ASCEND COMMUNICATIONS INC, 10-K/A, 1999-05-19

ASCEND COMMUNICATIONS INC
10-K/A, 1999-05-19
COMPUTER COMMUNICATIONS EQUIPMENT

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K/A

AMENDMENT NO. 1

( X ) ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998

( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ________ TO ________

Commission File Number: 000-23774

ASCEND COMMUNICATIONS, INC.
(Exact name of registrant as specified in its charter)

Delaware 94-3092033
---------------------------------------- -------------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

1701 Harbor Bay Parkway, Alameda, CA 94502
---------------------------------------- --------------------
(Address of principal executive offices) (Zip code)

Registrant's telephone number, including area code: (510) 769-6001

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:
common stock, $0.001 Par Value

Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act
of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days.

Yes X No___
---

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]

As of December 31, 1998 the approximate aggregate market value of voting
stock held by non-affiliates of the Registrant was $11,672,400,250 (based
upon the closing price for shares of the Registrant's common stock as
reported by the Nasdaq National Market on that date). Shares of common
stock held by each officer, director and holder of 5% or more of the
outstanding common stock have been excluded in that such persons may be
deemed to be affiliates. The determination of affiliate status is not
necessarily a conclusive determination for other purposes.

As of February 28, 1999, 222,250,267 shares of the Registrant's common stock
were outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Not applicable.

PORTIONS AMENDED

The Registrant hereby amends and restates Items 3 and 7 of this Report on
Form 10-K and Footnotes 3, 8 and 9 to the Registrant's Consolidated
Financial Statements set forth in this Report on Form 10-K, in each case as
set forth below.

ITEM 3. LEGAL PROCEEDINGS

On January 13, 1999, four purported class action complaints
challenging the proposed merger between Ascend and Lucent were filed in the
Delaware Court of Chancery by individuals who claim to be stockholders of
Ascend. The complaints name the Company, its directors and certain former
directors of Cascade Communications Corp. as defendants. One of the
complaints also names Lucent as a defendant. The complaints allege, among
other things, that the defendants have resolved to wrongfully allow Lucent
to obtain the assets of Ascend at a bargain price, that the defendants have
breached their fiduciary duties to the class, that action by the defendants
will prevent Ascend's stockholders from receiving a fair price for their
shares, that Ascend's directors failed to make an informed decision in
recommending Lucent's offer, and that the terms of the proposed merger fail
to include appropriate mechanisms to protect Ascend's stockholders against
a decline in the price of Lucent's or Ascend's stock. The complaint naming
Lucent alleges that it aided and abetted the breaches of fiduciary duty by
the other defendants. The plaintiffs seek, among other things, (i) a
declaration that the proposed transaction is unfair, unjust and
inequitable; (ii) preliminary and permanent injunctive relief against the
consummation or closing of the proposed transaction; (iii) rescission of
the transaction in the event it is consummated; (iv) damages, (v) allowance
for plaintiffs' attorneys' fees and expenses; and, (vi) other relief as the
Court may deem just and proper.

These actions are in the early stages of proceedings and the
Company is currently investigating the allegations. Based on its current
information, the Company believes the suits to be without merit and intends
to defend itself and the named defendants vigorously. Although it is
reasonably possible the Company may incur a loss upon the conclusion of
these claims, an estimate of any loss or range of loss cannot be made. No
provision for any liability that may result upon adjudication has been made
in the consolidated financial statements. In the opinion of management,
resolution of this matter is not expected to have a material adverse effect
on the financial position of the Company. However, depending on the amount
and timing, an unfavorable resolution of this matter could materially
affect the Company's financial position, future results of operations or
cash flows in a particular period.

The Company and various of its current and former officers and
directors are defendants in a number of consolidated class action lawsuits
pending in the United Stated District Courts for the Central District of
California, which have been filed on behalf of all persons who purchased or
acquired the Company's stock (excluding the defendants and parties related
to them) for the period November 5, 1996 to September 30, 1997 ("federal
securities actions"). In addition, the Company and one of its officers are
defendants in a securities action filed in the Superior Court of Alameda
County, California ("state securities action"). The state securities action
purports to be brought in behalf of all purchasers of the Company's stock
between July 15, 1997 and September 29, 1997 (excluding the defendants and
parties related to them). The lawsuits allege that the defendants violated
the federal or state securities laws by engaging in a scheme to
artificially inflate and maintain the Company's stock price by
disseminating materially false and misleading information concerning its
business and earnings and the development, efficiency, introduction and
deployment of its digital modems based on 56K-bps technology.

On August 17, 1998, the Court certified the federal securities
actions as a class action and appointed four plaintiffs to serve as class
representatives. On September 4, 1998, plaintiffs filed a second Amended
and Consolidated Complaint. On February 2, 1999, the Court issued an Order
granting the motion to dismiss and allowing plaintiffs to file an amended
complaint. The state securities action has been stayed pending resolution
of the motion to dismiss in the federal securities action.

These actions are in the early stages of proceedings and the Company
is currently investigating the allegations. Based on its current
information, the Company believes the suits to be without merit and intends
to defend itself and its officers and directors vigorously. Although it is
reasonably possible the Company may incur a loss upon the conclusion of
these claims, an estimate of any loss or range of loss cannot be made. No
provision for any liability that may result upon adjudication has been made
in the consolidated financial statements. In the opinion of management,
resolution of this matter is not expected to have a material adverse effect
on the financial position of the Company. However, depending on the amount
and timing, an unfavorable resolution of this matter could materially
affect the Company's financial position, future results of operations or
cash flows in a particular period. In connection with these legal
proceedings, the Company expects to incur substantial legal and other
expenses. Shareholder suits of this kind are highly complex and can extend
for a protracted period of time, which can substantially increase the cost
of such litigation and divert the attention of the Company's management.

In April 1997, a civil action was filed against Sahara, its three
founders and ten employees of Sahara by General Datacomm Industries, Inc.
in the Superior Court for the State of Connecticut. The complaint alleges
several causes of action, including: breach of contract; tortious
interference with contractual relations; misappropriation of trade secrets;
unfair competition and violation of the Connecticut Unfair Trade Practices
Act. The plaintiff seeks relief of unspecified monetary damages, costs and
injunctive relief. The Company has not yet engaged in substantive discovery
and the ultimate outcome of this matter cannot yet be determined. The
Company plans to vigorously defend this lawsuit. Although it is reasonably
possible the Company may incur a loss upon the conclusion of these claims,
an estimate of any loss or range of loss cannot be made. No provision for
any liability that may result from the action has been recognized in the
consolidated financial statements. In the opinion of management, resolution
of this litigation is not expected to have a material adverse effect on the
financial position of the Company. However, depending on the amount and
timing, an unfavorable resolution of this matter could materially affect
the Company's future results or cash flows in a particular period.

The Company is a party as a defendant in various other lawsuits,
contractual disputes and other legal claims arising in the ordinary course
of business, the results of which are not presently determinable. Although
it is reasonably possible the Company may incur a loss upon the conclusion
of these claims, an estimate of any loss or range of loss cannot be made.
No provision for any liability that may result from these claims has been
recognized in the consolidated financial statements. However, in the
opinion of management, after consultation with legal counsel, the amount of
losses that might be sustained, if any, from these lawsuits would not
materially affect the Company's financial position. However, depending on
the amount and timing, an unfavorable resolution of some or all of these
matters could materially affect the Company's future results of operations
or cash flows in a particular period.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

Overview

Ascend develops, manufactures and sells wide area networking
solutions for telecommunications carriers, ISPs and corporate customers
worldwide which enable them to build: (i) Internet access systems
consisting of POP equipment for ISPs and remote site Internet access
equipment for Internet subscribers; (ii) telecommunications carrier and ISP
backbone networks utilizing high speed Frame Relay, ATM and IP switches;
(iii) extensions and enhancements to corporate backbone networks that
facilitate access by remote offices, telecommuters and mobile computer
users; (iv) non-stop computing platforms and Intelligent Networking ("IN")
solutions for enhanced voice services in telephony networks; and (v)
videoconferencing and multimedia access solutions. The Company's products
support existing digital and analog networks.

