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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549





FORM 10-Q





(Mark One)

|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------------

For the quarterly period ended March 31, 2011

OR



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------

For the transition period from              to

000-32743

(Commission File Number)





ZHONE
TECHNOLOGIES, INC.

(Exact name of registrant as specified in its charter)







|                                                               |  |                                        
|-------------------------------------------------------------- |  | ---------------------------------------
|Delaware                                                       |  | 22-3509099                             
|(State or other jurisdiction of
incorporation or organization) |  | (I.R.S. Employer Identification Number)
|                                                               | 
|7195 Oakport Street Oakland, California                        |  | 94621                                  
|(Address of principal executive offices)                       |  | (Zip code)                             

(510)
777-7000

(Registrants telephone number, including area code)





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 whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule
405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such
files).    Yes   ̈    No   ̈

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of large accelerated
filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one):



|                        |  |                                                  |  |                           |  |  
|----------------------- |  | ------------------------------------------------ |  | ------------------------- |  | -
|Large accelerated filer |  |  ̈                                                |  | Accelerated filer         |  |  ̈
|                        |  |                                                  | 
|Non-accelerated filer   |  |  ̈  (Do not check if a smaller reporting company) |  | Smaller reporting company |  | x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes   ̈    No  x

As of
May 2, 2011, there were approximately 30,627,994 shares of the registrants common stock outstanding.









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TABLE OF CONTENTS



|                              |  |                                                                                       |  |      |    | 
|----------------------------- |  | ------------------------------------------------------------------------------------- |  | ---- | -- | 
|                              |  |                                                                                       |  | Page |   
|PART I. FINANCIAL INFORMATION |  |                                                                                       |  |     
|                              |  |                                                                                      
|Item 1.                       |  | Financial Statements                                                                  |  |      | 3  | 
|                              |  |                                                                                      
|                              |  | Unaudited Condensed Consolidated Balance Sheets                                       |  |      | 3  | 
|                              |  |                                                                                      
|                              |  | Unaudited Condensed Consolidated Statements of Operations                             |  |      | 4  | 
|                              |  |                                                                                      
|                              |  | Unaudited Condensed Consolidated Statements of Cash Flows                             |  |      | 5  | 
|                              |  |                                                                                      
|                              |  | Notes to Unaudited Condensed Consolidated Financial Statements                        |  |      | 6  | 
|                              |  |                                                                                      
|Item 2.                       |  | Managements Discussion and Analysis of Financial Condition and Results of Operations |  |      | 16 | 
|                              |  |                                                                                      
|Item 3.                       |  | Quantitative and Qualitative Disclosures About Market Risk                            |  |      | 23 | 
|                              |  |                                                                                      
|Item 4.                       |  | Controls and Procedures                                                               |  |      | 24 | 
|                              | 
|PART II. OTHER INFORMATION    |  |                                                                                       |  |     
|                              |  |                                                                                      
|Item 1.                       |  | Legal Proceedings                                                                     |  |      | 25 | 
|                              |  |                                                                                      
|Item 1A.                      |  | Risk Factors                                                                          |  |      | 25 | 
|                              |  |                                                                                      
|Item 6.                       |  | Exhibits                                                                              |  |      | 25 | 
|                              |  |                                                                                      
|                              |  | Signatures                                                                            |  |      | 26 | 



2



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PART I. FINANCIAL INFORMATION



|Item 1. | Financial Statements
|------- | --------------------

ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES

Unaudited Condensed Consolidated Balance Sheets

(In thousands, except par value)



|                                                                                                                                                                    |  |               |            |   |                  |   |            |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------- | ---------- | - | ---------------- | - | ---------- | -
|                                                                                                                                                                    |  | March 31,2011 |            |   | December 31,2010 |  
|                                                                                                                                                                    |  | (Unaudited)   |            |   |                  |  
|Assets                                                                                                                                                              |  |               |            |   |                  |   |            |  
|Current assets:                                                                                                                                                     |  |               |            |   |                  |   |            |  
|Cash and cash equivalents                                                                                                                                           |  | $             | 19,179     |   |                  | $ | 21,174     |  
|Accounts receivable, net of allowances for sales returns and doubtful accounts of $2,277 as of March 31, 2011 and $2,433 as
of December 31, 2010                    |  |               | 29,418     |   |                  |   | 29,747     |  
|Inventories                                                                                                                                                         |  |               | 28,905     |   |                  |   | 31,048     |  
|Prepaid expenses and other current assets                                                                                                                           |  |               | 2,515      |   |                  |   | 2,514      |  
|                                                                                                                                                                    |  |               |            |   |                  |   |            |  
|Total current assets                                                                                                                                                |  |               | 80,017     |   |                  |   | 84,483     |  
|Property and equipment, net                                                                                                                                         |  |               | 5,074      |   |                  |   | 5,274      |  
|Restricted cash                                                                                                                                                     |  |               | 58         |   |                  |   | 58         |  
|Other assets                                                                                                                                                        |  |               | 228        |   |                  |   | 296        |  
|                                                                                                                                                                    |  |               |            |   |                  |   |            |  
|Total assets                                                                                                                                                        |  | $             | 85,377     |   |                  | $ | 90,111     |  
|                                                                                                                                                                    |  |               |            |   |                  |   |            |  
|Liabilities and Stockholders Equity                                                                                                                                |  |               |            |   |                  |   |            |  
|Current liabilities:                                                                                                                                                |  |               |            |   |                  |   |            |  
|Accounts payable                                                                                                                                                    |  | $             | 10,783     |   |                  | $ | 11,864     |  
|Line of credit                                                                                                                                                      |  |               | 10,000     |   |                  |   | 10,000     |  
|Accrued and other liabilities                                                                                                                                       |  |               | 12,251     |   |                  |   | 13,217     |  
|                                                                                                                                                                    |  |               |            |   |                  |   |            |  
|Total current liabilities                                                                                                                                           |  |               | 33,034     |   |                  |   | 35,081     |  
|Other long-term liabilities                                                                                                                                         |  |               | 5,099      |   |                  |   | 5,615      |  
|                                                                                                                                                                    |  |               |            |   |                  |   |            |  
|Total liabilities                                                                                                                                                   |  |               | 38,133     |   |                  |   | 40,696     |  
|                                                                                                                                                                    |  |               |            |   |                  |   |            |  
|Stockholders equity:                                                                                                                                               |  |               |            |   |                  |   |            |  
|Common stock, $0.001 par value. Authorized 180,000 shares; issued and outstanding 30,621 and 30,555 shares as of March 31,
2011 and December 31, 2010, respectively |  |               | 31         |   |                  |   | 30         |  
|Additional paid-in capital                                                                                                                                          |  |               | 1,069,791  |   |                  |   | 1,069,513  |  
|Other comprehensive income                                                                                                                                          |  |               | 267        |   |                  |   | 277        |  
|Accumulated deficit                                                                                                                                                 |  |               | (1,022,845 | ) |                  |   | (1,020,405 | )
|                                                                                                                                                                    |  |               |            |   |                  |   |            |  
|Total stockholders equity                                                                                                                                          |  |               | 47,244     |   |                  |   | 49,415     |  
|                                                                                                                                                                    |  |               |            |   |                  |   |            |  
|Total liabilities and stockholders equity                                                                                                                          |  | $             | 85,377     |   |                  | $ | 90,111     |  
|                                                                                                                                                                    |  |               |            |   |                  |   |            |  

See accompanying notes to unaudited condensed consolidated financial statements.



3



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ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES

Unaudited Condensed Consolidated Statements of Operations

(In thousands, except per share data)



|                                                                                         |  |                             |        |   |      |   |        |  
|---------------------------------------------------------------------------------------- |  | --------------------------- | ------ | - | ---- | - | ------ | -
|                                                                                         |  | Three Months EndedMarch
31, |       
|                                                                                         |  | 2011                        |        |   | 2010 |  
|Net revenue                                                                              |  | $                           | 29,572 |   |      | $ | 31,082 |  
|Cost of revenue                                                                          |  |                             | 18,993 |   |      |   | 19,765 |  
|                                                                                         |  |                             |        |   |      |   |        |  
|Gross profit                                                                             |  |                             | 10,579 |   |      |   | 11,317 |  
|                                                                                         |  |                             |        |   |      |   |        |  
|Operating expenses:                                                                      |  |                             |        |   |      |   |        |  
|Research and product development                                                         |  |                             | 5,516  |   |      |   | 5,277  |  
|Sales and marketing                                                                      |  |                             | 5,494  |   |      |   | 5,780  |  
|General and administrative                                                               |  |                             | 2,071  |   |      |   | 3,262  |  
|                                                                                         |  |                             |        |   |      |   |        |  
|Total operating expenses                                                                 |  |                             | 13,081 |   |      |   | 14,319 |  
|                                                                                         |  |                             |        |   |      |   |        |  
|Operating loss                                                                           |  |                             | (2,502 | ) |      |   | (3,002 | )
|Interest expense                                                                         |  |                             | (49    | ) |      |   | (322   | )
|Interest income                                                                          |  |                             | 2      |   |      |   |       |  
|Other income                                                                             |  |                             | 56     |   |      |   | 6      |  
|                                                                                         |  |                             |        |   |      |   |        |  
|Loss before income taxes                                                                 |  |                             | (2,493 | ) |      |   | (3,318 | )
|Income tax benefit                                                                       |  |                             | 53     |   |      |   | 114    |  
|                                                                                         |  |                             |        |   |      |   |        |  
|Net loss                                                                                 |  | $                           | (2,440 | ) |      | $ | (3,204 | )
|                                                                                         |  |                             |        |   |      |   |        |  
|Basic and diluted net loss per share                                                     |  | $                           | (0.08  | ) |      | $ | (0.11  | )
|Weighted average shares outstanding used to compute basic and diluted net loss per share |  |                             | 30,591 |   |      |   | 30,282 |  

See accompanying notes
to unaudited condensed consolidated financial statements.



