changes in delivery schedules or cancellation of orders which are made without significant penalty, the Company does not believe that its backlog as of any particular date is necessarily indicative of actual net sales for any future period. One reseller, Anixter Inc., a wholly-owned subsidiary of Anixter International, Inc., accounted for approximately 13% ($263.0 million), 14% ($198.0 million) and 14% ($162.0 million) of the Company's revenue in fiscal 1996, fiscal 1995 and fiscal 1994, respectively.
The Company has attempted to reduce its product manufacturing lead times and its backlog of orders. To the extent that backlog is reduced during any particular period, it could result in more variability and less predictability in the Company's quarter to quarter revenue and operating results. If manufacturing lead times are not reduced, the Company's customers may cancel, or not place, orders if shorter lead times are available from other manufacturers. In addition, the Company's ability to meet customer demand may also be dependent on the ability of the Company to increase manufacturing levels for new products to volumes based on anticipated orders by the market.
CUSTOMER SUPPORT, SERVICE AND WARRANTY
The Company services, repairs and provides technical support for its products. A significant portion of the Company's service and support activities is related to software and network configuration and is provided by the Company's assistance centers. The Company has contracted with third parties to supplement service provided directly by the Company for on-site hardware maintenance. International service is provided primarily by distributors, supplemented with phone support centers in France, Japan and Australia. The Company sells products to end-users with warranty periods of up to twelve months from the date of shipment for domestic sales and up to fifteen months from the date of shipment for international export sales. Following the expiration of the warranty period, if any, the Company offers services under maintenance contracts or on a time and materials basis. The Company also provides on-site network support services such as system installation, network integration services and technical consulting.
RESEARCH AND DEVELOPMENT
The Company has devoted significant resources to research and development, spending $213.5 million, $145.3 million and $117.6 million during the fiscal years ended June 30, 1996, 1995 and 1994, respectively.
During fiscal 1996, the Company continued development of enhancements to its current products and to the development of new products in the areas of emerging technologies such as ATM, remote access, switched internetworking technologies, and the integration of voice, video and data networking. The Company plans to continue its commitment to research and development in fiscal 1997, as the Company believes that the markets for its products are characterized by rapid rates of technological innovation for both hardware and software.
MANUFACTURING
The Company's manufacturing operations are located at its Santa Clara and Sunnyvale, California; Billerica and Burlington, Massachusetts; Tel Aviv, Israel and San Antonio, Texas facilities. The Company uses contract manufacturers in the United Kingdom for its Nautica(TM) product line to meet product demands for the United Kingdom market.
The Company's manufacturing process consists of purchasing; automated, semi-automated and manual assembly; burn in processing; in-circuit testing; final assembly and test; and inspection.
Most of the components used in the Company's products are available from more than one supplier. Failure of the Company's vendors to supply required items could have a material adverse effect upon the Company's business. The Company seeks to maintain an inventory level sufficient to meet its anticipated short-term production needs. In the past, the Company has paid premiums to secure adequate supplies of components, and it could become necessary to make such payments again in the future.
COMPETITION
The data networking industry has grown in the past few years, however, the Company's revenue may fluctuate year over year or any quarter over quarter based on competition and customers waiting for anticipated product introductions. The networking industry is highly competitive and competition is expected to intensify and could adversely affect the Company's future results. Networking and communications suppliers compete in areas such as: conformity to existing and emerging industry standards; interoperability with other networking products; the ability to run Ethernet, token ring and FDDI networks on most common cabling systems; network management capabilities; ease of use; scalability; price; performance; reliability; product features; technical support; marketing expertise; and product innovation.
There are many companies competing in various segments of the intelligent hub, switching, router and remote access network markets. The Company's principal competitors include Ascend Communications, Cabletron Systems, Inc., Cascade Communications, Cisco Systems, Inc., Digital Equipment Corporation, Fore Systems, Inc., Hewlett-Packard Company, Inc., International Business Machines Corporation and 3Com Corporation, among others. Several of the Company's competitors have greater name recognition, more extensive engineering, manufacturing and marketing capabilities, and greater financial, technological and personnel resources than those available to the Company. In addition, certain companies in the networking industry have expanded their product lines or technologies in recent years as a result of acquisitions. Specifically, 3Com Corporation acquired Chipcom Corporation and Cisco Systems, Inc. recently acquired Stratacom, Inc. Cisco Systems, Inc. also recently announced its intention to acquire Telebit Corporation. There can be no assurance that the Company will be able to compete successfully in the future with existing or new competitors.
With industry standards established and new standards emerging, more companies have developed standards-based products and have sought to compete on the basis of price. Pressures from competitors offering lower priced products could result in future price reductions for the Company's products.
PROPRIETARY RIGHTS AND LICENSES
The Company currently relies upon a combination of patents, copyrights, trademarks and trade secret laws to establish and protect its proprietary rights in its products. The Company maintains as proprietary the software and other portions of the technology incorporated in its network management and other products, and may license that technology to others as necessary. There can be no assurance that the steps taken by the Company in this regard will be adequate to prevent misappropriation of its technology or that the Company's competitors will not independently develop technologies that are substantially equivalent or superior to the Company's technology. In addition, the laws of some foreign countries do not protect the Company's proprietary rights to the same extent as do the laws of the United States. The Company has a number of patents and may apply for additional patents. There can be no assurance that patents will issue from any applications filed by the Company or that, if patents do issue, the claims will be sufficiently broad to protect the technology invented by the Company. In addition, no assurance can be given that any patents issued to the Company will not be challenged, invalidated or circumvented or that the rights granted thereunder will provide competitive advantages.
Because of the existence of a large number of patents in the networking field and the rapid rate of issuance of new patents or new standards that may issue or to obtain important technology, it may be necessary for the Company to enter into technology licenses from others. Such licenses could impact the
Company's operating results, and there is no assurance that the Company will be able to license such technology.
EMPLOYEES
As of June 30, 1996, the Company employed 5,758 persons, including regular, temporary and contract employees, none of whom is represented by a labor union. The Company has experienced no work stoppages and considers its employee relations to be positive.
ITEM 2.

ITEM 2. PROPERTIES
The Company's principal executive facility is located at the Company's corporate headquarters in Santa Clara, California. The Company has eastern operations located in Billerica and Burlington, Massachusetts. The Company has administrative, sales and marketing, product development, manufacturing and support facilities at both locations.
The Santa Clara facilities consist of approximately 1,021,975 square feet under leases that expire from April, 1999 to November, 2002. The Company has an option to renew certain of these leases for two additional five-year terms. The Company's Massachusetts facilities consist of approximately 663,963 square feet under leases that will expire through February, 2001 and the Company has an option to renew certain of these leases for various terms. The Company has additional fiscal year 1997 lease commitments in Billerica, Massachusetts, of approximately 165,000 square feet.