In January 1999, the Company entered into an Agreement and Plan of
Merger (the "Merger Agreement") with Lucent, pursuant to which each
outstanding share of Ascend common stock will be exchanged for 0.825 shares
of Lucent common stock, and each outstanding option or warrant to purchase
Ascend common stock will be converted into an option or warrant to purchase
Lucent common stock (adjusted for the exchange ratio). The merger is
expected to be accounted for as a pooling of interests, is subject to
standard regulatory approvals and is expected to close during the second
quarter of 1999.

In February 1999, Lucent announced a two-for-one stock split,
payable on April 1, 1999 to shareholders of record as of March 5, 1999.
Under the terms of the Merger Agreement the exchange ratio will be adjusted
for the effect of this stock split and any similar changes in the
capitalization of Lucent.

In October 1998, the Company purchased Stratus, a manufacturer of
fault-tolerant computer systems, and announced its intention to divest the
non-telecommunications business units of Stratus prior to the consummation
of the acquisition. In June 1997, the Company acquired Cascade, a developer
and manufacturer of wide area network switches. In April 1997, the Company
acquired Whitetree, a developer and manufacturer of high-speed ATM
switching products.

In February 1997, the Company purchased InterCon, a developer of
remote access client software products. In January 1997, Cascade acquired
Sahara, a privately held developer of scaleable high-speed broadband access
products.

Results of Operations

The following table summarizes the percentage of net sales
represented by certain line items from the Company's consolidated
statements of operations:
<TABLE>
<CAPTION>

YEAR ENDED DECEMBER 31,
-----------------------------------------
1998 1997 1996
---------- ----------- ----------

<S> <C> <C> <C>
Net sales................................................ 100% 100% 100%
Cost of sales............................................ 37 35 35
---------- ----------- ----------
Gross profit........................................... 63 65 65
Operating expenses:
Research and development............................... 15 14 10
Sales and marketing.................................... 20 21 18
General and administrative............................. 5 3 3
Purchased in-process research and development.......... 18 20 -
Costs of mergers....................................... (1) 13 2
--------- ----------- ----------
Total operating expenses............................ 57 71 33
--------- ----------- ----------
Operating income (loss) ................................. 6 (6) 32
Interest income, net..................................... 2 2 2
--------- ----------- ----------
Income (loss) before income taxes........................ 8 (4) 34
Provision for income taxes............................... 9 7 13
--------- ----------- ----------
Net income (loss)........................................ (1)% (11)% 21%
========= =========== ==========
</TABLE>

Years Ended December 31, 1998, 1997 and 1996

Net Sales. Net sales for 1998 increased 27% to $1.479 billion as
compared to $1.167 billion in 1997, which increased 31% from $890.3 million
in 1996. International sales (sales outside of North America) increased to
$427.5 million in 1998 as compared to $362.3 million in 1997 and to $313.3
million in 1996 and accounted for 29%, 31% and 35% of net sales in 1998,
1997 and 1996, respectively. Substantially all of the increase in sales in
each period was attributable to increases in unit shipments of the
Company's products.

The following table provides a breakdown of net sales by business
unit as a percentage of total Company net sales for 1998, 1997 and 1996,
respectively:

YEAR ENDED DECEMBER 31,
--------------------------------
BUSINESS UNIT 1998 1997 1996
- --------------------------------------- -------- -------- --------

Core Systems........................... 47 % 35 % 36 %
Access Switching....................... 41 52 48
Enterprise Access...................... 7 9 13
Other.................................. 5 4 3
-------- -------- --------
Total Company..................... 100 % 100 % 100 %
======== ======== ========

Core Systems - The Core Systems business unit consists of the
B-STDX family of Frame Relay switches, the CBX500 and GX 550 ATM switches,
the SA family of broadband access products, the Carrier Signaling Group of
products acquired from Stratus and the GRF family of IP switches. Core
Systems products accounted for 47%, 35% and 36% of total Company net sales
for 1998, 1997 and 1996, respectively. The increase in Core Systems sales
as a percentage of net sales in 1998 was primarily attributable to
significant growth in sales of ATM switches. Incremental revenues from the
acquisition of Stratus also contributed to the increase, to a lesser
extent. The decline in Core Systems revenues as a percent of net sales in
1997 was primarily attributable to the increase in sales of the MAX family
of Access Switching products.

Access Switching - The Access Switching business unit consists of
the MAX family of products, which accounted for 41%, 52% and 48% of total
Company net sales for 1998, 1997 and 1996, respectively. Access Switching
revenues were relatively flat year-over-year from 1997 to 1998, but
declined as a percentage of total sales due to the increase in total
revenues. The increase in Access Switching revenues as percent of net sales
in 1997 was primarily attributable to increased shipments of MAX products,
due to increased demand for corporate remote networking applications.

Enterprise Access - The Enterprise Access business unit consists of
the Pipeline family of remote access equipment as well as the Multiband MAX
family of inverse multiplexing equipment. Enterprise Access products
accounted for 7%, 9% and 13% of total Company net sales for 1998, 1997 and
1996, respectively. Enterprise Access revenues were relatively flat
year-over-year from 1997 to 1998, but declined as a percentage of total
sales due to the increase in total revenues. The decline in Enterprise
revenues as a percent of net sales in 1996 was primarily attributable to
price reductions of the Pipeline family of products due to increased
competition.

Gross Margin. Gross margin was 63% for 1998 and 65% for both 1997
and 1996. The decrease in gross margin in 1998 was primarily due to
decreases in the average selling prices of the Company's products. To a
lesser extent, the acquisition of Stratus contributed to the decrease in
gross margin, as gross margins for products sold by Stratus were lower than
the Company's gross margins. In the future, the Company's gross margin may
be affected by several factors, including the mix of products sold, the
price of products sold, the introduction of new products with lower gross
margins, the distribution channels used, price competition, increases in
material costs and changes in other components of cost of sales.

Research and Development. Research and development expenses
increased to $216.2 million in 1998 as compared to $156.0 million in 1997
and $93.7 million in 1996. These increases were primarily due to the
addition of engineering personnel, expenses related to the development and
enhancement of the Company's existing and new products, expenses related to
applications and product testing required to enter new markets, addition of
development laboratory equipment, and material costs associated with new
product prototypes. In addition, research and development expenses have
increased in part through the addition of engineering personnel as a result
of the Company's mergers and acquisitions. Research and development
expenses as a percent of net sales increased to 15% in 1998 from 14% in
1997 and 10% in 1996. The Company expects that spending for research and
development will increase in absolute dollars in 1999 but may continue to
vary as a percentage of net sales.

Sales and Marketing. Sales and marketing expenses increased to
$302.0 million in 1998 compared to $249.1 million in 1997 and $156.3
million in 1996. These increases were primarily due to the addition of
sales, marketing and technical support personnel and related commissions,
and expenses associated with opening additional sales offices in North
America, Europe and Asia and the Pacific Basin. Approximately 50% of the
total increase in sales and marketing expenses in 1998 were attributable to
each of the factors listed above, respectively. The growth in sales,
marketing and technical support personnel was primarily due to the need to
manage the activities of an increasing number of customers and products.
Sales and marketing expenses as a percent of net sales decreased slightly
to 20% in 1998 from 21% in 1997, which increased from 18% in 1996. The
Company expects that sales and marketing expenses will increase in absolute
dollars in 1999 but may continue to vary as a percentage of net sales.