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ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES

Unaudited Condensed Consolidated Statements of Cash Flows

(In thousands)



|                                                                            |  |                             |        |   |      |   |        |  
|--------------------------------------------------------------------------- |  | --------------------------- | ------ | - | ---- | - | ------ | -
|                                                                            |  | Three Months EndedMarch
31, |       
|                                                                            |  | 2011                        |        |   | 2010 |  
|Cash flows from operating activities:                                       |  |                             |        |   |      |   |        |  
|Net loss                                                                    |  | $                           | (2,440 | ) |      | $ | (3,204 | )
|Adjustments to reconcile net loss to net cash used in operating activities: |  |                             |        |   |      |   |        |  
|Depreciation and amortization                                               |  |                             | 453    |   |      |   | 446    |  
|Stock-based compensation                                                    |  |                             | 231    |   |      |   | 1,483  |  
|Provision for sales returns and doubtful accounts                           |  |                             | 487    |   |      |   | (112   | )
|Changes in operating assets and liabilities:                                |  |                             |        |   |      |   |        |  
|Accounts receivable                                                         |  |                             | (158   | ) |      |   | (253   | )
|Inventories                                                                 |  |                             | 2,143  |   |      |   | (1,609 | )
|Prepaid expenses and other current assets                                   |  |                             | (1     | ) |      |   | 60     |  
|Other assets                                                                |  |                             | 68     |   |      |   | (297   | )
|Accounts payable                                                            |  |                             | (1,081 | ) |      |   | 701    |  
|Accrued and other liabilities                                               |  |                             | (1,482 | ) |      |   | 2,122  |  
|                                                                            |  |                             |        |   |      |   |        |  
|Net cash used in operating activities                                       |  |                             | (1,780 | ) |      |   | (663   | )
|                                                                            |  |                             |        |   |      |   |        |  
|Cash flows from investing activities:                                       |  |                             |        |   |      |   |        |  
|Purchases of property and equipment                                         |  |                             | (253   | ) |      |   | (210   | )
|Proceeds from sale and maturities of short-term investments                 |  |                             |       |   |      |   | 306    |  
|                                                                            |  |                             |        |   |      |   |        |  
|Net cash (used in) provided by investing activities                         |  |                             | (253   | ) |      |   | 96     |  
|                                                                            |  |                             |        |   |      |   |        |  
|Cash flows from financing activities:                                       |  |                             |        |   |      |   |        |  
|Proceeds from exercise of stock options and purchases under the ESPP plan   |  |                             | 48     |   |      |   | 51     |  
|Repayment of debt                                                           |  |                             |       |   |      |   | (104   | )
|                                                                            |  |                             |        |   |      |   |        |  
|Net cash provided by (used in) financing activities                         |  |                             | 48     |   |      |   | (53    | )
|                                                                            |  |                             |        |   |      |   |        |  
|Effect of exchange rate changes on cash                                     |  |                             | (10    | ) |      |   | 17     |  
|                                                                            |  |                             |        |   |      |   |        |  
|Net decrease in cash and cash equivalents                                   |  |                             | (1,995 | ) |      |   | (603   | )
|Cash and cash equivalents at beginning of period                            |  |                             | 21,174 |   |      |   | 21,460 |  
|                                                                            |  |                             |        |   |      |   |        |  
|Cash and cash equivalents at end of period                                  |  | $                           | 19,179 |   |      | $ | 20,857 |  
|                                                                            |  |                             |        |   |      |   |        |  

See accompanying notes to unaudited condensed consolidated financial statements.



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Notes to Unaudited Condensed Consolidated Financial Statements



|(1) | Organization and Summary of Significant Accounting Policies
|--- | -----------------------------------------------------------



| | (a) | Description of Business
| | --- | -----------------------

Zhone Technologies, Inc. (sometimes referred to, collectively with its subsidiaries, as Zhone or the Company) designs, develops and manufactures communications network equipment
for telecommunications, wireless, and cable operators worldwide. The Companys products allow network service providers to deliver video and interactive entertainment services in addition to their existing voice and data service offerings. The
Company was incorporated under the laws of the state of Delaware in September 1999. The Company began operations in September 1999 and is headquartered in Oakland, California.



| | (b) | Basis of Presentation
| | --- | ---------------------

The condensed consolidated financial statements are unaudited and reflect all adjustments (consisting only of normal recurring adjustments) that, in the opinion of management, are necessary for a fair
presentation of the results for the interim periods presented in accordance with accounting principles generally accepted in the United States of America (GAAP). The results of operations for the current interim period are not necessarily indicative
of results to be expected for the current year or any other period. These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Companys
Form 10-K for the year ended December 31, 2010.



| | (c) | Risks and Uncertainties
| | --- | -----------------------

The accompanying condensed consolidated financial statements have been prepared assuming that the Company will continue as a going concern. The Companys continued losses reduced cash and cash
equivalents in 2010 and the three months ended March 31, 2011. As of March 31, 2011, the Company had approximately $19.2 million in cash and cash equivalents and $10.0 million in current debt outstanding under its revolving line of credit
and letter of credit facility (the SVB Facility). The Company renewed and amended the SVB Facility on March 14, 2011 to provide liquidity and working capital through March 13, 2012, as discussed in Note 10. Continued
uncertainty regarding financial institutions ability and inclination to lend may negatively impact the Companys ability to refinance its existing indebtedness on favorable terms, or at all.

The global unfavorable economic and market conditions could impact the Companys business in a number of ways, including:



| |  |  | Potential deferment of purchases and orders by customers;
| | - |  | ---------------------------------------------------------



| |  |  | Customers inability to obtain financing to make purchases from the Company and/or maintain their business;
| | - |  | -----------------------------------------------------------------------------------------------------------



| |  |  | Negative impact from increased financial pressures on third-party dealers, distributors and retailers; and
| | - |  | ----------------------------------------------------------------------------------------------------------



| |  |  | Negative impact from increased financial pressures on key suppliers.
| | - |  | --------------------------------------------------------------------

If the economic, market and geopolitical conditions in the United States and the rest of the world do not continue to improve or if they
deteriorate, the Company may experience material adverse impacts on its business, operating results and financial condition.

The Company expects that operating losses and negative cash flows from operations may continue. In order to meet the Companys
liquidity needs and finance its capital expenditures and working capital needs for the business, the Company may be required to sell assets, issue debt or equity securities or borrow on unfavorable terms. Continued uncertainty in credit markets may
negatively impact the Companys ability to access debt financing or to refinance existing indebtedness in the future on favorable terms, or at all. The Company may be unable to sell assets, issue securities or access additional indebtedness to
meet these needs on favorable terms, or at all. As a result, the Company may become unable to pay its ordinary expenses, including its debt service, on a timely basis. The Companys current lack of liquidity could harm it by:



| |  |  | increasing its vulnerability to adverse economic conditions in its industry or the economy in general;
| | - |  | ------------------------------------------------------------------------------------------------------



| |  |  | requiring substantial amounts of cash to be used for debt servicing, rather than other purposes, including operations;
| | - |  | ----------------------------------------------------------------------------------------------------------------------



| |  |  | limiting its ability to plan for, or react to, changes in its business and industry; and
| | - |  | ----------------------------------------------------------------------------------------



| |  |  | influencing investor and customer perceptions about its financial stability and limiting its ability to obtain financing or acquire customers.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------



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If additional capital is raised through the issuance of debt securities or other debt
financing, the terms of such debt may include covenants, restrictions and financial ratios that may restrict the Companys ability to operate its business. Likewise, any equity financing could result in additional dilution of the Companys
stockholders. If the Company is unable to obtain additional capital or is required to obtain additional capital on terms that are not favorable, it may be required to reduce the scope of its planned product development and sales and marketing
efforts beyond the reductions it has previously taken. Based on the Companys current plans and business conditions, it believes that its existing cash, cash equivalents and available credit facilities will be sufficient to satisfy its
anticipated cash requirements for the foreseeable future.



| | (d) | Use of Estimates
| | --- | ----------------

The preparation of the condensed consolidated financial statements in conformity with generally accepted accounting principles in the
United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated financial
statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ materially from those estimates.



| | (e) | Revenue Recognition
| | --- | -------------------

The Company recognizes revenue when the earnings process is complete. The Company recognizes product revenue upon shipment of product under contractual terms which transfer title to customers upon
shipment, under normal credit terms, net of estimated sales returns and allowances at the time of shipment. Revenue is deferred if there are significant post-delivery obligations or if the fees are not fixed or determinable. When significant
post-delivery obligations exist, revenue is deferred until such obligations are fulfilled. The Companys arrangements generally do not have any significant post-delivery obligations. If the Companys arrangements include customer
acceptance provisions, revenue is recognized upon obtaining the signed acceptance certificate from the customer, unless the Company can objectively demonstrate that the delivered products or services meet all the acceptance criteria specified in the
arrangement prior to obtaining the signed acceptance. In those instances where revenue is recognized prior to obtaining the signed acceptance certificate, the Company uses successful completion of customer testing as the basis to objectively
demonstrate that the delivered products or services meet all the acceptance criteria specified in the arrangement. The Company also considers historical acceptance experience with the customer, as well as the payment terms specified in the
arrangement, when revenue is recognized prior to obtaining the signed acceptance certificate. When collectability is not reasonably assured, revenue is recognized when cash is collected.