A subsidiary of the Company has a fifty percent interest in a limited partnership which owns one of the Company's manufacturing facilities. Of the above total, the Company leases 118,000 square feet from the limited partnership. The Company has, also included in the above total, approximately 405,113 square feet of space in other manufacturing buildings in Sunnyvale and Santa Clara, California, and Billerica, Massachusetts.
The Company acquired additional manufacturing, research and development operations during fiscal year 1996. Bay Networks Israel (1996) Ltd., which acquired the business of Armon Networking, Ltd. in Tel Aviv, Israel occupies 27,975 square feet and Performance Technology, Inc. in San Antonio, Texas, occupies 19,413 square feet.
Some of the Company's manufacturing and distribution facilities, as well as a portion of the Company's research and development, and sales and administrative functions, are located in areas of seismic risk. The Company's future operating results could be materially affected by a major earthquake.
The Company leases and occupies sales and service offices in 36 states throughout the United States and Puerto Rico and 34 countries worldwide. The Company's worldwide operations are located in Argentina, Australia, Austria, Belgium, Brazil, Canada, Cayman Islands, China, Colombia, Denmark, Finland, France, Germany, Hong Kong, India, Indonesia, Israel, Italy, Japan, Korea, Malaysia, Mexico, the Netherlands, New Zealand, Norway, Portugal, Russia, Singapore, South Africa, Spain, Sweden, Switzerland, Taiwan, Thailand, United Arab Emirates and the United Kingdom.
ITEM 3.

ITEM 3. LEGAL PROCEEDINGS
From time to time, as a normal incidence of the nature of the Company's business, various claims, charges and litigation are asserted or commenced against the Company. In the opinion of management, final judgments from such claims, charges and litigation, if any, against the Company would not have a material adverse effect on its consolidated financial position, results of operations or cash flows.
At various times the Company has been approached by others claiming to hold valid patents applicable to its products, who have offered to license the patented technology. The Company may enter into such licensing agreements or may vigorously contest such claims, depending upon the specific circumstances.
ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of the security holders during the fourth quarter ended June 30, 1996.
MANAGEMENT
The executive officers of the Company are as follows:
PART II
ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
STOCK MARKET INFORMATION (UNAUDITED)
The following tables set forth, for the periods indicated, the high and low closing prices for the Company's common stock as reported by The Nasdaq Stock Market and the New York Stock Exchange. The Company began trading on the New York Stock Exchange on February 29, 1996. The prices shown for the period that the Company's common stock was traded on The Nasdaq Stock Market represent quotations among dealers without adjustments for retail markups, markdowns, or commissions and may not represent actual transactions.
As of June 30, 1996, the Company had approximately 4,332 stockholders of record. To date, the Company has not paid any cash dividends on its capital stock, and there can be no assurances that the Company will do so.
ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA
- - --------------- (1) All amounts and per share data for prior periods have been retroactively restated to reflect the acquisition of Xylogics, Inc. in a pooling of interests transaction effective December 15, 1995. (See Note 2 to Notes to Consolidated Financial Statements.) All per share data applicable to prior periods have also been retroactively restated to reflect a three-for-two stock split, in the form of a stock dividend, effective November 24, 1995.
(2) Includes charges of $39.7 million, $6.7 million, $17.9 million and $17.9 million for the years ended June 30, 1996, 1995, 1994 and 1993, respectively, for in-process research and development charges resulting from acquisitions and $10.2 million and $63.4 million for the years ended June 30, 1996 and 1995 for merger related expenses.
ITEM 7.

ITEM 7.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Business Environment and Risk Factors. The following discussion should be read in conjunction with the consolidated financial statements and related notes included elsewhere herein as well as the section below under the heading "Risk Factors That May Affect Future Results". The Company's future operating results may be affected by various trends and factors which are beyond the Company's control. These include, among other factors, changes in general economic conditions, rapid or unexpected changes in technologies and uncertain business conditions that affect the data networking industry. Accordingly, past results and trends should not be used by investors to anticipate future results or trends.
With the exception of historical information, the matters discussed below under the headings "Results of Operations" and "Liquidity and Capital Resources" may include forward-looking statements that involve risks and uncertainties. The Company wishes to caution readers that a number of important factors, including those identified in the section entitled "Risk Factors That May Affect Future Results," as well as factors discussed elsewhere in this report and in the Company's other reports filed with the Securities and Exchange Commission, could affect the Company's actual results and cause actual results to differ materially from those in the forward-looking statements.
Results of Operations
Revenue. Revenue increased 46.5% to $2,056.6 million in fiscal 1996 as compared to $1,403.6 million in fiscal 1995 and $1,136.4 million in fiscal 1994. The growth in revenue in fiscal 1996 was attributable to market growth and strong demand for the Company's products. This growth was a result of worldwide unit volume increases for virtually all of the Company's product lines. While sales in all major product areas increased, the highest percentage increase was in the switching product line; the Company's new products in the remote access market, including the Xylogics' Nautica line, were particularly well received in those markets. Revenue from the router product line grew over fiscal 1995 as sales to the telecommunications industry increased. The increase in revenue in fiscal 1995 was attributable to growth in market demand for the Company's products with growth across all of the Company's product lines. The Company has continued to increase revenue through execution of its multi-channel distribution strategy and growth in international operations.
International revenue was $716.5 million or 34.8% of total revenue in fiscal 1996, compared to $458.4 million or 32.7% of total revenue and $345.7 million or 30.4% of total revenue in fiscal 1995 and fiscal 1994, respectively. The increase in each period was primarily due to the Company's international expansion and growth in the Asia/Pacific market, as well as continued growth in the European market. The Company continues to emphasize the multi-channel sales strategy which consists of qualified resellers, distributors and dealers. The Company's international revenue was primarily denominated in U.S. dollars. The effect of foreign exchange rate fluctuations did not have a significant impact on the Company's operating results in any period.
Revenue in past periods may not be indicative of revenue in the future, which may be affected by other business environment and risk factors previously discussed, as well as other factors included elsewhere herein.
Gross Profit. Gross profit was $1,111.3 million or 54.0% of revenue in fiscal 1996, compared to $772.6 million or 55.0% of revenue and $630.7 million or 55.5% of revenue in fiscal 1995 and fiscal 1994, respectively. The gross profit increase was due to sequentially higher worldwide unit volume each year. The gross margin percentage decline in fiscal 1996 was affected by several factors: a product mix shift towards shared media, including increased volumes of stackable Ethernet products, and additional reserves for excess inventory as a result of product transitions that occurred in fiscal 1996. The decline was partially offset by manufacturing cost reductions, reductions in material premium charges, and increased router sales which carry higher margins. The decline in fiscal 1995 was primarily from competitive list price reductions, product mix shifts toward non-modular products which carry lower margins, and price increases on certain components.