General and Administrative. General and administrative expenses
increased to $78.9 million in 1998 as compared to $35.3 million in 1997 and
$29.9 million in 1996. The increase in 1998 was partially due to the effect
of special charges totaling $27.5 million related to the settlement of a
patent issue, the settlement of an outstanding receivable from a contract
manufacturer and the establishment of reserves against certain customers
afforded working capital loans. In addition, the increases in absolute
dollars in both years were due to the addition of finance and
administrative personnel, bonus compensation paid to the Company's
employees, and increased costs for insurance and contract personnel
associated with information systems service and support. For 1998,
excluding the impact of the $27.5 million in special charges, approximately
20%, 35% and 45% of the total increase in general and administrative
expenses were attributable to each of the factors listed above,
respectively. General and administrative expenses as a percent of net sales
were 5% in 1998 compared to 3% in both 1997 and 1996. Excluding the effect
of the special charges discussed above, general and administrative expenses
were 3% of net sales in 1998. The Company expects that spending for general
and administrative activities will increase in absolute dollars in 1999 but
may continue to vary as a percentage of net sales.

Purchased In-Process Research and Development. Purchased in-process
research and development costs were $267.0 million for 1998 and $231.1
million for 1997. These costs were related to the acquisition of Stratus
during the fourth quarter of 1998, and the acquisitions of InterCon and
Sahara during the first quarter of 1997. These acquisitions provide
technology and expertise that the Company is using to enhance and expand
the breadth of its product offerings to end-user markets.

In connection with the acquisition of Stratus, purchased in-process
research and development totaling $267.0 million was written off as a
non-recurring charge at the date of acquisition because the purchased
in-process research and development had not yet reached technological
feasibility and had no future alternative use. A total of $133.5 million
was allocated to existing technology ($130.0 million) and the assembled
work force ($3.5 million), with these amounts being amortized over periods
of ten years and three years, respectively.

The purchased in-process research and development acquired in 1998
is expected to facilitate the development of products which will enable
carriers and network service providers to more effectively integrate their
existing voice and data networks. As a result, the Company expects to be
able to target markets that have historically been served by traditional
telecommunications equipment suppliers. The Company is using the purchased
in-process research and development to create new products that will become
part of the Core Systems business unit product suite, with anticipated
product release dates throughout 1999 and 2000. Although the Company
expects that the purchased in-process research and development will be
successfully developed, there can be no assurance that commercial viability
of these products will be achieved.

The nature of the efforts required to develop the purchased
in-process research and development into commercially viable products
principally relates to the completion of all planning, designing,
prototyping, verification and testing activities that are necessary to
establish whether the product will be able to meet its design
specifications, including functions, features and technical performance
requirements. The estimated cost to develop the in-process research and
development was approximately $48 million, the majority of which is
expected to be incurred in 1999.

Brief descriptions of the relevant hardware and software technologies are
as follows:

Hardware

FTX: FTX is an implementation of a UNIX system V operating system for
Stratus' line of fault-tolerant computers. When run on FTX, UNIX
applications can take advantage of Stratus' single-processor or
multiprocessor fault- tolerant architecture that provides continuous system
availability and a high level of data protection. FTX was classified as a
core/developed technology for purposes of the valuation.

HP-UX: Stratus licenses Hewlett-Packard Company's HP-UX UNIX operating
system and has enabled the operating system to run on the Continuum family
of fault tolerant systems. Applications that run on HP platforms will run
unaltered in the Stratus Continuum fault-tolerant environment. These
applications include mainstream products from companies such as Oracle,
Sybase, and Informix, as well as other solutions and tools listed in the
HP-UX operating system product catalog. HP-UX was classified as an
in-process technology that is estimated to be released during the first
quarter of 1999. Stratus management estimated that 10 months had been spent
on the development of this technology prior to the acquisition and
approximately 4 months were required post-close to complete this
technology.

Continuum 1248: Continuum 1248 replaces Continuum 1228 at the high-end of
the Continuum product line. The high-end systems offer the growth path and
expandability users demand for large online transaction processing
applications. The Continuum family combines Reduced Instruction Set
Computing based, symmetric multiprocessing technology with Stratus' proven
continuous availability architecture to provide customers with robust,
continuously available open systems. Continuum 1248 is available on the FTX
operating system and the Stratus Virtual Operating System, which is
Stratus' fault- tolerant proprietary multiprocessing operating system.
Continuum 1248 was classified as an in-process technology, and revenues are
not expected until fiscal year 2000. Stratus' management estimated that 2
months had been spent on the development of this technology prior to the
transaction and approximately 14 months were required post-close to
complete this technology.

Continuum 448: Continuum 448 gives customers continuous availability in an
entry-level system at the lowest cost in the marketplace. Continuum 448 is
available on the FTX and HP-UX operating systems. Continuum 448 was
classified as an in-process technology, and revenues are not expected until
the fourth quarter of fiscal year 1999. Stratus' management estimated that
2 months had been spent on the development of this technology prior to the
transaction and approximately 12 months were required post-close to
complete this technology. As of the acquisition date, the remaining risk to
development was that the I/O subsystem may not be sufficient to support
4-way scaling in some applications.

M708: M708 is a memory board which will support 1 GB - 4 GB. M708 was
classified as an in-process technology, and revenues are not expected until
the second quarter of fiscal year 1999. Stratus' management estimated that
11 months had been spent on the development of this technology prior to the
transaction and approximately 6 months were required post-close to complete
this technology.

SPHINX: SPHINX provides scalable software fault tolerance for clustered or
networked environments. Through SPHINX, distributed applications can be
made robust to hardware, network and operating system faults, and many
application software faults. The technology can be applied across a broad
range of environments from high speed cluster interconnects to wide area
networks. SPHINX combines replication for fault tolerance with load
balancing for scalability. These capabilities are built on a foundation of
fault-tolerant multicast. SPHINX was classified as an in-process
technology, that is estimated to be released during the first quarter of
fiscal year 1999 and will start generating revenue at this time. Stratus'
management estimated that 15 months had been spent on the development of
this technology prior to the acquisition and approximately 3 months were
required post-close to complete this technology.

Other Continuum Systems: Stratus offers three ranges of hardware fault-
tolerant systems including the Continuum 400 Series (entry-level systems),
the Continuum 600 Series (mid-range systems), and the Continuum 1200 Series
(high- end systems). The six developed Continuum 400 Series models are
entry-level systems. The five developed Continuum 600 Series models are
mid-range systems that provide open continuously available computing. The
seven developed Continuum 1200 Series models are the family's high-end
systems for the expandability and growth path customers need for large
online transaction processing applications. All 400 Series Continuum
products can be ordered with the FTX or HP-UX operating systems. These
Continuum products were classified as developed technologies.

HARMONY: HARMONY is the first product offering of the Continuum II series,
or the follow on product line from the Continuum I series (i.e., Continuum
1248 and Continuum 448). HARMONY is a mid-range fault-tolerant computer
based on the Intel 64-bit architecture. Migrating to a 64-bit processor
architecture will give Continuum II improved scalability and performance
over previous Continuum products. HARMONY supports HP-UX, FTX, and Windows
NT operating system platforms. HARMONY was classified as an in-process
technology. HARMONY is anticipated to begin generating revenue during
fiscal year 2000. Stratus management estimated that 18 months had been
spent on the development of this technology prior to the acquisition and
approximately 18 months were required post-close to complete this
technology.

Software

LNP: Local Number Portability ("LNP") software gives both wireline and
wireless carriers performance-tested solutions for managing and
provisioning LNP services, and for communicating with regional Number
Portability Administration Centers. LNP products run on HP-UX on the
Stratus Continuum Series platform. Uninterrupted availability, a prime
requisite for LNP, is ensured by Stratus' fault tolerant technology. LNP
was classified as an in- process technology that is expected to begin
generating revenue during the first quarter of fiscal year 1999. Stratus'
management estimated that 12 months had been spent on the development of
this technology prior to the acquisition and approximately 3 months were
required post-close to complete this technology.