The Company makes certain sales to product distributors. These customers are given certain privileges to return a portion of inventory.
Return privileges generally allow distributors to return inventory based on a percent of purchases made within a specific period of time. The Company recognizes revenue on sales to distributors that have contractual return rights when the products
have been sold by the distributors, unless there is sufficient customer specific sales and sales returns history to support revenue recognition upon shipment. In those instances when revenue is recognized upon shipment to distributors, the Company
uses historical rates of return from the distributors to provide for estimated product returns. The Company accrues for warranty costs, sales returns and other allowances at the time of shipment based on historical experience and expected future
costs.

In October 2009, the Financial Accounting Standards Board (FASB) amended the accounting standards for
multiple deliverable revenue arrangements to:



| | (i) | provide updated guidance on whether multiple deliverables exist, how the deliverables in an arrangement should be separated, and how the consideration should be
allocated;
| | --- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (ii) | require an entity to allocate revenue in an arrangement using best estimate of selling prices, or BSP, for deliverables if a vendor does not have vendor-specific
objective evidence of selling price, or VSOE, or third-party evidence of selling price, or TPE; and
| | ---- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (iii) | eliminate the use of the residual method and require an entity to allocate revenue using the relative selling price method.
| | ----- | ---------------------------------------------------------------------------------------------------------------------------

The Company adopted the updated accounting standards on January 1, 2011 on a prospective basis for applicable transactions
originating or materially modified after December 31, 2010. This guidance does not change the units of accounting for revenue transactions. The Companys products and services qualify as separate units of accounting and are deemed to be
non-contingent deliverables as the Companys arrangements typically do not have any significant performance, cancellation, termination and refund type provisions. Products are typically considered delivered upon shipment. Revenue from services
is recognized ratably over the period during which the services are to be performed.



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Prior to the adoption of Accounting Standards Update (ASU) 2009-13, Multiple
Revenue Recognition (Topic 605): Multiple-Deliverable Revenue Arrangements, the Company established the fair value or TPE of services in multiple-element arrangements based primarily on sales prices when the products and services were sold
separately. As such, the Company applied the residual method to allocate the arrangement fee between products and services. In limited circumstances, if fair value could not be established for undelivered elements, all of the revenue under the
arrangement was deferred until those elements were delivered. Upon adoption of ASU 2009-13, on January 1, 2011, the Company allocated revenue to the products and services using the relative selling price method to recognize revenue when the basic
revenue recognition criteria for each deliverable are met.

The Company derives revenue primarily from stand-alone sales of its
products. In certain cases, the Companys products are sold along with services, which include education, training, installation, and/or extended warranty services. The Company has established TPE for its training, education and installation
services. TPE is determined based on competitor prices for similar deliverables when sold separately. These service arrangements are typically short term in nature and are largely completed shortly after delivery of the product. Training and
education services are based on a daily rate per person and vary according to the type of class offered. Installation services are based on daily rate per person and vary according to the complexity of the products being installed.

Extended warranty services are priced based on the type of product and are sold in one to five year durations. Extended warranty services
include the right to warranty coverage beyond the standard warranty period. In substantially all of the arrangements with multiple deliverables pertaining to arrangements with these services, the Company has used and intends to continue using VSOE
to determine the selling price for the services. Consistent with its methodology under previous accounting guidance, the Company determines VSOE based on its normal pricing practices for these specific services when sold separately.

In most instances, particularly as it relates to products, the Company is not able to establish VSOE for all deliverables in an
arrangement with multiple elements. This may be due to infrequently selling each element separately, not pricing products within a narrow range, or only having a limited sales history. When VSOE cannot be established, the Company attempts to
establish the selling price of each element based on TPE. Generally, the Companys marketing strategy differs from that of the Companys peers and the Companys offerings contain a significant level of customization and
differentiation such that the comparable pricing of products with similar functionality cannot be obtained. Furthermore, the Company is unable to reliably determine what similar competitor products selling prices are on a stand-alone basis.
Therefore, the Company is typically not able to determine TPE for the Companys products.

When the Company is unable to
establish selling price using VSOE or TPE, the Company uses BSP. The objective of BSP is to determine the price at which the Company would transact a sale if the product or service were sold on a stand-alone basis. The BSP of each deliverable is
determined using average discounts from list price from historical sales transactions or cost plus margin approaches based on the factors, including but not limited to, the Companys gross margin objectives and pricing practices plus customer
and market specific considerations.

The adoption did not have a material effect on the Companys condensed consolidated
financial statements for the three months period ended March 31, 2011 and is not expected to have a material effect on future periods.



| | (f) | Fair Value of Financial Instruments
| | --- | -----------------------------------

The carrying amounts of the Companys consolidated financial instruments which include cash and cash equivalents, accounts receivable, accounts payable, and accrued liabilities approximate their fair
values as of March 31, 2011 and December 31, 2010 due to the relatively short maturities of these instruments. The carrying value of the Companys debt obligations at March 31, 2011 and December 31, 2010 approximate their
fair value.



| | (g) | Concentration of Risk
| | --- | ---------------------

The Companys customers include competitive and incumbent local exchange carriers, competitive access providers, Internet service providers, wireless carriers and resellers serving these markets. The
Company performs ongoing credit evaluations of its customers and generally does not require collateral. Allowances are maintained for potential doubtful accounts. For the three months ended March 31, 2011, Emirates Telecommunications
Corporation (Etisalat) accounted for 22% of net revenue. For the three months ended March 31, 2010, the same customer accounted for 34% of net revenue.

As of March 31, 2011, Etisalat receivables, which are denominated in United Arab Emirates Dirhams, a currency that tracks to the U.S. dollar, accounted for 43% of net accounts receivable. As of
December 31, 2010, the same customer accounted for 30% of net accounts receivable.



8



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As of March 31, 2011 and December 31, 2010, receivables from customers in
countries other than the United States represented 72% and 74%, respectively, of net accounts receivable.



| | (h) | Property and Equipment
| | --- | ----------------------

Property and equipment are stated at cost and depreciated using the straight-line method over their estimated useful lives. Useful lives of all property and equipment range from 3 to 5 years. Leasehold
improvements are generally amortized over the shorter of their useful lives or the remaining lease term.



| | (i) | Inventories
| | --- | -----------

Inventories are stated at the lower of cost or market, with cost being determined using the first-in, first-out (FIFO) method. In
assessing the net realizable value of inventories, the Company is required to make judgments as to future demand requirements and compare these with the current or committed inventory levels. Once inventory has been written down to its estimated net
realizable value, its carrying value cannot be increased due to subsequent changes in demand forecasts. To the extent that a severe decline in forecasted demand occurs, or the Company experiences a higher incidence of inventory obsolescence due to
rapidly changing technology and customer requirements, the Company may incur significant charges for excess inventory.



|(2) | Cash and Cash Equivalents
|--- | -------------------------

Cash and cash equivalents as of March 31, 2011 and December 31, 2010 consisted of the following (in thousands):



|                           |  |               |        |  |                  |   |        | 
|-------------------------- |  | ------------- | ------ |  | ---------------- | - | ------ | 
|                           |  | March 31,2011 |        |  | December 31,2010 |  
|Cash and Cash Equivalents: |  |               |        |  |                  |   |        | 
|Cash                       |  | $             | 18,962 |  |                  | $ | 16,957 | 
|Money Market Funds         |  |               | 217    |  |                  |   | 4,217  | 
|                           |  |               |        |  |                  |   |        | 
|                           |  | $             | 19,179 |  |                  | $ | 21,174 | 
|                           |  |               |        |  |                  |   |        | 

As of March 31, 2011 and December 31, 2010, the fair value equaled cost of the cash and cash
equivalents.



|(3) | Fair Value Measurement
|--- | ----------------------

The Company utilizes the market approach to measure fair value of its financial assets and liabilities. The market approach uses prices
and other relevant information generated by market transactions involving identical or comparable assets or liabilities.