The Company believes there is a risk that gross margin percentages may decline if the product mix continues to shift towards non-modular products and competition continues to increase. The Company expects
market emphasis on lower margin routers and high-speed switching products in the future. Other factors, including changes in material and labor costs and distribution channels, may also have an adverse effect on gross margin percentages in the future.
Operating Expenses. Research and development spending grew by 46.9% to $213.5 million in fiscal 1996 from $145.3 million in fiscal 1995 and 23.6% from $117.6 million in fiscal 1994 as compared with fiscal 1995, although the percentage of revenue of 10.4% remained constant for each fiscal year. The increase in expense relates to the Company's continued development of enhancements to its current products and to the development of new products and addition of personnel through hiring and through acquisitions and business combinations. During the year, the Company continued development of new products in the areas of emerging technologies such as ATM, remote access, switched internetworking technologies, and the integration of voice, video and data networking. The Company plans to continue its commitment to research and development in fiscal 1997, as the Company believes that the markets for its products are characterized by rapid rates of technological innovation for both hardware and software. Research and development expenses may increase in absolute dollars in future periods, and such expenditures may vary as a percentage of revenue. There can be no assurance that the Company's research and development efforts will result in commercially successful new technology and products in the future, and those efforts may be affected by other factors noted below.
Selling and marketing expenses were $452.3 million or 22.0% of revenue in fiscal 1996, compared to $302.5 million or 21.6% of revenue and $246.8 million or 21.7% of revenue in fiscal 1995 and fiscal 1994, respectively. The increase in expense in both fiscal 1996 and fiscal 1995, as compared with the prior fiscal year, was primarily related to the increased costs associated with larger sales and sales support staffs, commission expenses resulting from higher sales levels, expansion of the Company's sales and marketing programs, and investments related to new product launches and entry into new markets worldwide. The Company's investment in its sales, marketing and support staff may vary as a percentage of revenue in the future.
General and administrative expenses were $72.2 million or 3.5% of revenue in fiscal 1996, compared to $55.7 million or 4.0% of revenue and $47.5 million or 4.2% of revenue in fiscal 1995 and fiscal 1994, respectively. The absolute dollar increase in general and administrative expenses each year related to the addition of personnel, and expenditures related to both domestic and international facilities and information technology needed to support the growth in the Company's business. General and administrative expenses may vary as a percentage of revenue in the future.
In fiscal 1996, the Company acquired all of the outstanding shares of Performance Technology, Inc., a developer of LAN-to-Internet access technology, for a total purchase price of $12.6 million, and substantially all of the net assets of Armon Networking, Ltd., a technology developer of RMON-based distributed analysis tools and multi-segment LAN probes, for a total purchase price of $34.2 million. Approximately $39.7 million was charged to in-process research and development related to internetworking technologies associated with these acquisitions.
The Company incurred in-process research and development expenses of $6.7 million and $17.9 million related to the acquisitions of Scorpion Ltd. and Coral Network Corporation in fiscal 1995 and 1994, respectively.
In June 1996, the Company signed a definitive agreement to acquire the Digital Signal Processing (DSP) modem business of Penril DataComm Networks, Inc., a provider of advanced DSP-based modems and remote access products. Based on preliminary estimates, the Company expects to allocate approximately $60 million to $65 million of the total purchase price, which is based on a fixed formula, to in-process research and development, which will be charged to expense upon the closing of the transaction, currently expected to be in the quarter ending December 31, 1996.
As a result of the various business combinations in fiscal 1996 and 1995, the Company has incurred merger related expenses of $16.1 million and $63.4 million, respectively. These merger related expenses related to transaction costs, severance related expenses, closing of duplicate facilities, write off of duplicate inventory and other assets and other costs incident to the transactions. In fiscal 1996, the Company reversed previously accrued merger costs of $5.9 million associated with the Wellfleet/SynOptics business combination
and the Centillion acquisition. The reduction in the estimated costs were realized primarily due to the usage of facilities which the Company had previously planned to vacate. (See Note 2 to the Notes to Consolidated Financial Statements.)
Net Interest Income and Other. Net interest income and other was $28.5 million, or 1.4% of revenue in fiscal 1996, compared to $21.8 million or 1.6% of revenue and $7.3 million or 0.6% of revenue in fiscal 1995 and fiscal 1994, respectively. The increase in absolute dollars in interest income was due to higher average invested cash and investment balances, which yielded higher interest income in fiscal year 1996 and 1995.
Income Taxes. The Company's effective income tax rate was 37.5%, 37.8% and 37.6% in fiscal 1996, fiscal 1995 and fiscal 1994, respectively, and excludes the effect of the in-process research and development charges and certain merger related expenses which were not deductible for income tax purposes. At June 30, 1996, a valuation allowance of $6.8 million was offset against the net operating losses and credit carryforwards acquired from Coral Network Corporation, Centillion Networks, Inc. and Performance Technology, Inc. which are subject to substantial limitation. Management has concluded that other than the allowance related to these acquisitions, no valuation allowance is required based on its assessment that future levels of taxable income will be sufficient to realize the future tax benefits represented by the deferred income taxes.
Liquidity and Capital Resources. As of June 30, 1996, total cash and short- and long-term investments totaled $588.2 million, down from $651.6 million at June 30, 1995. Cash generated from operating activities declined to $105.9 million, compared to $258.1 million and $169.0 million in fiscal 1995 and fiscal 1994, respectively.
Cash provided from operations decreased from the prior year due to an increase in income before depreciation and amortization which was more than offset by increases in accounts receivable and inventory. The increase in accounts receivable in fiscal 1996 was due to revenue growth, including the continued expansion in international operations relative to total operations which typically have longer collection cycles. Days sales outstanding in receivables were 54 days at June 30, 1996 compared to 40 days at June 30, 1995. Days sales outstanding may continue to vary, due to, among other things, timing of product shipments and international expansion. The increase in inventory was primarily attributable to increasing inventory levels to meet desired manufacturing lead times and anticipated demand for new product introductions.
The Company used $119.7 million, $298.5 million and $222.3 million for investing activities in fiscal 1996, fiscal 1995 and fiscal 1994, respectively. The consumption of cash in fiscal 1996 was due to increases in property, plant and equipment needed for increased levels of business and the Company's information technology. The Company expects to spend additional cash related to additional property, plant and equipment and information technology required to support the Company's operations in fiscal 1997. Furthermore, the Company acquired two companies in fiscal 1996, Performance Technology, Inc., for $12.6 million, and Armon Networking, Ltd., for $34.2 million, for the purpose of entering new markets, including the Internet market. The major investing activities in fiscal 1995 and fiscal 1994 were primarily attributable to capital additions to support business operations.