CORE IN: CORE IN is Stratus' performance-tested mobile number portability
solution. The CORE IN solution implements an advanced intelligent signaling
relay architecture for mobile porting. In this design, standard messages
used to locate the mobile in order to route calls are transparently
redirected to the ported subscriber's network. Ported calls can then be
handled in a manner similar to ordinary roaming calls. CORE IN was
classified as an in-process technology that is expected to begin generating
revenue during the second quarter of fiscal year 1999. Stratus' management
estimated that 12 months had been spent on the development of this
technology prior to the acquisition and approximately 5 months were
required post-close to complete this technology.

PN: Personal Number ("PN") portability. PN is included in the CORE IN
solution. PN was classified as an in-process technology that is expected to
begin generating revenue during the first quarter of fiscal year 1999.
Stratus' management estimated that 9 months had been spent on the
development of this technology prior to the acquisition and approximately 4
months were required post-close to complete this technology.

Signaling System 7 ("SS7") Gateway and Internet Gateway: Stratus' SS7
Gateway and Internet Gateway offer a new solution for telecommunications
service providers and Internet service providers who need to meet
fast-growing demand for Internet connections at an affordable cost. The
gateways are used to transfer data traffic between the Internet and the
public switched telephone network, or PSTN. The solution acts as a virtual
switch to offload Internet traffic from switching equipment and
Inter-Machine Trunks in the PSTN. The SS7 and Internet Gateway solution
allows the user to gain an immediate way to expand Internet connection
capacity, enhance service levels, improve network manageability, and
control spiraling costs. The SS7 Gateway allows phone companies to provide
reliability as well as value-added services like credit card verification,
caller identification, call forwarding and 800 calling. SS7 Gateway was
classified as core/developed technology and Internet Gateway was classified
as in-process technology which is estimated to be released during the first
quarter of fiscal year 1999. Stratus' management estimated that 16 months
had been spent on the development of this technology prior to the
acquisition and approximately 1 month was required post-close to complete
this technology.

The fair value of the in-process research and development projects
was estimated at $267.0 million (after the pro-rata allocation of the
excess purchase price to the long-term assets acquired). The estimated
costs to complete these technologies were $11.2 million in 1998, $28.7
million in 1999 and $8.0 million in 2000.

Material risks affecting the timely completion and
commercialization of the in-process research and development projects
include the risk that development schedules may be delayed, the Company may
not be able to retain key personnel involved in the development efforts,
integration issues between the hardware and software components may not be
resolved on a timely basis, and that the anticipated market demand for the
products to be developed based on the in-process technology may not
materialize.

The value of the purchased in-process research and development from
the Stratus acquisition was determined by estimating the projected net cash
flows related to such products, including costs to complete the development
of the technology and the future revenues to be earned upon
commercialization of the products. These cash flows were discounted back to
their net present value. The resulting projected net cash flows from such
projects were based on management's estimates of revenues and operating
profits related to such projects. These estimates were based on several
assumptions, including those summarized below. If these projects to develop
commercial products based on the purchased in-process research and
development are not successfully completed, the Company's operating results
may be adversely affected in future periods.

Revenues and operating profit attributable to the in-process
research and development were estimated to total $5.1 billion and $2.3
billion, respectively, over an eleven-year projection period. The resulting
projected net cash flows were discounted to their present value using a
discount rate of 35%, which was calculated based on the weighted average
cost of capital, adjusted for the technology risk associated with the
purchased in-process research and development, which was considered to be
significant due to the rapid pace of technological change in the
telecommunications industry. The resulting valuation of $370.8 million was
subsequently reduced to $267.0 million due to the pro-rata allocation of
the excess of the estimated fair value of the net assets acquired over the
purchase price.

For projected cash flows attributable to existing technology, a
discount rate of 30% was used, which reflects the weighted average cost of
capital, adjusted for the technology risk associated with these
technologies.

The primary purchased in-process research and development in 1997
was the Broadband access technology acquired through the January 1997
acquisition of Sahara by Cascade, which was subsequently acquired by the
Company. In connection with the acquisition of Sahara, purchased in-process
research and development totaling $213.0 million was written off as a
non-recurring charge at the date of acquisition because the purchased
technology had not yet reached technological feasibility and had no future
alternative use. At the acquisition date, Sahara had no revenues or
commercially available products. The Company's revenues attributable to the
Broadband access technology were not significant in either 1998 or 1997.

Cost of Mergers. In 1998, the Company reversed accrued merger costs
of $18.3 million, which related to the estimated costs charged to
operations in 1997 of approximately $150.3 million. These costs principally
related to the acquisition of Cascade and consisted primarily of investment
banking fees, professional fees, reserves for redundant assets, redundant
products and employee severance packages. In 1996, the Company charged to
operations merger costs of approximately $13.9 million. These costs
principally related to the acquisition of NetStar, Inc. and consisted
primarily of investment banking fees, professional fees and other direct
costs associated with the merger. There were no remaining merger related
accruals at September 30, 1998.

In conjunction with the acquisition of Stratus in the fourth
quarter of 1998, the Company recorded, as part of the purchase price,
accrued merger costs of $49.3 million, which consist of $7.6 million of
merger transaction costs and $41.7 million of integration expenses.
Integration expenses consist of $2.4 million for severance and outplacement
costs, $34.8 million for costs associated with the divestiture of the
non-telecommunications business units, and $4.5 million of other merger
related costs. The $2.4 million of severance and outplacement costs relates
to approximately 150 employees involved in duplicate functions, including
manufacturing and logistics, sales and marketing, and finance and
administration. The $34.8 million of costs associated with the divestiture
of the non-telecommunications business units consists of the following
major components: (1) $22.2 million of costs associated with termination of
lease agreements and relocation of the non- telecommunication business
units, (2) $8.6 million of investment banker and professional fees related
to the divestitures, and (3) $4.0 million of other miscellaneous expenses.
At December 31, 1998, the accrued merger costs for Stratus were $49.3
million, with such costs expected to be paid during the first three
quarters of 1999. Substantially all of the accrued merger costs represent
anticipated cash expenditures.

Interest Income. Interest income increased to $28.1 million in 1998
compared to $23.0 million in 1997 and $17.2 million in 1996. The increase
in interest income during 1998 and 1997 was primarily due to increases in
cash and investments balances, which were primarily attributable to cash
generated from operations, and proceeds received from the exercise of stock
options.

Provision for Income Taxes. The provision for income taxes for 1998
was $136.6 million compared to $79.4 million for 1997 and $118.1 million in
1996. The Company's tax expense for 1998 and 1997 was impacted by
non-deductible costs associated with the Company's business combinations.
Excluding the effects of these non-deductible charges, the Company's
effective tax rate was 35.6% for 1998 and 37.3% for 1997, which
approximates the effective statutory federal and state income tax rates
adjusted for the impact of tax exempt interest, the benefits associated
with the Company's Foreign Sales Corporation and the utilization of various
tax credits. The decrease in the Company's effective tax rate from 1997 to
1998 was primarily attributable to the utilization of various tax credits.
Excluding the effects of non-deductible one-time charges, the Company's
effective tax rate was 38.2% for 1996.

Liquidity and Capital Resources

At December 31, 1998, the Company's principal sources of liquidity
included cash and cash equivalents, short-term investments and investments
totaling $1.137 billion and an unsecured $25.0 million revolving line of
credit which expires in June 1999. There were no borrowings or amounts
outstanding under the line of credit as of December 31, 1998. The increase
in cash and cash equivalents of $201.8 million for 1998 was attributable to
$281.9 million of cash provided by operations and $203.8 million of cash
provided by financing activities, offset by $283.9 million of cash used in
investing activities. The net cash provided by operating activities for
1998 was primarily due to the net loss, adjusted for the effects of
purchased research and development and depreciation and amortization,
offset by changes in working capital assets.