The
Company utilizes a fair value hierarchy that is intended to increase consistency and comparability in fair value measurements and related disclosures. The fair value hierarchy is based on inputs to valuation techniques that are used to measure fair
value that are either observable or unobservable. Observable inputs reflect assumptions market participants would use in pricing an asset or liability based on market data obtained from independent sources while unobservable inputs reflect a
reporting entitys pricing based upon their own market assumptions. The fair value hierarchy consists of the following three levels:



|          |  |                                                                                                                                                                                                                                                                                                                                              
|--------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Level 1 - |  | Inputs are quoted prices in active markets for identical assets or liabilities.                                                                                                                                                                                                                                                              
|          | 
|Level 2 - |  | Inputs are quoted prices for similar assets or liabilities in an active market, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs
other than quoted prices that are observable and market-corroborated inputs which are derived principally from or corroborated by observable market data.
|          | 
|Level 3 - |  | Inputs are derived from valuation techniques in which one or more significant inputs or value drivers are unobservable.                                                                                                                                                                                                                      



9



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##### Table of Contents

The following table represents the Companys financial assets and liabilities measured
at fair value on a recurring basis as of March 31, 2011 and December 31, 2010 and the basis for that measurement:



|                       |  |                                                                 |       |  |                                                          |   |       |                                           |  |   |                                        |  |  |   |   | 
|---------------------- |  | --------------------------------------------------------------- | ----- |  | -------------------------------------------------------- | - | ----- | ----------------------------------------- |  | - | -------------------------------------- |  |  | - | - | 
|                       |  | Fair Value Measurements as of March 31, 2011 (In 
Thousands)    |      
|                       |  | Total                                                           |       |  | QuotedPrices inActiveMarkets forIdenticalAssets(Level 1) |   |       | SignificantOtherObservableInputs(Level 2) |  |   | SignificantUnobservableInputs(Level 3) | 
|Money market funds (1) |  | $                                                               | 217   |  |                                                          | $ | 217   |                                           |  | $ |                                       |  |  | $ |  | 
|                       |  |                                                                 |       |  |                                                          |   |       |                                           |  |   |                                        |  |  |   |   | 
|Total                  |  | $                                                               | 217   |  |                                                          | $ | 217   |                                           |  | $ |                                       |  |  | $ |  | 
|                       |  |                                                                 |       |  |                                                          |   |       |                                           |  |   |                                        |  |  |   |   | 
|                       | 
|                       |  | Fair Value Measurements as of December 31, 2010 (In 
Thousands) |      
|                       |  | Total                                                           |       |  | QuotedPrices inActiveMarkets forIdenticalAssets(Level 1) |   |       | SignificantOtherObservableInputs(Level 2) |  |   | SignificantUnobservableInputs(Level 3) | 
|Money market funds (1) |  | $                                                               | 4,217 |  |                                                          | $ | 4,217 |                                           |  | $ |                                       |  |  | $ |  | 
|                       |  |                                                                 |       |  |                                                          |   |       |                                           |  |   |                                        |  |  |   |   | 
|Total                  |  | $                                                               | 4,217 |  |                                                          | $ | 4,217 |                                           |  | $ |                                       |  |  | $ |  | 
|                       |  |                                                                 |       |  |                                                          |   |       |                                           |  |   |                                        |  |  |   |   | 



|(1) | Included in cash and cash equivalents on the Companys condensed consolidated balance sheet.
|--- | --------------------------------------------------------------------------------------------



|(4) | Operating Lease Liabilities
|--- | ---------------------------

As a result of the acquisition of Paradyne Networks, Inc. (Paradyne) in September 2005, the Company assumed certain lease liabilities for facilities in Largo, Florida. The Company has accrued
a liability for the excess portion of these facilities. The term of the lease expires in June 2012 and had an estimated remaining obligation of approximately $5.4 million as of March 31, 2011, of which $2.3 million was accrued for excess
facilities, net of estimated sublease income.

A summary of current period activity related to excess lease liabilities accrued
is as follows (in thousands):



|                             |  |            |       |  
|---------------------------- |  | ---------- | ----- | -
|                             |  | Exit Costs |      
|Balance at December 31, 2010 |  | $          | 2,727 |  
|Cash payments, net           |  |            | (447  | )
|                             |  |            |       |  
|Balance at March 31, 2011    |  | $          | 2,280 |  
|                             |  |            |       |  

A summary of the excess lease liabilities at their net present value is as follows (in thousands):



|                                       |  |            |       |  
|-------------------------------------- |  | ---------- | ----- | -
|                                       |  | Exit Costs |      
|Future lease payments for excess space |  | $          | 2,921 |  
|Less: contractual sublease income      |  |            | (641  | )
|                                       |  |            |       |  
|Balance at March 31, 2011              |  | $          | 2,280 |  
|                                       |  |            |       |  

The current portion of the excess lease liability as of March 31, 2011 of $1.8 million is classified in
Accrued and other liabilities and the long-term portion of $0.5 million is classified in Other long-term liabilities in the accompanying condensed consolidated balance sheet.



10



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##### Table of Contents

|(5) | Inventories
|--- | -----------

Inventories
as of March 31, 2011 and December 31, 2010 were as follows (in thousands):



|                |  |               |        |  |                  |   |        | 
|--------------- |  | ------------- | ------ |  | ---------------- | - | ------ | 
|                |  | March 31,2011 |        |  | December 31,2010 |  
|Inventories:    |  |               |        |  |                  |   |        | 
|Raw materials   |  | $             | 18,189 |  |                  | $ | 20,539 | 
|Work in process |  |               | 2,665  |  |                  |   | 2,751  | 
|Finished goods  |  |               | 8,051  |  |                  |   | 7,758  | 
|                |  |               |        |  |                  |   |        | 
|                |  | $             | 28,905 |  |                  | $ | 31,048 | 
|                |  |               |        |  |                  |   |        | 



|(6) | Property and Equipment, net
|--- | ---------------------------

Property and equipment, net, as of March 31, 2011 and December 31, 2010 were as follows (in thousands):



|                                               |  |               |        |   |                  |   |        |  
|---------------------------------------------- |  | ------------- | ------ | - | ---------------- | - | ------ | -
|                                               |  | March 31,2011 |        |   | December 31,2010 |  
|Property and equipment:                        |  |               |        |   |                  |   |        |  
|Machinery and equipment                        |  | $             | 8,542  |   |                  | $ | 8,367  |  
|Computers and acquired software                |  |               | 3,640  |   |                  |   | 3,573  |  
|Furniture and fixtures                         |  |               | 416    |   |                  |   | 416    |  
|Leasehold improvements                         |  |               | 2,017  |   |                  |   | 2,006  |  
|                                               |  |               |        |   |                  |   |        |  
|                                               |  |               | 14,615 |   |                  |   | 14,362 |  
|Less accumulated depreciation and amortization |  |               | (9,541 | ) |                  |   | (9,088 | )
|                                               |  |               |        |   |                  |   |        |  
|                                               |  | $             | 5,074  |   |                  | $ | 5,274  |  
|                                               |  |               |        |   |                  |   |        |  

Depreciation and amortization expense associated with property and equipment amounted to $0.5 million and
$0.4 million for the three months ended March 31, 2011 and 2010, respectively.



|(7) | Stock-Based Compensation
|--- | ------------------------

As of March 31, 2011, the Company had two types of share-based compensation plans related to stock options and employee stock
purchases. The compensation cost that has been charged as an expense in the statement of operations for those plans was $0.2 million and $1.5 million for the three months ended March 31, 2011 and 2010, respectively.

The following table summarizes stock-based compensation expense for the three months ended March 31, 2011 and 2010 (in thousands):



|                                                              |  |                             |     |  |      |   |       | 
|------------------------------------------------------------- |  | --------------------------- | --- |  | ---- | - | ----- | 
|                                                              |  | Three Months EndedMarch
31, |    
|                                                              |  | 2011                        |     |  | 2010 |  
|Compensation expense relating to employee stock options       |  | $                           | 230 |  |      | $ | 1,459 | 
|Compensation expense relating to non-employees                |  |                             | 1   |  |      |   | 7     | 
|Compensation expense relating to Employee Stock Purchase Plan |  |                             |    |  |      |   | 17    | 
|                                                              |  |                             |     |  |      |   |       | 
|Stock-based compensation expense                              |  | $                           | 231 |  |      | $ | 1,483 | 
|                                                              |  |                             |     |  |      |   |       | 

Stock Options

The Companys stock-based compensation plans are designed to attract, motivate, retain and reward talented employees, directors and consultants and align stockholder and employee interests. The
Company has two active stock option plans, the Amended and Restated Special 2001 Stock Incentive Plan and the Amended and Restated 2001 Stock Incentive Plan. Stock options are primarily issued from the Amended and Restated 2001 Stock Incentive Plan.
This plan provides for the grant of incentive stock options, non-statutory stock options, restricted stock awards and other stock-based awards to officers, employees, directors and consultants of the Company. As of March 31, 2011,
1.2 million shares were available for grant under these plans.