Financing activities provided $44.9 million, $34.3 million and $24.5 million in fiscal 1996, fiscal 1995 and fiscal 1994, respectively. The cash generated from financing activities was primarily due to cash received in connection with the issuance of stock under the Company's stock plans, which resulted in net proceeds of $45.4 million, $34.0 million and $24.4 million, respectively.
A subsidiary of the Company has outstanding $110 million of convertible subordinated debentures which bear interest of 5 1/4% per annum, payable semi-annually, and mature in May 2003. The debentures are convertible at the option of the holder into the Company's common stock at a conversion price of $42.61 per share. The Company has reserved 2,581,725 shares of common stock for the conversion of these debentures. Beginning May 1996, the debentures are redeemable at the option of the Company, initially at approximately 103.7% and at decreasing prices thereafter to 100% at maturity. To date, the Company's management has made no decision whether to redeem the debentures.
The Company believes that it has the financial resources needed to meet business requirements, including capital expenditures, working capital requirements, the debt obligations outstanding and operating lease commitments for facilities at least through the next twelve months.
RISK FACTORS THAT MAY AFFECT FUTURE RESULTS.
As noted above, the foregoing discussion may include forward-looking statements that involve risks and uncertainties. In addition, Bay Networks identifies the following risk factors which could affect the Company's actual results and cause actual results to differ materially from those in the forward-looking statements.
Risks Related to New Products. The Company's future revenue is dependent on its ability to successfully develop, manufacture and market products for customers worldwide. In this regard, future growth is dependent on the Company's ability to timely and successfully develop and introduce new products, establish new distribution channels, develop affiliations with leading market participants which facilitate product development and distribution, and market existing and new products with service providers, resellers and channel partners, and others. Also, future revenue may be affected in part by factors which influence the business of the Company's direct and indirect resellers, such as the resellers' organization structure, purchasing patterns and inventory levels.
The Company believes that the markets for its products are characterized by rapid rates of technological innovation for both hardware and software. There can be no assurance that the Company's research and development efforts will result in commercially successful new technology and products in the future. In addition, as the technical complexity of new products increases, it may become increasingly difficult to introduce new products quickly and according to schedule.
Risks Related to Recent Developments. The Company recently announced an internal reorganization and implemented a new information system which it believes will better serve its customers and the market overall. There can be no assurances that these actions will achieve the Company's objectives.
Dependence on Personnel. The Company's success depends upon the continued contributions of its personnel, many of whom would be difficult to replace. The success of the Company will depend on the ability of the Company to attract and retain skilled employees. Changes in personnel, therefore, could adversely affect operating results.
Risks Related to Gross Margin. The Company's gross margin percentage is a function of the product mix sold in any period. Other factors such as unit volumes, obsolescence of inventory, heightened price competition, changes in channels of distribution, shortages in components due to timely supplies of parts from vendors or ability to obtain items at reasonable prices, and availability of skilled labor, also may continue to affect the cost of sales and the fluctuation in gross margin percentages in future periods. In the past, the Company has paid premiums to secure adequate supplies of components, and it could become necessary to make such payments again in the future.
Risks Related to Timing of Product Shipments. One of the risks potentially affecting the Company's operating results is the fact that a substantial portion of the Company's revenue in any period may result from shipments during the latter part of a period. Because the Company establishes its operating expense level based on its operational goals, if shipments in any period do not meet goals, net profits may be adversely affected.
Risks Related to Backlog. The Company has attempted to reduce its product manufacturing lead times and its backlog of orders. To the extent that backlog is reduced during any particular period, it could result in more variability and less predictability in the Company's quarter to quarter revenue and operating results. If manufacturing lead times are not reduced, the Company's customers may cancel, or not place, orders if shorter lead times are available from other manufacturers. In addition, the Company's ability to meet customer demand may also be dependent on the ability of the Company to increase manufacturing levels for new products to volumes required based on anticipated orders by the market.
Risks Related to Intellectual Property Rights. The Company currently relies upon a combination of patents, copyrights, trademarks and trade secret laws to establish and protect its proprietary rights in its products. The Company maintains as proprietary the software and other portions of the technology incorporated in its network management and other products, and may license that technology to others as necessary. There can be no assurance that the steps taken by the Company in this regard will be adequate to prevent misappropriation of its technology or that the Company's competitors will not independently develop technologies that are substantially equivalent or superior to the Company's technology. In addition, the laws of some foreign countries do not protect the Company's proprietary rights to the same extent as do the laws of the United States. The Company has a number of patents and may apply for additional patents. There can be no assurance that patents will issue from any applications filed by the Company or that, if patents do issue, the claims will be sufficiently broad to protect the technology invented by the Company. In addition, no assurance can be given that any patents issued to the Company will not be challenged, invalidated or circumvented or that the rights granted thereunder will provide competitive advantages.
Because of the existence of a large number of patents in the networking field and the rapid rate of issuance of new patents or new standards that may issue or to obtain important technology, it may be necessary for the Company to enter into technology licenses from others. Such licenses could impact the Company's operating results, and there is no assurance that the Company will be able to license such technology.
Risks Related to New Markets. During 1996, the Company entered new markets, including the remote access and Internet markets, primarily through the acquisition of other businesses. The revenue or net profits from these new markets and businesses has not been material in the past. At present, these new markets are undeveloped and rapidly changing. If these markets do not develop, or if the Company's strategies for these markets are unsuccessful, the Company's operating results may be adversely affected.
Revenue Fluctuations and Competition. The data networking industry has grown in the past few years, however, the Company's revenue may fluctuate year over year or any quarter over quarter based on competition and customers waiting for anticipated product introductions. The networking industry is highly competitive and competition is expected to intensify and could adversely affect the Company's future results. Networking and communications suppliers compete in areas such as: conformity to existing and emerging industry standards; interoperability with other networking products; the ability to run Ethernet, token ring and FDDI networks on most common cabling systems; network management capabilities; ease of use; scalability; price; performance; reliability; product features; technical support; marketing expertise; and product innovation.