Net cash used in investing activities of $283.9 million for 1998
related primarily to net purchases of investments of $362.9 million and
expenditures for property and equipment of $157.5 million, offset by cash
acquired in conjunction with the acquisition of Stratus of $269.4 million.
Financing activities provided $203.8 million in 1998, due to proceeds from
the exercise of stock options and issuance of common stock in connection
with the Company's stock option and stock purchase plans.

At December 31, 1998, the Company had $1.051 billion in working
capital. The Company currently has no significant capital commitments other
than commitments under facilities and operating leases. The Company
believes that its available sources of funds and anticipated cash flow from
operations will be adequate to finance current operations, anticipated
investments and capital expenditures for at least the next twelve months.

Factors which may affect future results

The Company's quarterly and annual operating results are affected
by a wide variety of risks and uncertainties as discussed below and in the
Company's Registration Statement on Form S-4/A (No. 333-62281) filed on
September 9, 1998 in connection with the acquisition of Stratus. This
Report on Form 10-K should be read in conjunction with such Form S-4/A,
particularly the section entitled "Risk Factors".

Merger Agreement with Lucent

On January 12, 1999, the Company and Lucent executed a definitive
merger agreement pursuant to which Dasher Merger Inc., a Delaware
corporation and a wholly owned subsidiary of Lucent, will merge, subject to
certain conditions, with and into the Company and the Company will become a
wholly owned subsidiary of Lucent. Under the terms of the merger, each
outstanding share of common stock of the Company will be exchanged for
0.825 shares of common stock of Lucent, subject to adjustment for changes
in Lucent's capitalization, including the two-for-one stock split announced
by Lucent in February 1999. The announcement of the merger could have an
impact on the ability of the Company to market its products and services to
its customers, possibly causing operating results to vary from those
expected. The merger is subject to approval by the Company's stockholders
and various regulatory agencies, including the Department of Justice, and
there can be no assurance that the merger will be successfully completed.
In the event that the merger is not successfully completed, the Company's
results of operations and common stock price could be materially adversely
affected.

If the merger is successfully completed, holders of the Company's
common stock will become holders of Lucent common stock. Lucent's business
is different from that of the Company, and Lucent's results of operations,
as well as the price of Lucent common stock, may be affected by factors
different than those affecting the Company's results of operations and the
price of the Company's common stock. For a discussion of Lucent's business
and certain factors to consider in connection with such business, see
Lucent's Annual Report on Form 10-K for the fiscal year ended September 30,
1998.

Dependence on the Internet Access and Telecommunications Markets

A substantial portion of the Company's sales of its MAX and
Pipeline products is related to the Internet industry. In North America,
the Company sells a substantial percentage of its products, particularly
its MAX products, to ISPs. Additionally, a substantial portion of the
Company's sales of its core systems products is related to the
telecommunications carrier industry. In North America, the Company sells a
substantial percentage of its core systems products to public carriers.
There can be no assurance that these industries and their infrastructure
will continue to develop or that acceptance of the Company's products by
these industries will be sustained. The Company believes competition in the
Internet and public carrier industry will increase significantly in the
future and could have a material adverse effect on the Company's business,
results of operations or financial condition.

Integration of Acquisitions

The Company concluded the acquisition of one company in 1998 and
four companies in 1997. Achieving the anticipated benefits of these
acquisitions or any other acquisitions the Company may undertake will
depend in part upon whether the integration of the acquired companies'
products and technologies, research and development activities, and sales,
marketing and administrative organizations is accomplished in an efficient
and effective manner. There can be no assurance that this will occur.
Moreover, the integration process may temporarily divert management
attention from the day-to-day business of the Company. Failure to
successfully accomplish the integration of acquired companies could have a
material adverse effect on the Company's business, financial condition or
results of operations.

International Sales

The Company expects that international sales will continue to
account for a significant portion of the Company's net sales in future
periods. International sales are subject to certain inherent risks,
including unexpected changes in regulatory requirements and tariffs,
political and economic instability, difficulties in staffing and managing
foreign operations, longer payment cycles, problems in collecting accounts
receivable and potentially adverse tax consequences. The Company depends on
third party resellers for a substantial portion of its international sales.
Certain of these third party resellers also act as resellers for
competitors of the Company that can devote greater effort and resources to
marketing competitive products. The loss of certain of these third party
resellers could have a material adverse effect on the Company's business,
financial condition or results of operations. Although substantially all of
the Company's sales are denominated in U.S. dollars, fluctuations in
currency exchange rates could cause the Company's products to become
relatively more expensive to customers in a particular country, leading to
a reduction in sales and profitability in that country. Furthermore, future
international activity may result in foreign currency denominated sales,
and, in such event, gains and losses on the conversion to U.S. dollars of
accounts receivable and accounts payable arising from international
operations may contribute to fluctuations in the Company's results of
operations. In addition, sales in Europe and certain other parts of the
world typically are adversely affected in the third quarter of each
calendar year as many customers reduce their business activities during the
summer months. These seasonal factors may have a material adverse effect on
the Company's business, results of operations and financial condition.

Fluctuations in Quarterly Operating Results

The Company typically operates with a relatively small backlog. As
a result, quarterly sales and operating results generally depend on the
volume of, timing of and ability to fulfill orders received within the
quarter, all of which are difficult to forecast. In the Company's most
recent quarters, the sequential sales growth has fluctuated significantly,
and a disproportionate share of the sales occurred in the last month of the
quarter. These occurrences are extremely difficult to predict and may
happen in the future. The Company's ability to meet financial expectations
could be hampered if the nonlinear sales pattern continues in future
periods. Accordingly, the cancellation or delay of even a small percentage
of customer purchases could materially adversely affect the Company's
results of operations in the quarter. A significant portion of the
Company's net sales in prior periods has been derived from relatively large
sales to a limited number of customers, and therefore the failure of the
Company to secure expected large sales may have a material adverse impact
on results of operations. A significant portion of the Company's expenses
are fixed in advance based in large part on the Company's forecasts of
future sales. If sales are below expectations in any given quarter, the
adverse impact of the sales shortfall on the Company's operating results
may be magnified by the Company's inability to adjust spending to
compensate for the shortfall.

Rapidly Changing Technologies

The market for the Company's products is characterized by rapidly
changing technologies, evolving industry standards, frequent new product
introductions and short product life cycles. The introduction of new
products requires the Company to manage the transition from older products
in order to minimize disruption in customer ordering patterns, avoid
excessive levels of older product inventories and ensure that adequate
supplies of new products can be delivered to meet customer demand.
Furthermore, products such as those offered by the Company may contain
undetected or unresolved hardware problems or software errors when they are
first introduced or as new versions are released. There can be no assurance
that, despite extensive testing by the Company, hardware problems or
software errors will not be found in new products after commencement of
commercial shipments, resulting in delay in or loss of market acceptance.
Future delays in the introduction or shipment of new or enhanced products,
the inability of such products to gain market acceptance or problems
associated with new product transitions could have a material adverse
effect on the Company's business, results of operations or financial
condition.

Competition

The Company mainly competes in four segments of the data networking
market: (i) WAN and Internet access, (ii) WAN and Internet backbone
switching, (iii) remote LAN access and Internet subscriber access, and (iv)
videoconferencing and multimedia access. The Company competes in one or
more of these market segments with Cisco, 3Com, Newbridge, Nortel and many
others. Some of these competitors have substantially greater financial,
marketing and technical resources than the Company. The Company expects
additional competition from existing competitors and from a number of other
companies, some of which may have substantially greater financial,
marketing and technical resources than the Company, that may enter the
Company's existing and future markets. Increased competition could result
in price reductions, reduced profit margins and loss of market share, each
of which would have a material adverse effect on the Company's business,
results of operations and financial condition.