11



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##### Table of Contents

The assumptions used to value option grants for the three months ended March 31, 2011
and 2010 are as follows:



|                        |  |                                  |           |   |                                  |  |           |  
|----------------------- |  | -------------------------------- | --------- | - | -------------------------------- |  | --------- | -
|                        |  | Three Months EndedMarch 31,
2011 |           |   | Three Months EndedMarch 31,
2010 | 
|Expected term           |  |                                  | 4.7 years |   |                                  |  | 4.7 years |  
|Expected volatility     |  |                                  | 95        | % |                                  |  | 93        | %
|Risk free interest rate |  |                                  | 2.21      | % |                                  |  | 2.55      | %

The following table sets
forth the summary of option activity under the stock option program for the three months ended March 31, 2011 (in thousands, except per share data):



|                                              |  |                    |       |   |                              |   |       |                                                 |  |  |                         |  |  |   |       | 
|--------------------------------------------- |  | ------------------ | ----- | - | ---------------------------- | - | ----- | ----------------------------------------------- |  |  | ----------------------- |  |  | - | ----- | 
|                                              |  | OptionsOutstanding |       |   | WeightedAverageExercisePrice |   |       | WeightedAverageRemainingContractualTerm (years) |  |  | AggregateIntrinsicValue | 
|Outstanding as of December 31, 2010           |  |                    | 5,102 |   |                              | $ | 3.54  |                                                 |  |  | 5.01                    |  |  | $ | 7,415 | 
|Granted                                       |  |                    | 38    |   |                              | $ | 2.50  |                                                 |  |  |                         |  |  |   |       | 
|Canceled/Forfeited                            |  |                    | (68   | ) |                              | $ | 53.10 |                                                 |  |  |                         |  |  |   |       | 
|Exercised                                     |  |                    | (65   | ) |                              | $ | 0.71  |                                                 |  |  |                         |  |  |   |       | 
|                                              |  |                    |       |   |                              |   |       |                                                 |  |  |                         |  |  |   |       | 
|Outstanding as of March 31, 2011              |  |                    | 5,007 |   |                              | $ | 2.89  |                                                 |  |  | 4.78                    |  |  | $ | 5,726 | 
|                                              |  |                    |       |   |                              |   |       |                                                 |  |  |                         |  |  |   |       | 
|Vested and expected to vest at March 31, 2011 |  |                    | 4,657 |   |                              | $ | 2.99  |                                                 |  |  | 4.73                    |  |  | $ | 5,142 | 
|                                              |  |                    |       |   |                              |   |       |                                                 |  |  |                         |  |  |   |       | 
|Vested and exercisable at March 31, 2011      |  |                    | 3,137 |   |                              | $ | 3.73  |                                                 |  |  | 4.36                    |  |  | $ | 4,028 | 
|                                              |  |                    |       |   |                              |   |       |                                                 |  |  |                         |  |  |   |       | 

The aggregate intrinsic value represents the total pretax intrinsic value, based on the
Companys closing stock price of $2.30 as of March 31, 2011, which would have been received by the option holders had the option holders exercised their options as of that date.

As of March 31, 2011, there was $1.7 million of unrecognized compensation costs, adjusted for estimated forfeitures related to
unvested stock-based payments granted, which are expected to be recognized over a weighted average period of 1.9 years.



|(8) | Net Loss Per Share
|--- | ------------------

Basic
net loss per share is computed by dividing the net loss applicable to holders of common stock for the period by the weighted average number of shares of common stock outstanding during the period. The calculation of diluted net loss per share gives
effect to common stock equivalents; however, potential common equivalent shares are excluded if their effect is antidilutive. Potential common equivalent shares are composed of common stock subject to repurchase rights and incremental shares of
common equivalent shares issuable upon the exercise of stock options and warrants, and the conversion of convertible debt.

The
following tables set forth potential common stock that is not included in the diluted net loss per share calculation because their effect would be anti-dilutive for the periods indicated (in thousands, except exercise price per share data):



|                                                         |  |                                  |       |  |                              |   |        | 
|-------------------------------------------------------- |  | -------------------------------- | ----- |  | ---------------------------- | - | ------ | 
|                                                         |  | Three Months EndedMarch 31,
2011 |       |  | WeightedAverageExercisePrice |  
|Warrants                                                 |  |                                  | 7     |  |                              | $ | 116.54 | 
|Outstanding stock options and unvested restricted shares |  |                                  | 5,037 |  |                              | $ | 3.03   | 
|                                                         |  |                                  |       |  |                              |   |        | 
|                                                         |  |                                  | 5,044 |  |                              |   |        | 
|                                                         |  |                                  |       |  |                              |   |        | 
|                                                         |  |                                 
|                                                         |  | Three Months EndedMarch 31,
2010 |       |  | WeightedAverageExercisePrice |  
|                                                         |  |                                  |       |  |                              |   |        | 
|Warrants                                                 |  |                                  | 7     |  |                              | $ | 116.54 | 
|Outstanding stock options and unvested restricted shares |  |                                  | 4,443 |  |                              | $ | 4.04   | 
|                                                         |  |                                  |       |  |                              |   |        | 
|                                                         |  |                                  | 4,450 |  |                              |   |        | 
|                                                         |  |                                  |       |  |                              |   |        | 



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##### Table of Contents

|(9) | Comprehensive Loss
|--- | ------------------

The
components of comprehensive loss, net of tax, for the three months ended March 31, 2011 and 2010 were as follows (in thousands):



|                                         |  |                             |        |   |      |   |        |  
|---------------------------------------- |  | --------------------------- | ------ | - | ---- | - | ------ | -
|                                         |  | Three Months EndedMarch
31, |       
|                                         |  | 2011                        |        |   | 2010 |  
|Net loss                                 |  | $                           | (2,440 | ) |      | $ | (3,204 | )
|Other comprehensive loss:                |  |                             |        |   |      |   |        |  
|Foreign currency translation adjustments |  |                             | (10    | ) |      |   | 17     |  
|                                         |  |                             |        |   |      |   |        |  
|Total comprehensive loss                 |  | $                           | (2,450 | ) |      | $ | (3,187 | )
|                                         |  |                             |        |   |      |   |        |  



|(10) | Debt
|---- | ----

Credit
Facility

In March 2011, the Company renewed its SVB Facility with Silicon Valley Bank (SVB) to provide
liquidity and working capital through March 13, 2012.

Under the SVB Facility, the Company has the option of borrowing
funds at agreed upon interest rates. The amount that the Company is able to borrow under the SVB Facility varies based on eligible accounts receivable, as defined in the agreement, as long as the aggregate amount outstanding does not exceed $25.0
million. In addition, under the SVB Facility, the Company is able to utilize the facility as security for letters of credit.

Under the SVB Facility, $10.0 million was outstanding at March 31, 2011. In addition, $7.3 million was committed as security for
various letters of credit and $7.7 million was unused and available for borrowing as of March 31, 2011. The amounts borrowed under the SVB Facility bear interest, payable monthly, at a floating rate equal to the Wall Street Journal Prime Rate
plus a margin of 0.0%-1.0% depending on the Companys quarterly EBITDA as defined in the agreement. The interest rate on the SVB Facility was 4.25% at March 31, 2011.

The Companys obligations under the SVB Facility are secured by substantially all of its personal property assets and those of its subsidiaries, including their intellectual property. The SVB
Facility contains certain financial covenants, and customary affirmative covenants and negative covenants. If the Company does not comply with the various covenants and other requirements under the SVB Facility, SVB is entitled to, among other
things, require the immediate repayment of all outstanding amounts and sell the Companys assets to satisfy the obligations under the SVB Facility. As of March 31, 2011, the Company was in compliance with these covenants.



|(11) | Commitments and Contingencies
|---- | -----------------------------

Operating Leases

The Company has entered into operating leases for
certain office space and equipment, some of which contain renewal options. Estimated future lease payments under all non-cancelable operating leases with terms in excess of one year, including taxes and service fees, are as follows (in thousands):



|                             |  |                  |       | 
|---------------------------- |  | ---------------- | ----- | 
|                             |  | Operating Leases |      
|Year ending December 31:     |  |                  |       | 
|2011 (remainder of the year) |  | $                | 3,982 | 
|2012                         |  |                  | 3,021 | 
|2013                         |  |                  | 804   | 
|2014                         |  |                  | 738   | 
|2015 and thereafter          |  |                  | 486   | 
|                             |  |                  |       | 
|Total minimum lease payments |  | $                | 9,031 | 
|                             |  |                  |       | 



13



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##### Table of Contents

The total minimum lease payments shown above include projected payments and obligations for
leases that the Company is no longer utilizing, some of which relate to excess facilities obtained through acquisitions. At March 31, 2011, the Company had estimated commitments of $5.4 million related to facilities assumed as a result of the
Paradyne acquisition, of which $2.3 million was accrued for excess facilities, which is net of estimated sublease income. The above amounts also include $2.8 million of future minimum lease payments spread over the five-year lease term
under the Lease Agreement entered into with LBA Realty, LLC (LBA Realty) in September 2010 with respect to the Companys Oakland, California campus in connection with the sale and leaseback transaction. For operating leases that
include contractual commitments for operating expenses and maintenance, estimates of such amounts are included based on current rates.

Warranties

The Company accrues for warranty costs based on
historical trends for the expected material and labor costs to provide warranty services. Warranty periods are generally one year from the date of shipment. The following table reconciles changes in the Companys accrued warranties and related
costs for the three months ended March 31, 2011 and 2010 (in thousands):



|                           |  |                             |       |   |      |   |       |  
|-------------------------- |  | --------------------------- | ----- | - | ---- | - | ----- | -
|                           |  | Three months EndedMarch
31, |      
|                           |  | 2011                        |       |   | 2010 |  
|Beginning balance          |  | $                           | 1,683 |   |      | $ | 1,662 |  
|Charged to cost of revenue |  |                             | 205   |   |      |   | 636   |  
|Claims and settlements     |  |                             | (283  | ) |      |   | (568  | )
|                           |  |                             |       |   |      |   |       |  
|Ending balance             |  | $                           | 1,605 |   |      | $ | 1,730 |  
|                           |  |                             |       |   |      |   |       |  

Other Commitments

Certain pre-acquisition contingencies from the acquisition of Tellium, Inc. in 2003 continue to exist for which the Company has reserved an estimated amount that it believes is sufficient to cover the
probable loss from these matters.