There are many companies competing in various segments of the intelligent hub, switching, router and remote access network markets. The Company's principal competitors include Ascend Communications, Cabletron Systems, Inc., Cascade Communications, Cisco Systems, Inc., Digital Equipment Corporation, Fore Systems, Inc., Hewlett-Packard Company, Inc., International Business Machines Corporation and 3Com Corporation, among others. Several of the Company's competitors have greater name recognition, more extensive engineering, manufacturing and marketing capabilities, and greater financial, technological and personnel resources than those available to the Company. In addition, certain companies in the networking industry have expanded their product lines or technologies in recent years as a result of acquisitions. Specifically, 3Com Corporation acquired Chipcom Corporation and Cisco Systems, Inc. recently acquired Stratacom, Inc. and announced its intention to acquire Telebit Corporation, a manufacturer of digital modems. There can be no assurance that the Company will be able to compete successfully in the future with existing or new competitors.
With industry standards established and new standards emerging, more companies have developed standards-based products and have sought to compete on the basis of price. Pressures from competitors offering lower priced products could result in future price reductions for the Company's products.
Risks Related to Acquisitions. To implement its business plans, the Company may make further acquisitions in the future. Acquisitions require significant financial and management resources both at the time of the transaction and during the process of integrating the newly acquired business into the Company's
operations. The Company's operating results could be adversely affected if it is unable to successfully integrate such new companies into its operations. Certain acquisitions or strategic transactions may be subject to approval by the other party's board or shareholders, domestic or foreign governmental agencies, or other third parties. Accordingly, there is a risk that important acquisitions or transactions could fail to be concluded as planned. Future acquisitions by the Company could also result in issuances of equity securities or the rights associated with the equity securities, which could potentially dilute earnings per share. In addition, future acquisitions could result in the incurrence of additional debt, taxes, or contingent liabilities, and amortization expenses related to goodwill and other intangible assets. These factors could adversely affect the Company's future operating results and financial position.
Reliance on Resellers and Distributors. VAR and distributor networks have continued to represent an important part of the Company's overall sales and distribution strategy. While the Company is not dependent on any single VAR or distributor, the loss of, or changes in the relationship with or performance by, several VARs or distributors nevertheless could have a material adverse effect on the Company's revenue and operating results. The loss of, or changes in the relationship with or performance by, one or more international distributors could have a material adverse effect on the Company's revenue and operating results.
Risks Related to International Sales. International sales may be an increasingly important contributor to the Company's revenue and net profits. As a result, operating results are increasingly affected by the risks of such activities, including economic conditions in the international markets in which the Company sells its products and political and economic instability, fluctuations in currency exchange rates, changes in international regulatory requirements, international staffing and employment issues, tariffs and other trade barriers, import and export controls and the burden of complying with foreign laws. Sales into developing nations may fluctuate to a greater extent than sales to customers in developed nations, as those markets are only beginning to adopt new technologies and establish purchasing practices. These risks may adversely affect the Company's future operating results and financial position.
Risks Related to Government Regulations and Product Certification. The Company's operations are also subject to laws, regulations, government policies, and product certification requirements worldwide. Changes in such laws, regulations, policies, or requirements could affect the demand for the Company's products or result in the need to modify products, which may involve substantial costs or delays in sales and could have an adverse effect on the Company's future operating results.
Risks of Stock Volatility and Absence of Dividends. In recent years, the stock market in general and the market for technology stocks in particular, including the Company's common stock, have experienced extreme price fluctuations. There is a risk that stock price fluctuation could impact the Company's operations. Changes in the price of the Company's common stock could affect the Company's ability to successfully attract and retain qualified personnel or complete necessary business combinations or other transactions in the future. The Company has never paid any cash dividends on its capital stock, and there can be no assurance that the Company will do so.
ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors and Stockholders Bay Networks, Inc.
We have audited the accompanying consolidated balance sheets of Bay Networks, Inc. as of June 30, 1996 and 1995, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended June 30, 1996. These consolidated financial statements are the responsibility of the company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We did not audit the financial statements of Wellfleet Communications, Inc., which statements reflect net income constituting approximately 51% of the related 1994 consolidated financial statement total. Those statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to data included for Wellfleet Communications, Inc. is based solely on the report of the other auditors.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the report of other auditors provide a reasonable basis for our opinion.
In our opinion, based on our audits, and for 1994 the report of other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Bay Networks, Inc. at June 30, 1996 and 1995, and the consolidated results of its operations and its cash flows for each of the three years in the period ended June 30, 1996, in conformity with generally accepted accounting principles.
ERNST & YOUNG LLP
Palo Alto, California July 19, 1996
REPORT OF PRICE WATERHOUSE LLP, INDEPENDENT ACCOUNTANTS
The Board of Directors and Stockholders of Wellfleet Communications, Inc.
In our opinion, the consolidated statements of income, of stockholders' equity and of cash flows of Wellfleet Communications, Inc. and its subsidiaries (not presented separately herein) present fairly, in all material respects, the results of their operations and their cash flows for the year ended June 30, 1994, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the company's management; our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for the opinion expressed above. We have not audited the consolidated financial statements of Wellfleet Communications, Inc. for any period subsequent to June 30, 1994.
PRICE WATERHOUSE LLP
Boston, Massachusetts July 18, 1994
BAY NETWORKS, INC.
CONSOLIDATED BALANCE SHEETS (In thousands, except share and par value amounts)
The accompanying notes are an integral part of these financial statements.
BAY NETWORKS, INC.
CONSOLIDATED STATEMENTS OF INCOME (In thousands, except per share amounts)
The accompanying notes are an integral part of these financial statements.
BAY NETWORKS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (In thousands)
The accompanying notes are an integral part of these financial statements.
BAY NETWORKS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands)
The accompanying notes are an integral part of these financial statements.
BAY NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
The consolidated financial statements include the accounts of Bay Networks, Inc. (Bay Networks or the Company) and its subsidiaries. All significant intercompany accounts and transactions have been eliminated.
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.
Cash Equivalents, Fair Values of Financial Instruments & Concentration of Credit Risk
Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash equivalents, investments and trade receivables.
All of the Company's cash equivalents and investments are classified as available-for-sale and are reported at fair value with material unrealized gains and losses, if any, included in stockholders' equity. The fair value of investments is based on quoted market prices. Realized gains and losses are included in net interest income and other. Cash equivalents have original maturities of three months or less. The Company has cash equivalents and investments with various high quality institutions and, by policy, limits the amount of credit exposure to any one institution.
The Company sells its products to customers in diversified industries worldwide. The Company performs on-going credit evaluations of its customers' financial condition and generally does not require collateral. The Company maintains reserves for potential credit losses, and such losses have been within management's expectations and have not been material in any year. The Company's trade receivables are derived from sales spread across various industries and various geographical areas.
Foreign Currency Translation
The functional currency of each of the Company's international subsidiaries is the foreign subsidiary's local currency. Assets and liabilities of the Company's international operations are translated into U.S. dollars at exchange rates in effect at the balance sheet date. Income and expense items are translated at average exchange rates for the period. Accumulated net translation adjustments were not material. Foreign exchange transaction gains and losses were not material and are included in the results of operations.