The Company expects that its gross margins could be adversely
affected in future periods by price changes resulting from increased
competition. In addition, increased sales of Pipeline products as a
percentage of net sales may materially adversely affect the Company's gross
margins in future periods as these products have lower gross margins than
the Company's other products.

Reliance on Third Party Telecommunications Carriers, Value-Added Resellers
and Distributors

The Company's use of third parties to distribute its products to
VARs may adversely affect the Company's gross margins. The Company's sales
are, to a significant degree, made through telecommunications carriers,
VARs and distributors. Accordingly, the Company is dependent on the
continued viability and financial stability of these companies. While the
Company has contractual relationships with many telecommunications
carriers, VARs and distributors, these agreements do not require these
companies to purchase the Company's products and can be terminated by these
companies at any time. There can be no assurance that any of the
telecommunications carriers, VARs or distributors will continue to market
the Company's products. The telecommunications carrier customers, to the
extent they are resellers, VARs and distributors, generally offer products
of several different companies, including products that are competitive
with the Company's products. Accordingly, there is a risk that these
companies may give higher priority to products of other suppliers, thus
reducing their efforts to sell the Company's products. Any special
distribution arrangement or product pricing arrangement that the Company
may implement in one or more distribution channels for strategic purposes
could materially adversely affect gross profit margins.

Dependence on Key Personnel

The Company's success depends to a significant degree upon the
continuing contributions of its key management, sales, marketing and
product development personnel. The Company typically does not have
employment contracts with its key personnel and does not maintain any key
person life insurance policies. The loss of key personnel could materially
adversely affect the Company.

Management of Growth

The Company is currently experiencing rapid growth and expansion,
which has placed, and will continue to place, a significant strain on its
administrative, operational and financial resources and increased demands
on its systems and controls. This growth has resulted in a continuing
increase in the level of responsibility for both existing and new
management personnel. The Company anticipates that its continued growth
will require it to recruit and hire a substantial number of new
engineering, sales, marketing and managerial personnel. There can be no
assurance that the Company will be successful at hiring or retaining these
personnel. The Company's ability to manage its growth successfully will
also require the Company to continue to expand and improve its operational,
management and financial systems and controls and to expand its
manufacturing capacity. If the Company's management is unable to manage
growth effectively, the Company's business, results of operations and
financial condition may be materially and adversely affected.

Proprietary Rights

The Company relies on a combination of patents, copyright, and
trade secret laws and non-disclosure agreements to protect its proprietary
technology. However, there can be no assurance that any of the Company's
proprietary technology rights will not be challenged, invalidated or
circumvented, or that any such rights will provide significant competitive
advantage. From time to time, the Company receives notices from third
parties regarding patent or copyright claims. Any such claims, with or
without merit, could be time consuming to defend, result in costly
litigation, divert management's attention and resources and cause the
Company to incur significant expenses. The Company is currently involved in
patent disputes the results of which are not presently determinable. Such
disputes could result in significant expenses to the Company and divert the
efforts of the Company's technical management personnel.

Dependence on Contract Manufacturers and Single-Source Suppliers

Although the Company generally uses standard parts and components
for its products, certain components, including certain key microprocessors
and integrated circuits, are presently available only from a single source
or from limited sources. The Company has no supply commitments from its
vendors and generally purchases components on a purchase order basis as
opposed to entering into long term procurement agreements with vendors. The
Company has generally been able to obtain adequate supplies of components
in a timely manner from current vendors or, when necessary to meet
production needs, from alternate vendors. The Company believes that, in
most cases, alternate vendors can be identified if current vendors are
unable to fulfill needs. However, delays or failure to identify alternate
vendors, if required, or a reduction or interruption in supply, or a
significant increase in the price of components could materially adversely
affect the Company's revenues and financial results and could impact
customer relations.

Ascend Year 2000 Readiness Disclosure

The Year 2000 computer issue creates a risk for Ascend and
therefore the Company makes the following Year 2000 readiness disclosure.
If computer systems do not correctly recognize date information when the
year changes to 2000, there could be a materially adverse impact on the
Company's operations. The risk for the Company exists in four areas:
systems used by the Company to run its business, systems used by the
Company's suppliers, potential warranty or other claims from the Company's
customers, and the potential reduced spending by other companies on
networking solutions as a result of significant information systems
spending on Year 2000 remediation. The Company is currently evaluating its
exposure in all of these areas and expects to complete such evaluation no
later than June 30, 1999.

Internal Systems. The Company has almost completed a comprehensive
assessment and evaluation of its systems, equipment and facilities. The
Company has a number of projects underway to test and replace or upgrade
systems, equipment and facilities that are known to be Year 2000
non-compliant. The Company expects Year 2000 internal testing to be
complete by June 1999. The Company has not identified alternative
remediation plans if upgrade or replacement is not feasible. The Company
will consider the need for such remediation plans as it continues to assess
the Year 2000 risk. For the Year 2000 non-compliance issues identified to
date, the cost of upgrade or remediation is not expected to be material to
the Company's operating results. If implementation of replacement systems
is delayed, or if significant new non-compliance issues are identified, the
Company's results of operations or financial condition could be materially
adversely affected.

Suppliers. The Company is also in the process of contacting its
critical suppliers to determine whether the suppliers' operations and the
products and services they provide are Year 2000 compliant. The Company's
process for assessing such compliance includes obtaining supplier
certifications, supplier follow-up meetings and external testing, if
required. Supplier certifications, supplier follow-up meetings and external
testing, if required, are expected to be completed by June 1999. In the
event that suppliers are not Year 2000 compliant, the Company will seek
alternative sources of supplies. However, such failures remain a
possibility and could have a materially adverse impact on the Company's
results of operations or financial condition. Additionally, litigation may
arise from situations in which the Company has minimum purchase commitment
contracts with suppliers that are not Year 2000 compliant.

Warranty. On the basis of product designs and quality assurance
tests, the Company believes the majority of its current products are Year
2000 compliant; however, some of the products sold by the Company in the
past may not be Year 2000 compliant. The Company currently identifies the
products that are certified as Y2K compliant through its Year 2000
readiness disclosure to customers, and for other products, does not have
any obligation to upgrade these products. However, the Company's products
are sometimes bundled or marketed with, or used by customers with, third
party products which may not always be Year 2000 compliant. For these
reasons, the Company may experience an increase in warranty and other
claims as a result of the Year 2000 transition and such claims could have a
material adverse impact on the Company's results of operations or financial
condition. In addition, in the event that a significant number of the
Company's customers experience Year 2000-related problems, whether or not
due to the Company's products, demand for technical support and assistance
may increase substantially. In such case, the Company's costs for providing
technical support may rise and the quality of such technical support or the
Company's ability to manage incoming requests may be impaired.

Sales Impact. Year 2000 compliance is an issue for almost all
businesses, whose computer systems and applications may require significant
hardware and software upgrades or modifications. Companies owning and
operating such systems may plan to devote a substantial portion of their
information systems' spending to fund such upgrades and modifications and
divert spending away from networking solutions. Such changes in customers'
spending patterns could have a material adverse impact on the Company's
sales, operating results or financial condition.

General. In order to evaluate the risks outlined above and to
implement Year 2000 compliance solutions, Ascend has established a company
wide team coupled with outside consultants. The internal Ascend Year 2000
compliance team consists of representatives from various functional areas,
including risk management, finance, engineering, purchasing, and legal. The
external Year 2000 compliance team includes various national Year 2000
compliance consultants. The team has established an overall Year 2000
compliance goal, incremental milestones and meets regularly to assess
progress on its milestones. Currently, the Company is establishing
contingency plans to address the impact to the Company in the event its
suppliers, products and internal systems are not Year 2000 compliant.