The Company is currently under audit examination by several state taxing authorities for
non-income based taxes. The Company has reserved an estimated amount which the Company believes is sufficient to cover potential claims.

Performance Bonds

In the normal course of operations, the Company
arranges for the issuance of various types of surety bonds, such as bid and performance bonds, which are agreements under which the surety company guarantees that the Company will perform in accordance with contractual or legal obligations. If the
Company fails to perform under its obligations, the maximum potential payment under these surety bonds would have been $0.9 million as of March 31, 2011.

Purchase Commitments

The Company has agreements with various
contract manufacturers which include non-cancellable inventory purchase commitments. The Companys inventory purchase commitments typically allow for cancellation of orders 30 days in advance of the required inventory availability date as set
by the Company at time of order. The amount of non-cancellable purchase commitments outstanding was $6.3 million as of March 31, 2011.

Royalties

The Company has certain royalty commitments associated
with the shipment and licensing of certain products. Royalty expense is generally based on a dollar amount per unit shipped or a percentage of the underlying revenue and is recorded in cost of revenue.

Legal Proceedings

The Company is subject to legal proceedings, claims and litigation arising in the ordinary course of business. While the outcome of these matters is currently not determinable, the Company does not expect
that the ultimate costs to resolve these matters will have a material adverse effect on its consolidated financial position or results of operations. However, litigation is subject to inherent uncertainties, and unfavorable rulings could occur. If
an unfavorable ruling were to occur, there exists the possibility of a material adverse impact on the results of operations of the period in which the ruling occurs, or future periods.



14



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##### Table of Contents

|(12) | Enterprise-Wide Information
|---- | ---------------------------

The Company designs, develops and manufactures communications products for network service providers. The Company derives substantially all of its revenues from the sales of the Zhone product family. The
Companys chief operating decision maker is the Companys Chief Executive Officer. The Chief Executive Officer reviews financial information presented on a consolidated basis accompanied by disaggregated information about revenues by
geographic region for purposes of making operating decisions and assessing financial performance. The Company has determined that it has operated within one discrete reportable business segment since inception. The following summarizes geographic
revenue concentrations by region.



|                            |  |                             |        |  |      |   |        | 
|--------------------------- |  | --------------------------- | ------ |  | ---- | - | ------ | 
|                            |  | Three Months EndedMarch
31, |       
|                            |  | 2011                        |        |  | 2010 |  
|                            |  | (in thousands)              |       
|Revenue by Geography:       |  |                             |        |  |      |   |        | 
|United States               |  | $                           | 12,697 |  |      | $ | 9,864  | 
|Canada                      |  |                             | 732    |  |      |   | 1,131  | 
|                            |  |                             |        |  |      |   |        | 
|Total North America         |  |                             | 13,429 |  |      |   | 10,995 | 
|                            |  |                             |        |  |      |   |        | 
|Latin America               |  |                             | 5,795  |  |      |   | 4,966  | 
|Europe, Middle East, Africa |  |                             | 10,187 |  |      |   | 14,542 | 
|Asia Pacific                |  |                             | 161    |  |      |   | 579    | 
|                            |  |                             |        |  |      |   |        | 
|Total International         |  |                             | 16,143 |  |      |   | 20,087 | 
|                            |  |                             |        |  |      |   |        | 
|                            |  | $                           | 29,572 |  |      | $ | 31,082 | 
|                            |  |                             |        |  |      |   |        | 



|(13) | Income Taxes
|---- | ------------

The total
amount of unrecognized tax benefits, including interest and penalties, at March 31, 2011 was not material. The amount of tax benefits that would impact the effective rate, if recognized, is not expected to be material. There were no significant
changes to unrecognized tax benefits during the quarters ended March 31, 2011 and 2010. The Company does not anticipate any significant changes with respect to unrecognized tax benefits within the next 12 months.

The Company and its subsidiaries file income tax returns in the U.S. federal jurisdiction, and various state and foreign jurisdictions.
The open tax years for the major jurisdictions are as follows:



|                                |  |  |             | 
|------------------------------- |  |  | ----------- | 
|    Federal                    |  |  | 2007  2010 | 
|                                | 
|    California and Canada      |  |  | 2006  2010 | 
|                                | 
|    Brazil                     |  |  | 2005  2010 | 
|                                | 
|    Germany and United Kingdom |  |  | 2006  2010 | 

However, due to the
fact the Company had net operating losses and credits carried forward in most jurisdictions, certain items attributable to technically closed years are still subject to adjustment by the relevant taxing authority through an adjustment to tax
attributes carried forward to open years.

In addition, to the extent the Company is deemed to have a sufficient connection to
a particular taxing jurisdiction to enable that jurisdiction to tax the Company but the Company has not filed an income tax return in that jurisdiction for the year(s) at issue, the jurisdiction would typically be able to assert a tax liability for
such years without limitation on the number of years it may examine.

The Company is not currently under examination for income
taxes in any material jurisdiction.



15



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##### Table of Contents

|Item 2. | Managements Discussion and Analysis of Financial Condition and Results of Operations
|------- | -------------------------------------------------------------------------------------

Forward-Looking Statements

This report, including Managements Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements regarding future events and our future
results that are subject to the safe harbors created under the Securities Act of 1933 and the Securities Exchange Act of 1934. These statements are based on current expectations, estimates, forecasts, and projections about the industries in which we
operate and the beliefs and assumptions of our management. We use words such as anticipate, believe, continue, could, estimate, expect, goal, intend,
may, plan, project, seek, should, target, will, would, variations of such words, and similar expressions to identify forward-looking statements. In
addition, statements that refer to projections of earnings, revenue, costs or other financial items; anticipated growth and trends in our business or key markets; future growth and revenues from our Single Line Multi-Service, or SLMS, products; our
ability to refinance or repay our existing indebtedness prior to the applicable maturity date; future economic conditions and performance; anticipated performance of products or services; plans, objectives and strategies for future operations; and
other characterizations of future events or circumstances, are forward-looking statements. Readers are cautioned that these forward-looking statements are only predictions and are subject to risks, uncertainties and assumptions that are difficult to
predict, including those identified under the heading Risk Factors in Part II, Item 1A elsewhere in this report and our other filings with the Securities and Exchange Commission. Therefore, actual results may differ materially and
adversely from those expressed in any forward-looking statements. Factors that might cause such a difference include, but are not limited to, the ability to generate sufficient revenue to achieve or sustain profitability, the ability to raise
additional capital to fund existing and future operations or to repay or refinance our existing indebtedness, defects or other performance problems in our products, the economic slowdown in the telecommunications industry that has restricted the
ability of our customers to purchase our products, commercial acceptance of our SLMS products, intense competition in the communications equipment market from large equipment companies as well as private companies with products that address the same
networks needs as our products, higher than anticipated expenses that we may incur, and other factors identified elsewhere in this report and in our most recent reports on Forms 10-K, 10-Q and 8-K. We undertake no obligation to revise or update any
forward-looking statements for any reason.

OVERVIEW

We believe that we are the first company dedicated solely to developing the full spectrum of next-generation access network solutions to cost-effectively deliver high bandwidth services while
simultaneously preserving the investment in todays networks. Our next-generation solutions are based upon our SLMS architecture. From its inception, this SLMS architecture was specifically designed for the delivery of multiple classes of
subscriber services (such as voice, data and video distribution), rather than being based on a particular protocol or media. In other words, our SLMS products are built to support the migration from legacy circuit to packet technologies and from
copper to fiber technologies. This flexibility and versatility allows our products to adapt to future technologies while allowing service providers to focus on the delivery of additional high bandwidth services. Because this SLMS architecture is
designed to interoperate with existing legacy equipment, service providers can leverage their existing networks to deliver a combination of voice, data and video services today, while they migrate, either simultaneously or at a future date, from
legacy equipment to next-generation equipment with minimal interruption. We believe that our SLMS solution provides an evolutionary path for service providers from their existing infrastructures, as well as gives newer service providers the
capability to deploy cost-effective, multi-service networks that can support voice, data and video.

Our global customer base
includes regional, national and international telecommunications carriers. To date, our products are deployed by over 750 network service providers on six continents worldwide. We believe that we have assembled the employee base, technological
breadth and market presence to provide a simple yet comprehensive set of next-generation solutions to the bandwidth bottleneck in the access network and the other problems encountered by network service providers when delivering communications
services to subscribers.

Since inception, we have incurred significant operating losses and had an accumulated deficit of
$1,022.8 million as of March 31, 2011, and we expect that our operating losses and negative cash flows from operations may continue. If we are unable to access or raise the capital needed to meet liquidity needs and finance capital expenditures
and working capital, or if the economic, market and geopolitical conditions in the United States and the rest of the world do not continue to improve or deteriorate, we may experience material adverse impacts on our business, operating results and
financial condition.

Going forward, our key financial objectives include the following:



| |  |  | Increasing revenue while continuing to carefully control costs;
| | - |  | ---------------------------------------------------------------



| |  |  | Continued investments in strategic research and product development activities that will provide the maximum potential return on investment; and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Minimizing consumption of our cash and short-term investments.
| | - |  | --------------------------------------------------------------



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CRITICAL ACCOUNTING POLICIES AND ESTIMATES

There have been no material changes to our critical accounting policies and estimates from the information provided in Part II, Item
7. Managements Discussion and Analysis of Financial Condition and Results of Operations  Critical Accounting Policies and Estimates included in our Annual Report on Form 10-K for the year ended December 31, 2010, except as set
forth below.