Bay Networks' international business is an important contributor to the Company's revenue and net profits. However, the majority of Bay Networks' international sales are denominated in the U.S. dollar, and an increase in the value of the U.S. dollar relative to foreign currencies could make products sold internationally less competitive. The operating expenses of Bay Networks' overseas offices are paid in local currencies and are subject to the effect of fluctuations in foreign currency exchange rates. The effect of foreign exchange rate fluctuations did not significantly impact the Company's operating results. Financial exposure may nonetheless result, primarily from the timing of transactions and the movement of exchange rates.
BAY NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Inventories
Inventories, stated at the lower of cost (first-in, first-out) or market, consist of:
Property and Equipment
Property and equipment are stated at cost. Depreciation is provided for on the straight-line method over the estimated useful lives of the assets ranging from two to five years. Leasehold improvements are recorded at cost and are amortized using the straight-line method over the remaining lease term or the economic useful life, whichever is shorter.
Warranty
Upon shipment to its customers, the Company provides for the estimated cost to repair or replace products to be returned under warranty. The Company's warranty period is up to 12 months from the date of shipment for domestic sales and up to 15 months from the date of shipment for international export sales.
Revenue Recognition
The Company recognizes revenue from product sales and accrues for estimated returns at the time of shipment. Service revenue is recognized at the time service is provided or ratably over the contractual service period.
Advertising Costs
Advertising costs are charged to operations as incurred. Advertising expense was $18.2 million, $7.6 million and $8.4 million in 1996, 1995 and 1994, respectively.
Net Income per Share
Net income per share is calculated using the weighted average number of common shares and dilutive common share equivalents outstanding during the period. Dilutive common share equivalents consist of stock options using the treasury stock method.
BAY NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Stock Distribution
On November 24, 1995, the Company effected a stock distribution in the form of a three-for-two stock split to stockholders of record as of October 30, 1995. All share and per share amounts applicable to prior periods have been retroactively restated to reflect the effect of this split.
Effect of New Accounting Standards
In 1995, the Financial Accounting Standards Board (FASB) issued Statement No. 121 (SFAS 121), Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of. The Company will adopt SFAS 121 in the first quarter of fiscal year 1997 and, based on current circumstances, does not believe the effect of adoption will be material.
The Company accounts for its stock options and its employee stock purchase plan in accordance with the provisions of the Accounting Principles Board Opinion No. 25 (APB 25), Accounting for Stock Issued to Employees. In 1995, the FASB issued Statement No. 123 (SFAS 123), Accounting for Stock-Based Compensation. The Company intends to adopt the pro forma disclosure alternative of SFAS 123 for the Company's fiscal year 1997. The adoption of SFAS 123 is not expected to have a material effect on consolidated financial position, results of operations, or cash flows.
Reclassifications
Certain reclassifications have been made to the 1995 and 1994 consolidated financial statements to conform to the 1996 presentation.
2. BUSINESS COMBINATIONS
On October 21, 1994, SynOptics Communications, Inc. (SynOptics) and Wellfleet Communications, Inc. (Wellfleet) effected a strategic combination of the two companies through the merger of a wholly-owned subsidiary of Wellfleet with and into SynOptics (the Combination). In connection with the Combination, Wellfleet changed its name to Bay Networks, Inc. and issued 70,612,759 shares of common stock for all the outstanding stock of SynOptics in a transaction accounted for as a pooling of interests. The accompanying consolidated financial statements are presented on a combined basis for all periods presented.
In May 1995, Bay Networks acquired Centillion Networks, Inc. (Centillion) and issued 5,353,275 shares of common stock for all the outstanding stock of Centillion in a transaction accounted for as a pooling of interests. As the results of operations and financial position of Centillion were not material to Bay Networks' 1995 consolidated financial statements, the prior years' amounts were not restated.
In December 1995, Bay Networks acquired Xylogics, Inc. (Xylogics), in a transaction accounted for as a pooling of interests. The Company issued 8,710,865 shares of common stock for all the outstanding stock of Xylogics and reserved 1,655,275 shares of its common stock for issuance under Xylogics stock option plans which the Company assumed in the acquisition. The accompanying consolidated financial statements for prior periods have, accordingly, been restated to reflect this transaction.
BAY NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
2. BUSINESS COMBINATIONS (CONTINUED) The following information shows revenue and net income (loss) of the separate companies through the periods preceding the business combinations and the combined results following the business combinations.
- - --------------- (1) Xylogics' net loss includes a portion of the merger related expenses.
Merger related expenses for these transactions were as follows:
Of the total amount for the year ended June 30, 1995, $61.1 million relates to the Wellfleet/SynOptics combination and $2.3 million relates to the Centillion acquisition. Of the total amount for the year ended June 30, 1996, $16.1 million relates to the Xylogics acquisition and $5.9 million represents a reversal of previously recorded merger related expenses in connection with the prior year's transactions. Such reduction in the previous estimate was due primarily to the usage of facilities which the Company had previously planned to vacate. The remaining $5.5 million accrued at June 30, 1996 allows for accrued rent and severance related expenses to be paid principally over periods of up to two years.
The Company has acquired several smaller businesses, each of which has been accounted for as a purchase. Bay Networks purchased Performance Technology, Inc. for approximately $12.6 million and Armon
BAY NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
2. BUSINESS COMBINATIONS (CONTINUED) Networking, Ltd. for approximately $34.2 million in 1996; Scorpion Ltd. for approximately $9.3 million in 1995; and Coral Network Corporation for approximately $18.0 million in 1994. The purchase price of each acquired company was allocated to the acquired assets and liabilities based on their estimated fair values as of the date of respective acquisition. Amounts allocated to developed technology, workforce and goodwill are being amortized on a straight-line basis over a five year period. Amounts allocated to in-process research and development of approximately $39.7 million, $6.7 million and $17.9 million in 1996, 1995 and 1994, respectively, were expensed upon the closing of the respective transactions. Pro forma information has not been presented because the effects of these acquisitions were not material to the Company's consolidated financial position, results of operations, or cash flows.
On June 16, 1996, Bay Networks signed a definitive agreement to acquire the Digital Signal Processing (DSP) modem business of Penril DataComm Networks, Inc. (Penril), a provider of advanced DSP-based modems and remote access products. Under terms of the agreement, the Company will exchange $10 payable in the Company's common stock according to an exchange value determined by averaging the Company's closing stock prices over a specified period prior to closing, for each share of Penril's common stock. (At June 6, 1996, Penril had 10,543,369 shares of common stock outstanding.) Immediately prior to the closing of this transaction, the remaining non-DSP modem businesses of Penril will be spun off to Penril stockholders. This acquisition is subject to regulatory approval and Penril stockholders' approval. The acquisition will be accounted for as a purchase. Based on preliminary estimates, the Company expects to allocate approximately $60 million to $65 million to in-process research and development, which will be charged to expense upon the closing of the transaction, currently expected to be in the quarter ending December 31, 1996.