Costs incurred to date on the Company's Year 2000 compliance
project are approximately $11.5 million. Total costs of the project and
compliance are estimated to be $20.0 million to $24.0 million and should be
substantially incurred by June 30, 1999. However, there can be no assurance
that these costs will not be greater than anticipated, or that corrective
actions undertaken will be completed before any Year 2000 compliance
problems occur.

The Company's Year 2000 compliance criteria comply with the
requirements established by the US Government as stated in The Final GSA -
Year 2000 Compliance.

Volatility of Stock Price

The Company's common stock has experienced significant price
volatility, and such volatility may occur in the future, particularly as a
result of quarter-to-quarter variations in the actual or anticipated
financial results of the Company or other companies in the networking
industry, announcements by the Company or competitors regarding new product
introductions or other developments affecting the Company or changes in
financial estimates by public market analysts. In addition, the market has
experienced extreme price and volume fluctuations that have affected the
market price of many technology companies' stocks and that have been
unrelated or disproportionate to the operating performance of these
companies. These broad market fluctuations may materially adversely affect
the market price of the Company's common stock. Recent periods of
volatility in the market price of the Company's securities resulted in
securities class action litigation against the Company and various officers
and directors. Such litigation could result in substantial costs and a
diversion of management's attention and resources, which would have a
material adverse effect on the operating results and financial condition of
the Company.

In consideration of these factors, there can be no assurance that
the Company will be able to sustain growth in revenues or profitability,
particularly on a period-to-period basis.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company is experiencing a greater proportion of its sales
activity through its partners in two-tier distribution channels. Such
partners tend to have access to more limited financial resources than other
resellers and end-user customers and therefore represent potential sources
of increased credit risk. Additionally, the Company is experiencing
increased demands for customer financing and leasing solutions. The Company
also continues to monitor increased credit exposures because of the
weakened financial conditions in Asia and South America and the impact that
such conditions may have on the worldwide economy. Although the Company has
not experienced significant losses due to customer default to date, such
losses, if incurred, may have a material adverse impact on the Company's
business, operating results, and financial position.

The Company maintains investment portfolio holdings of various
issuers, types, and maturities. These securities are generally classified
as available for sale. The Company also has certain real estate lease
commitments with payments tied to short-term interest rates. At any time, a
sharp rise in interest rates could have a material adverse impact on the
fair value of the Company's investment portfolio while increasing the costs
associated with its lease commitments. Conversely, declines in interest
rates could have a material impact on interest earnings for the Company's
investment portfolio. The Company does not currently hedge these interest
rate exposures.

The following table presents the hypothetical changes in fair
values in the financial instruments held by the Company at December 31,
1998 that are sensitive to changes in interest rates. These instruments are
not leveraged and are held for purposes other than trading. The modeling
technique used measures the change in fair values arising from selected
potential changes in interest rates. Market changes reflect immediate
hypothetical parallel shifts in the yield curve of plus or minus 50 basis
points ("BPS"), 100BPS, and 150BPS over a twelve-month time horizon.
Beginning fair values represent the market principal plus accrued interest
and dividends for investments at December 31, 1998, which consist entirely
of obligations of states and political subdivisions. Ending fair values
comprise the market principal plus accrued interest, dividends, and
reinvestment income at a twelve-month time horizon. This table estimates
the fair value of the portfolio at a twelve-month time horizon (in
thousands):
<TABLE>
<CAPTION>

Valuation of securities No change Valuation of securities
given an interest rate in interest given an interest rate
decrease of X basis points rates increase of X basis points
-------------------------- ----------- --------------------------

A 50BPS move in the Federal Funds Rate has occurred in 9 of the
last 10 years; a 100BPS move in the Federal Funds Rate has occurred in 6 of
the last 10 years; and a 150BPS move in the Federal Funds Rate has occurred
in 3 of the last 10 years. The Company also is exposed to interest rate
risk associated with a lease on its facilities whose payments are tied to
the London Interbank Offered Rate (LIBOR), and has evaluated the
hypothetical change in lease obligations held at December 31, 1998 due to
changes in the LIBOR rate. Market changes reflected immediate hypothetical
parallel shifts in the LIBOR curve of plus or minus 50BPS, 100BPS, and
150BPS over a twelve-month period. The results of this analysis were not
material to the Company's financial results.

The Company also maintains investments in various privately held
companies totaling $37.0 million at December 31, 1998, and may acquire
additional investments in the future. The carrying value of these
investments is subject to potential declines in value, depending on the
financial performance of the privately held companies in which the
investments are maintained. Although the Company believes that the
investments are fairly valued at cost at December 31, 1998, there can be no
assurance that unanticipated declines in value will not occur, the results
of which could have a material adverse effect on the Company's financial
position and results of operations.

Prior to the acquisition of Stratus in the fourth quarter of 1998,
substantially all of the Company's sales were denominated in US dollars.
With the acquisition of Stratus, nondollar-denominated sales have increased
to some extent. Accordingly, the Company has entered into forward foreign
exchange contracts to offset the impact of currency fluctuations on certain
nonfunctional currency assets and liabilities, primarily denominated in
certain European, Japanese, Asian, and Australian currencies. The forward
currency contracts generally have original maturities of one to three
months, with none having a maturity greater than one year in length. The
total notional values of forward contracts purchased and forward contracts
sold were not material at December 31, 1998, and management does not expect
gains or losses on these contracts to have a material impact on the
Company's financial position and results of operations.

As a global concern, the Company faces exposure to adverse
movements in foreign currency exchange rates. These exposures may change
over time as business practices evolve and could have a material adverse
impact on the Company's financial results. Currently, the Company's primary
exposures relate to nondollar-denominated sales in Europe, Japan, the rest
of Asia, and Australia and nondollar-denominated operating expenses in
Europe and Asia. The introduction of the Euro as a common currency for
members of the European Monetary Union has not had a material effect on the
Company. At the present time, the Company hedges only those currency
exposures associated with certain known assets and liabilities, denominated
in nonfunctional currencies, and does not hedge anticipated foreign
currency cash flows. The hedging activity of the Company is intended to
offset the impact of currency fluctuations on certain nonfunctional
currency assets and liabilities. The success of this activity depends upon
estimation of balances denominated in various currencies, primarily certain
European, Japanese and Australian currencies. To the extent that these
estimates are over- or understated during periods of currency volatility,
the Company could experience unanticipated currency gains or losses.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

3. Business Combinations

Pooling of Interests Combinations

Business combinations which were accounted for as pooling of
interests are summarized as follows (in millions):

CASCADE WHITETREE NETSTAR

Acquisition date June 1997 April 1997 August 1996
Shares of common stock issued............ 66.3 1.3 3.9
Stock options and warrants assumed....... 8.5 0.1 0.7

Cascade Communications Corp. ("Cascade") was a developer and
manufacturer of wide area network switches. Whitetree, Inc. ("Whitetree")
was a developer and manufacturer of high-speed ATM switching products.
NetStar, Inc. ("NetStar") was a developer and manufacturer of high
performance, high-speed IP network routers. The Company's historical
financial results were restated for each pooling of interest business
combination, except in the case of Whitetree, where the results of the
acquired entity were not material to the Company's consolidated results.