Revenue Recognition

We recognize revenue when the earnings process is complete. We recognize product revenue upon shipment of product under contractual terms which transfer title to customers upon shipment, under normal
credit terms, net of estimated sales returns and allowances at the time of shipment. Revenue is deferred if there are significant post-delivery obligations or if the fees are not fixed or determinable. When significant post-delivery obligations
exist, revenue is deferred until such obligations are fulfilled. Our arrangements generally do not have any significant post-delivery obligations. If our arrangements include customer acceptance provisions, revenue is recognized upon obtaining the
signed acceptance certificate from the customer, unless we can objectively demonstrate that the delivered products or services meet all the acceptance criteria specified in the arrangement prior to obtaining the signed acceptance. In those
instances where revenue is recognized prior to obtaining the signed acceptance certificate, we use successful completion of customer testing as the basis to objectively demonstrate that the delivered products or services meet all the acceptance
criteria specified in the arrangement. We also consider historical acceptance experience with the customer, as well as the payment terms specified in the arrangement, when revenue is recognized prior to obtaining the signed acceptance certificate.
When collectability is not reasonably assured, revenue is recognized when cash is collected.

We make certain sales to product
distributors. These customers are given certain privileges to return a portion of inventory. Return privileges generally allow distributors to return inventory based on a percent of purchases made within a specific period of time. We recognize
revenue on sales to distributors that have contractual return rights when the products have been sold by the distributors, unless there is sufficient customer specific sales and sales returns history to support revenue recognition upon shipment. In
those instances when revenue is recognized upon shipment to distributors, we use historical rates of return from the distributors to provide for estimated product returns. We accrue for warranty costs, sales returns and other allowances at the time
of shipment based on historical experience and expected future costs.

In October 2009, the Financial Accounting Standards
Board, or FASB, amended the accounting standards for multiple deliverable revenue arrangements to:



| | (i) | provide updated guidance on whether multiple deliverables exist, how the deliverables in an arrangement should be separated, and how the consideration should be
allocated;
| | --- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (ii) | require an entity to allocate revenue in an arrangement using best estimate of selling prices, or BSP, for deliverables if a vendor does not have vendor-specific
objective evidence of selling price, or VSOE, or third-party evidence of selling price, or TPE; and
| | ---- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (iii) | eliminate the use of the residual method and require an entity to allocate revenue using the relative selling price method.
| | ----- | ---------------------------------------------------------------------------------------------------------------------------

We adopted the updated accounting standards on January 1, 2011 on a prospective basis for applicable transactions originating or
materially modified after December 31, 2010. This guidance does not change the units of accounting for revenue transactions. Our products and services qualify as separate units of accounting and are deemed to be non-contingent deliverables as
our arrangements typically do not have any significant performance, cancellation, termination and refund type provisions. Products are typically considered delivered upon shipment. Revenue from services is recognized ratably over the period during
which the services are to be performed.

Prior to the adoption of Accounting Standards Update, or ASU, 2009-13, Revenue
Recognition (Topic 605): Multiple-Deliverable Revenue Arrangements, we established the fair value or TPE of services in multiple-element arrangements based primarily on sales prices when the products and services were sold separately. As such,
we applied the residual method to allocate the arrangement fee between products and services. In limited circumstances, if fair value could not be established for undelivered elements, all of the revenue under the arrangement was deferred until
those elements were delivered. Upon adoption of ASU 2009-13, on January 1, 2011, we allocated revenue to the products and services using the relative selling price method to recognize revenue when the basic revenue recognition criteria for each
deliverable are met.

We derive revenue primarily from stand-alone sales of our products. In certain cases, our products are
sold along with services, which include education, training, installation, and/or extended warranty services. We have established TPE for our training, education and installation services. These service arrangements are typically short term in
nature and are largely completed shortly after delivery of the product. TPE is determined based on competitor prices for similar deliverables when sold separately. Training and education services are based on a daily rate per person and vary
according to the type of class offered. Installation services are based on daily rate per person and vary according to the complexity of the products being installed.



17



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##### Table of Contents

Extended warranty services are priced based on the type of product and are sold in one to
five year durations. Extended warranty services include the right to warranty coverage beyond the standard warranty period. In substantially all of the arrangements with multiple deliverables pertaining to arrangements with these services, we have
used and intend to continue using VSOE to determine the selling price for the services. Consistent with our methodology under previous accounting guidance, we determine VSOE based on our normal pricing practices for these specific services when sold
separately.

In most instances, particularly as it relates to products, we are not able to establish VSOE for all deliverables
in an arrangement with multiple elements. This may be due to infrequently selling each element separately, not pricing products within a narrow range, or only having a limited sales history. When VSOE cannot be established, we attempt to establish
the selling price of each element based on TPE. Generally, our marketing strategy differs from that of our peers and our offerings contain a significant level of customization and differentiation such that the comparable pricing of products with
similar functionality cannot be obtained. Furthermore, we are unable to reliably determine what similar competitor products selling prices are on a stand-alone basis. Therefore, we are typically not able to determine TPE for our products.

When we are unable to establish selling price using VSOE or TPE, we use BSP. The objective of BSP is to determine the price at
which we would transact a sale if the product or service were sold on a stand-alone basis. The BSP of each deliverable is determined using average discounts from list price from historical sales transactions or cost plus margin approaches based on
the factors, including but not limited to our gross margin objectives and pricing practices plus customer and market specific considerations.

The adoption did not have a material effect on our condensed consolidated financial statements for the three months period ended March 31, 2011 and is not expected to have a material effect on future
periods.

RESULTS OF OPERATIONS

We list in the table below the historical condensed consolidated statement of operations data as a percentage of net revenue for the periods indicated.



|                                 |  |                             |     |    |      |  |     |   
|-------------------------------- |  | --------------------------- | --- | -- | ---- |  | --- | --
|                                 |  | Three Months EndedMarch
31, |    
|                                 |  | 2011                        |     |    | 2010 | 
|Net revenue                      |  |                             | 100 | %  |      |  | 100 | % 
|Cost of revenue                  |  |                             | 64  | %  |      |  | 64  | % 
|                                 |  |                             |     |    |      |  |     |   
|Gross profit                     |  |                             | 36  | %  |      |  | 36  | % 
|                                 |  |                             |     |    |      |  |     |   
|Operating expenses:              |  |                             |     |    |      |  |     |   
|Research and product development |  |                             | 19  | %  |      |  | 17  | % 
|Sales and marketing              |  |                             | 18  | %  |      |  | 19  | % 
|General and administrative       |  |                             | 7   | %  |      |  | 10  | % 
|                                 |  |                             |     |    |      |  |     |   
|Total operating expenses         |  |                             | 44  | %  |      |  | 46  | % 
|                                 |  |                             |     |    |      |  |     |   
|Operating loss                   |  |                             | (8  | )% |      |  | (10 | )%
|Interest expense                 |  |                             | 0   | %  |      |  | (1  | )%
|Interest income                  |  |                             | 0   | %  |      |  | 0   | % 
|Other income                     |  |                             | 0   | %  |      |  | 0   | % 
|                                 |  |                             |     |    |      |  |     |   
|Loss before income taxes         |  |                             | (8  | )% |      |  | (11 | )%
|Income tax benefit               |  |                             | 0   | %  |      |  | (1  | )%
|                                 |  |                             |     |    |      |  |     |   
|Net loss                         |  |                             | (8  | )% |      |  | (10 | )%
|                                 |  |                             |     |    |      |  |     |   

Net Revenue

Information about our net revenue for products and services for the three months ended March 31, 2011 and 2010 is summarized below (in millions):



|         |  |                             |      |  |      |   |      |                    |  |   |          |   |  |  |    |   
|-------- |  | --------------------------- | ---- |  | ---- | - | ---- | ------------------ |  | - | -------- | - |  |  | -- | --
|         |  | Three Months EndedMarch
31, |     
|         |  | 2011                        |      |  | 2010 |   |      | Increase(Decrease) |  |   | % change |  
|Products |  | $                           | 28.5 |  |      | $ | 30.2 |                    |  | $ | (1.7     | ) |  |  | (6 | )%
|Services |  |                             | 1.1  |  |      |   | 0.9  |                    |  |   | 0.2      |   |  |  | 22 | % 
|         |  |                             |      |  |      |   |      |                    |  |   |          |   |  |  |    |   
|Total    |  | $                           | 29.6 |  |      | $ | 31.1 |                    |  | $ | (1.5     | ) |  |  | (5 | )%
|         |  |                             |      |  |      |   |      |                    |  |   |          |   |  |  |    |   