3. FINANCIAL INSTRUMENTS
Cash, Cash Equivalents and Investments
All of Bay Networks' cash, cash equivalents and investments were classified as available-for-sale and consist of the following:
BAY NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
3. FINANCIAL INSTRUMENTS (CONTINUED) The estimated fair value of available-for-sale securities by contractual maturity is as follows:
Both gross unrealized gains and losses as of June 30, 1996 and 1995, and realized gains and losses on sales of each type of security for the years ended June 30, 1996 and 1995, were immaterial. At June 30, 1996 and 1995, the fair market value of available-for-sale investments and cash equivalents approximates cost. For the purpose of determining gross realized gains and losses, the cost of securities sold is based upon specific identification.
Long-Term Debt
A subsidiary of the Company has outstanding $110,000,000 of convertible subordinated debentures which bear interest of 5 1/4% per annum, payable semi-annually, and mature in May 2003. The debentures are convertible at the option of the holder into the Company's common stock at a conversion price of $42.61 per share. Beginning May 1996, the debentures are redeemable at the option of the Company, initially at approximately 103.7% and at decreasing prices thereafter to 100% at maturity. The fair value of these debentures is estimated based on quoted market prices obtained from a third party for similar debt and is approximately $99.7 million and $101.3 million as of June 30, 1996 and 1995, respectively. The Company has reserved 2,581,725 shares of common stock for the conversion of these debentures. Interest expense, primarily related to these debentures, was approximately $5.9 million, $6.0 million and $5.9 million in 1996, 1995 and 1994, respectively.
4. COMMITMENTS AND CONTINGENCIES
Leases
The Company leases its domestic and international facilities under cancelable, non-cancelable and month-to-month operating leases. Rent expense was approximately $27.5 million, $22.7 million and $18.4 million in 1996, 1995 and 1994, respectively.
A subsidiary of the Company has a fifty percent interest in a limited partnership which owns one of the Company's manufacturing facilities. The Company leases this facility from the limited partnership. Included in the operating lease commitments table below are $13.7 million related to this facility.
BAY NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
4. COMMITMENTS AND CONTINGENCIES (CONTINUED) Future minimum lease payments as of June 30, 1996, of which $2.1 million has been accrued as merger related expenses, are as follows:
Legal
From time to time, as a normal incidence of the nature of the Company's business, various claims, charges and litigation are asserted or commenced against the Company. In the opinion of management, final judgments from such claims, charges and litigation, if any, against the Company would not have a material adverse effect on its consolidated financial position, results of operations, or cash flows.
5. EQUITY
Employee Stock Option Plans. Bay Networks established a Stock Option Plan in 1994 under which it authorized 30,000,000 shares of common stock for granting of either incentive or non-qualified stock options and increased the authorized shares to 41,700,000 in 1996. Exercisability, option price and other terms are determined by the Board of Directors, but the option price shall not be less than the fair market value of the stock at the date of grant. Shares of options generally vest at the rate of 25% after one year from the date of grant, and then ratably over the following 36 months. At June 30, 1996, 13,339,025 shares of common stock were reserved for future grants.
Pursuant to business combinations in 1995, the Company assumed stock option plans under which options were generally exercisable upon grant and vested at the rate of 25% after one year from the date of grant, and then ratably over the following 36 months; however, those shares received upon exercise prior to vesting were subject to repurchase by the Company. As of June 30, 1996, 60,222 shares were subject to repurchase.
Additionally, on December 15, 1995, pursuant to the acquisition of Xylogics, Bay Networks assumed 1,655,275 outstanding options originally issued under various Xylogics stock option plans. The options generally vest at the rate of 25% per year beginning one year from the date of grant.
Outside Directors Stock Option Plans. Bay Networks established an Outside Directors Stock Option Plan in 1994 under which it authorized 750,000 shares of the common stock pursuant to a fixed formula for granting of non-qualified stock options to directors of the Company who are not employees of the Company (Outside Directors) at exercise prices not less than the fair market value on the date of grant. Upon initial election or appointment, an Outside Director shall automatically receive an option to purchase 52,500 shares of common stock. An Outside Director is granted an additional 15,000 shares of common stock automatically on each of the second through seventh anniversary dates of his or her initial grant. The options granted under the Directors Stock Option Plan generally vest at a rate of 33 1/3% on the one year anniversary of the date of
BAY NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
5. EQUITY (CONTINUED) grant and then ratably over the following 36 months. As of June 30, 1996, 495,000 shares of common stock were reserved for future grants.
Additional information concerning stock option activity under the various plans is as follows:
Employee Stock Purchase Plans. Bay Networks has an Employee Stock Purchase Plan (the Purchase Plan) under which 2,695,812 shares of common stock remain available for future purchases. Each eligible employee may purchase shares of common stock through the accumulation of payroll deductions of up to 10% of each participating employee's gross wages not to exceed a maximum of $5,040 per purchase period. The Purchase Plan authorizes the purchase of shares of common stock at the end of semi-annual purchase periods beginning May 1 and November 1 of each year. The purchase price is an amount equal to 85% of its fair market value determined as of the beginning of an offering period and the end of a purchase period. In 1996 and 1995, employees purchased 696,712 shares and 613,070 shares and approximately $13.9 million and $8.2 million of proceeds were recorded to stockholders' equity, respectively. The Purchase Plan will expire upon either issuance of all shares reserved for issuance or at the discretion of the Board of Directors. There are no plans to terminate the Purchase Plan at this time.
Both Wellfleet and SynOptics maintained employee stock purchase plans under which eligible employees purchased common stock at a price equal to 85% of the lower of the fair market values as of the beginning of an offering period and the end of a purchase period. During 1994, 543,658 shares were issued under these plans and approximately $7.7 million of proceeds were recorded to stockholders' equity. Pursuant to the Combination, these plans were terminated.
Stock Purchase Rights Plan. Under a preferred stock purchase rights plan, adopted by the Company's Board of Directors on February 7, 1995, stockholders of the Company received rights to purchase stock in the Company, or in an acquirer of the Company, at a discounted price, under certain circumstances and in the event of particular hostile efforts to acquire control of the Company. The rights may be redeemed pursuant to the plan by the Board of Directors. The rights expire on February 7, 2005.