Purchase Combinations

Business combinations which were accounted for as a purchase are
summarized as follows (in millions):
<TABLE>
<CAPTION>

STRATUS INTERCON SAHARA
------- -------- ------
<S> <C> <C> <C>
Acquisition date.......................................... October 1998 February 1997 January 1997
Purchase price ........................................... $ 916.7 $ 21.6 $ 219.0
Consideration
Shares of common stock issued........................... 18.1 - 2.4
Fair value of common stock issued....................... $ 808.7 $ - $ 196.8
Fair value of common stock options assumed.............. $ 27.7 $ - $ 22.2
Cash paid............................................... $ - $ 12.0 $ -
Liabilities assumed..................................... $ 80.3 $ 9.6 $ -
Allocation of purchase price
Net tangible assets..................................... $ 400.2 $ 0.6 $ 6.0
Assets held for sale.................................... $ 116.0 $ - $ -
Purchased in-process research and development........... $ 267.0 $ 18.0 $ 213.0
Existing technology..................................... $ 130.0 $ 3.0 $ -
Assembled work force.................................... $ 3.5 $ - $ -
Amortization period - existing technology (years)....... 10 3 -
Amortization period - assembled work force (years)...... 3 - -
</TABLE>

Stratus Computer, Inc. ("Stratus") was a manufacturer of
fault-tolerant computer systems. InterCon Systems Corporation ("InterCon")
was a developer of remote access client software products. Sahara Networks,
Inc. ("Sahara") was a privately held developer of scaleable high-speed
broadband access products. Sahara was acquired by Cascade, which was
subsequently acquired by the Company. For business combinations accounted
for as a purchase, the Company's consolidated financial statements include
the operating results from the date of acquisition. The amounts allocated
to purchased in-process research and development were determined using the
discounted cash flow method and were expensed upon acquisition because
technological feasibility had not been established and no future
alternative uses existed.

Prior to the consummation of the acquisition of Stratus, the
Company announced its intention to divest the non-telecommunication
business units of Stratus, which consist of the Enterprise computer
business unit, two business units comprised of financial and enterprise
software (TCAM and S2), and a software joint venture interest (Astria).
Accordingly, these business units were recorded at their estimated fair
value upon acquisition and are classified as assets held for sale at
December 31, 1998. The estimated fair value was based on discussions with
independent third parties that expressed interest in acquiring these
business units. Based on these discussions, the fair value of these
business units was estimated to range from $132.0 million to $175.0
million. The assets held for sale were recorded within this range. This
amount was subsequently reduced by operating cash outflows totaling $21.6
million, partially offset by operating income of $5.6 million, both of
which were excluded from the Company's consolidated results of operations
and cash flows, for an adjusted book value of $116.0 million at December
31, 1998.

In January and February 1999, the Company entered into definitive
agreements to divest each of these business units, for a combined total of
approximately $165 million, subject to potential adjustments under certain
circumstances. To the extent that the sales proceeds of the business units
exceed the original estimate, or the accrued costs to divest the business
units is less than expected, the Company will reduce its original charge
for purchased in-process research and development and reduce the amount of
the purchase price allocated to non-current assets on a pro-rata basis.

The following summary of the unaudited pro forma combined results
of Ascend and Stratus (as if the acquisition had occurred on January 1,
1997) excludes the results of operations for the acquired business units
held for sale (thousands, except per share data):

YEAR ENDED DECEMBER 31,
--------------------------------------
1998 1997
----------------- ----------------
(UNAUDITED) (UNAUDITED)

Net sales................................. $ 1,647,075 $ 1,470,152
Operating income (loss)................... 74,684 (45,556)
Net loss.................................. (20,337) (102,637)
Net loss per share - basic and diluted.... (0.10) (0.50)

Included in the liabilities assumed are $49.3 million of accrued
merger costs, which consist of $7.6 million of merger transaction costs and
$41.7 million of integration expenses. Integration expenses consist of $2.4
million for severance and outplacement costs, $34.8 million for costs
associated with the divestiture of the non-telecommunications business
units, and $4.5 million of other merger related costs. The $2.4 million of
severance and outplacement costs relates to approximately 150 employees
involved in duplicate functions, including manufacturing and logistics,
sales and marketing, and finance and administration. The $34.8 million of
costs associated with the divestiture of the non-telecommunications
business units consists of the following major components: (1) $22.2
million of costs associated with termination of lease agreements and
relocation of the non-telecommunication business units, (2) $8.6 million of
investment banker and other professional fees related to the divestitures,
and (3) $4.0 million of other miscellaneous expenses.

The purchase price allocation for the Stratus acquisition is
tentative and will be adjusted based on certain factors, including the
value received for the business units held for sale. Accordingly, the
purchase price allocation will be adjusted during the first or second
quarter of 1999.

8. Litigation

These actions are in the early stages of proceedings and the
Company is currently investigating the allegations. Based on its current
information, the Company believes the suits to be without merit and intends
to defend itself and its officers and directors vigorously. Although it is
reasonably possible the Company may incur a loss upon the conclusion of
these claims, an estimate of any loss or range of loss cannot be made. No
provision for any liability that may result upon adjudication has been made
in the consolidated financial statements. In the opinion of management,
resolution of this matter is not expected to have a material adverse effect
on the financial position of the Company. However, depending on the amount
and timing, an unfavorable resolution of this matter could materially
affect the Company's financial position, future results of operations or
cash flows in a particular period. In connection with these legal
proceedings, the Company expects to incur substantial legal and other
expenses. Shareholder suits of this kind are highly complex and can extend
for a protracted period of time, which can substantially increase the cost
of such litigation and divert the attention of the Company's management.

9. Segment and Geographical Information

Segment Disclosures -- The Company operates in one business
segment, which is the global communications networking industry. For
management purposes, the Company is divided into three primary business
units, Core Systems, Access Switching and Enterprise Access. Each of these
groups has a vice president who reports directly to the Chief Executive
Officer ("CEO"), who is the Chief Operating Decision Maker as defined by
SFAS 131. The measures of profitability reviewed by the CEO consist of
revenues, gross profit and contribution margin. The majority of the
Company's operating expenses are not allocated to the business units, but
are treated as corporate expenses. Revenues attributable to each business
unit are as follows:

YEAR ENDED DECEMBER 31,
------------------------------------
1998 1997 1996
----------- ------------ ----------
Core Systems......................... $ 688,889 $ 410,144 $320,498
Access Switching..................... 603,523 605,906 427,331
Enterprise Access.................... 103,135 100,291 115,735
Other................................ 83,135 51,011 26,709
----------- ------------ ----------
$1,478,682 $1,167,352 $890,273
=========== ============ ==========

For financial reporting purposes, the Core Systems and Access
Switching business units (which total approximately 87%, 87% and 84% of
total revenues in 1998, 1997 and 1996, respectively) are combined into a
single industry segment, because the nature of the products and services,
the production processes, types of customers, distribution method and gross
margins for these business units are similar. No other business units meet
the revenue, profit/loss or assets criteria for reportable segments as
defined by SFAS 131.

Major Customers and Revenues by Geographic Area -- One customer
accounted for 13% and 17% of net sales in 1998 and 1997, respectively. No
customer accounted for more than 10% of net sales in 1996. Net sales were
derived from customers based in the following geographic areas (in
thousands):

YEAR ENDED DECEMBER 31,
------------------------------------------
1998 1997 1996
----------- ----------- ----------

North America...................... $1,051,160 $ 805,012 $ 576,996
Europe............................. 184,128 157,960 129,126
Asia and Pacific Basin............. 212,184 189,675 170,747
Latin and South America............ 31,210 14,705 13,404
------------ ----------- ----------
$1,478,682 $1,167,352 $ 890,273
============ =========== ==========

Substantially all of the Company's identifiable assets at December
31, 1998 and 1997 were attributable to North American operations.

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be
signed on its behalf by the undersigned thereunto duly authorized.

ASCEND COMMUNICATIONS, INC.

Date May 19, 1999 by /s/ Mory Ejabat
------------ ------------------------------
Mory Ejabat
President, Chief Executive
Officer and Director