6. EMPLOYEE BENEFIT PLAN
The Company maintains the Bay Networks, Inc. 401(k) Plan (the Plan) to provide retirement benefits for its employees. As allowed under Section 401(k) of the Internal Revenue Code, the Plan provides tax deferred salary deductions for eligible employees. Eligible employees may contribute from 1% to 15% of their annual compensation to the Plan, limited to a maximum amount as set by the Internal Revenue Service. The Company will make matching contributions unless business conditions dictate otherwise, pursuant to a fixed
BAY NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
6. EMPLOYEE BENEFIT PLAN (CONTINUED) formula and up to a maximum of $1,500 per year. Bay Networks' matching contributions to the Plan totaled $3.4 million in 1996 and immaterial in 1995 and 1994.
7. INCOME TAXES
The components of the provision for income taxes are as follows:
The components of the Company's total income (loss) before provision for income taxes are as follows:
For the year ended June 30, 1994, the foreign component of the Company's income before provision for income taxes was not material.
The Company's effective tax rate was different from the U.S. statutory income tax rate due to the following:
BAY NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
7. INCOME TAXES (CONTINUED) Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The Company's net deferred tax assets (net of deferred tax liabilities) are comprised primarily of the following:
The valuation allowance at June 30, 1994 was $4.3 million related to Coral Network Corporation. At June 30, 1996, the Company has available the following acquired tax carryforwards. Utilization of these carryforwards may be subject to substantial limitations due to the ownership change limitations provided by the Internal Revenue Code of 1986.
8. GEOGRAPHIC AREA AND SIGNIFICANT CUSTOMER INFORMATION
Bay Networks operates in one industry segment and develops, manufactures, markets and supports a comprehensive line of data networking products and services, including high-speed routers, switches, intelligent hubs, remote and Internet access solutions and sophisticated management software providing network design and configuration solutions. These products enable end users to build or enhance their data network systems, including all levels from small local area networks to large enterprise-wide information infrastructures.
One customer accounted for approximately 13% ($263.0 million), 14% ($198.0 million) and 14% ($162.0 million) of the Company's revenue in 1996, 1995 and 1994, respectively.
BAY NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
8. GEOGRAPHIC AREA AND SIGNIFICANT CUSTOMER INFORMATION (CONTINUED) The Company's foreign operations consist of sales, marketing, and support activities in subsidiaries throughout the world. The Company's international export sales represented 34.8%, 32.7% and 30.4% in 1996, 1995 and 1994, respectively. Substantially all of the export sales each year were denominated in U.S. dollars.
Operating income generated by the foreign operations of the Company and their corresponding identifiable assets were not material to the Company in 1995 and 1994, respectively. Revenue classified by major geographic area is as follows:
9. SELECTED QUARTERLY DATA (UNAUDITED)
ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS IN ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
PART III
Certain information required by Part III is omitted from this Report in that the Company will have filed its definitive proxy statement pursuant to Regulation 14A not later than 120 days after the end of the fiscal year covered by this report, and certain information included therein is incorporated herein by reference.
ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
Information relating to the directors of the Company is set forth under the caption "Information about Bay Networks -- Management" in the Company's definitive Proxy Statement (the "Proxy Statement") in connection with the Annual Meeting of Stockholders to be held October 17, 1996. Such information is incorporated herein by reference. Information relating to the executive officers of the Company is set forth in Part I of this report under the caption "Management." Information relating to compliance with Section 16(a) of the Securities Exchange Act of 1934 is set forth under the caption "Executive Compensation and Other Matters -- Section 16(a) of the Securities Exchange Act of 1934 -- Beneficial Ownership Reporting Compliance" in the Proxy Statement and incorporated herein by reference.
ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION.
Information relating to executive compensation is set forth under the caption "Executive Compensation and Other Matters -- Stock Options Granted in Fiscal 1996," "-- Option Exercises and Fiscal 1996 Year-End Values," "-- Change of Control Arrangements," "-- Compensation of Directors," and "-- Compensation Committee Interlocks and Insider Participation" in the Proxy Statement. Such Information is incorporated herein by reference.
ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
Information relating to ownership of equity securities of the Company by certain beneficial owners and management is set forth under the caption "Information about Bay Networks -- Stock Ownership of Certain Beneficial Owners and Management" in the Proxy Statement. Such information is incorporated herein by reference.
ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
Information is set forth under the caption "Executive Compensation and Other Matters -- Certain Transactions" in the Proxy Statement. Such information is incorporated herein by reference.
PART IV
ITEM 14.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) 1. Financial Statements
The financial statements listed in Item 14(a) are filed as part of this Form 10-K.
2. Financial Statement Schedule
The financial statement schedule listed in Item 14(a) is filed as part of this Form 10-K.
3. Exhibits
The exhibits listed in the accompanying Index to Exhibits are filed or incorporated by reference as part of this Form 10-K.
(b) Reports on Form 8-K
No reports on Form 8-K were filed during the fourth quarter of fiscal 1996.
(c) See Exhibit Index of this Form 10-K
(d) See Index to Consolidated Financial Statements and Financial Statement Schedule of this Form 10-K
SIGNATURE
Pursuant to the requirements of Section 13 or 15(d) of the Securities Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized in the City of Santa Clara, State of California, on the 5th day of September, 1996.
BAY NETWORKS, INC.
By: /s/ ANDREW K. LUDWICK
------------------------------------ Andrew K. Ludwick President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULE
ITEM 14(A)
Report of Independent Auditors Report of Independent Accountants Consolidated balance sheets at June 30, 1996 and June 30, 1995 Consolidated statements of income for the three years ended June 30, 1996, 1995 and 1994 Consolidated statements of stockholders' equity for the three years ended June 30, 1996, 1995 and 1994 Consolidated statements of cash flows for the three years ended June 30, 1996, 1995 and 1994 Notes to consolidated financial statements Selected quarterly data (unaudited): Three months ended fiscal years 1996 and 1995
SCHEDULE:
II Valuation Accounts for the years ended June 30, 1996, 1995, and 1994
All other schedules have been omitted since the required information is not present in amounts sufficient to require submission of the schedules, or because the information required is included in the consolidated financial statements or notes thereto.
SCHEDULE II
BAY NETWORKS, INC.
VALUATION ACCOUNTS (In thousands)
- - ---------------
(1) Due to the differing fiscal years of SynOptics and Wellfleet amount represents the elimination of SynOptics' net allowance for doubtful accounts activity for the six months ended December 31, 1993.
(2) Due to the differing fiscal years of the Company and Xylogics amount represents the elimination of Xylogics' net allowance for doubtful accounts activity for the three months ended October 31, 1994.
ITEM 15.

ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(A) EXHIBITS
- - --------------- (b) The following financial statement schedule is filed herewith.
II Valuation Account
* Indicates compensatory plan or arrangement.