18



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##### Table of Contents

Information about our net revenue for North America and international markets for the three
months ended March 31, 2011 and 2010 is summarized below (in millions):



|                            |  |                             |      |  |      |   |      |                    |  |   |          |   |  |  |     |   
|--------------------------- |  | --------------------------- | ---- |  | ---- | - | ---- | ------------------ |  | - | -------- | - |  |  | --- | --
|                            |  | Three Months EndedMarch
31, |     
|                            |  | 2011                        |      |  | 2010 |   |      | Increase(Decrease) |  |   | % change |  
|Revenue by geography:       |  |                             |      |  |      |   |      |                    |  |   |          |   |  |  |     |   
|United States               |  | $                           | 12.7 |  |      | $ | 9.9  |                    |  | $ | 2.8      |   |  |  | 28  | % 
|Canada                      |  |                             | 0.7  |  |      |   | 1.1  |                    |  |   | (0.4     | ) |  |  | (36 | )%
|                            |  |                             |      |  |      |   |      |                    |  |   |          |   |  |  |     |   
|Total North America         |  |                             | 13.4 |  |      |   | 11.0 |                    |  |   | 2.4      |   |  |  | 22  | % 
|                            |  |                             |      |  |      |   |      |                    |  |   |          |   |  |  |     |   
|Latin America               |  |                             | 5.8  |  |      |   | 5.0  |                    |  |   | 0.8      |   |  |  | 16  | % 
|Europe, Middle East, Africa |  |                             | 10.2 |  |      |   | 14.5 |                    |  |   | (4.3     | ) |  |  | (30 | )%
|Asia Pacific                |  |                             | 0.2  |  |      |   | 0.6  |                    |  |   | (0.4     | ) |  |  | (67 | )%
|                            |  |                             |      |  |      |   |      |                    |  |   |          |   |  |  |     |   
|Total International         |  |                             | 16.2 |  |      |   | 20.1 |                    |  |   | (3.9     | ) |  |  | (19 | )%
|                            |  |                             |      |  |      |   |      |                    |  |   |          |   |  |  |     |   
|Total                       |  | $                           | 29.6 |  |      | $ | 31.1 |                    |  | $ | (1.5     | ) |  |  | (5  | )%
|                            |  |                             |      |  |      |   |      |                    |  |   |          |   |  |  |     |   

For the three months ended March 31, 2011, net revenue decreased 5% or $1.5 million to $29.6 million
from $31.1 million for the same period last year. For the three months ended March 31, 2011, product revenue decreased 6% or $1.7 million to $28.5 million, compared to $30.2 million for the same period last year. The decreases in net revenue
and product revenue for the three months ended March 31, 2011 were primarily due to weather issues that caused an extended power outage at our manufacturing facility resulting in a shortfall in product shipments at the end of the quarter.

For the three months ended March 31, 2011, service revenue increased by 22% or $0.2 million to $1.1 million, compared to
$0.9 million for the same period last year. The increase in service revenue for the three months ended March 31, 2011 was primarily due to the timing of services performed and revenue earned. Service revenue represents revenue from maintenance
and other services associated with product shipments.

International revenue decreased 19% or $3.9 million to $16.2 million for
the three months ended March 31, 2011 from $20.1 million for the same period last year, and represented 55% of total revenue compared with 65% during the same period of 2010. The decrease in international revenue during the three months
ended March 31, 2011 was primarily due to fewer large product sales as compared with the same period last year.

For the
three months ended March 31, 2011, Etisalat represented 22% of net revenue as compared to 34% of net revenue for the same period in 2010. We anticipate that our results of operations in any given period may depend to a large extent on sales to
a small number of large accounts. As a result, our revenue for any quarter may be subject to significant volatility based upon changes in orders from one or a small number of key customers.

Cost of Revenue and Gross Profit

Total cost of revenue, including
stock-based compensation, decreased 4% or $0.8 million to $19.0 million for the three months ended March 31, 2011, compared to $19.8 million for the three months ended March 31, 2010. The decrease in cost of revenue for the three months
ended March 31, 2011 was primarily due to the changes in sales volume resulting in no material change to the overall gross margin as compared to the prior year period.

We expect that in the future our cost of revenue as a percentage of net revenue will vary depending on the mix and average selling prices of products sold. In addition, continued competitive and economic
pressures could cause us to reduce our prices, adjust the carrying values of our inventory, or record inventory charges relating to discontinued products and excess or obsolete inventory.

Research and Product Development Expenses

Research and product development
expenses increased 4% or $0.2 million to $5.5 million for the three months ended March 31, 2011, compared to $5.3 million for the three months ended March 31, 2010. The increase in the three months ended March 31, 2011 was primarily
due to the hiring of additional personnel since the prior year period to support our continued investment in research and product development projects.



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##### Table of Contents

Sales and Marketing Expenses

Sales and marketing expenses decreased 5% or $0.3 million to $5.5 million for the three months ended March 31, 2011, compared to $5.8 million for the three months ended March 31, 2010. The
decrease for the three months ended March 31, 2011 was primarily due to a reduction in stock-based compensation expense of $0.2 million resulting from the significant compensation expense incurred in connection with the acceleration of vesting
stock options in March 2010, and a decrease of $0.1 million in the allocation for facilities due to the move into our current building as part of our campus sale-leaseback transaction in the third quarter of 2010.

General and Administrative Expenses

General and administrative expenses decreased 36% or $1.2 million to $2.1 million for the three months ended March 31, 2011, compared to $3.3 million for the three months ended March 31, 2010.
The decrease for the three months ended March 31, 2011 was primarily due to a reduction in stock-based compensation expense of $0.9 million resulting from the significant compensation expense incurred in connection with the acceleration of
vesting of stock options in March 2010, a reduction of $0.1 million in property expenses as the result of our campus sale-leaseback transaction in the third quarter of 2010, and a decrease of $0.2 million relating to various other miscellaneous
expenses in the prior year period.

Income Tax Provision

During the three months ended March 31, 2011 and 2010, no material provision or benefit for income taxes was recorded, due to our recurring operating losses and the significant uncertainty regarding
the realization of our net deferred tax assets, against which we have continued to record a full valuation allowance.

OTHER PERFORMANCE
MEASURES

In managing our business and assessing our financial performance, we supplement the information provided by our
GAAP results with adjusted earnings before stock-based compensation, interest, taxes, and depreciation, or Adjusted EBITDA, a non-GAAP financial measure. We define Adjusted EBITDA as net income (loss) plus (i) interest expense,
(ii) provision (benefit) for taxes, (iii) depreciation and amortization, (iv) non-cash equity-based compensation expense, and (v) material one-time non-cash transactions, such as a gain (loss) on sale of assets. We believe that
the presentation of Adjusted EBITDA enhances the usefulness of our financial information by presenting a measure that management uses internally to monitor and evaluate our operating performance and to evaluate the effectiveness of our business
strategies. We believe Adjusted EBITDA also assists investors and analysts in comparing our performance across reporting periods on a consistent basis because it excludes the impact of items that we do not believe reflect our core operating
performance.

Adjusted EBITDA has limitations as an analytical tool. Some of these limitations are:



| |  |  | Adjusted EBITDA does not reflect our cash expenditures, or future requirements, for capital expenditures or contractual requirements;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Adjusted EBITDA does not reflect changes in, or cash requirements for, our working capital needs;
| | - |  | -------------------------------------------------------------------------------------------------



| |  |  | Adjusted EBITDA does not reflect the significant interest expense, or the cash requirements necessary to service interest or principal payments, on our
debts;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | although depreciation and amortization are non-cash charges, the assets being depreciated and amortized will often have to be replaced in the future,
and Adjusted EBITDA does not reflect any cash requirements for such replacements;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | non-cash compensation is and will remain a key element of our overall long-term incentive compensation package, although we exclude it as an expense
when evaluating our ongoing operating performance for a particular period;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Adjusted EBITDA does not reflect the impact of certain cash charges resulting from matters we consider not to be indicative of our ongoing operations;
and
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | other companies in our industry may calculate Adjusted EBITDA and similar measures differently than we do, limiting its usefulness as a comparative
measure.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------

Because of these limitations, Adjusted EBITDA should not be considered in isolation or as a
substitute for net income (loss) or any other performance measures calculated in accordance with GAAP or as a measure of liquidity. Management understands these limitations and compensates for these limitations by relying primarily on our GAAP
results and using Adjusted EBITDA only supplementally.



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##### Table of Contents

Set forth below is a reconciliation of Adjusted EBITDA to net income (loss), which we
consider to be the most directly comparable GAAP financial measure to Adjusted EBITDA:



|                                           |  |                             |        |   |      |   |        |  
|------------------------------------------ |  | --------------------------- | ------ | - | ---- | - | ------ | -
|                                           |  | Three Months EndedMarch
31, |       
|                                           |  | 2011                        |        |   | 2010 |  
|                                           |  | (in thousands)              |       
|Net loss                                   |  | $                           | (2,440 | ) |      | $ | (3,204 | )
|Add:                                       |  |                             |        |   |      |   |        |  
|Interest expense                           |  |                             | 49     |   |      |   | 322    |  
|Provision for taxes                        |  |                             | (53    | ) |      |   | (114   | )
|Depreciation and amortization              |  |                             | 453    |   |      |   | 446    |  
|Non-cash equity-based compensation expense |  |                             | 231    |   |      |   | 1,483  |  
|Non-cash material one-time transactions    |  |                             |       |   |      |   |       |  
|                                           |  |                             |        |   |      |   |        |  
|Adjusted EBITDA                            |  | $                           | (1,760 | ) |      | $ | (1,067 | )
|                                           |  |                             |        |   |      |   |        |  

LIQUIDITY AND CAPITAL RESOURCES

Our operations are financed through a combination of our existing cash, cash equivalents, available credit facilities, and sales of equity and debt instruments, based on our operating requirements and
market conditions.

At March 31, 2011, cash and cash equivalents were $19.2 million which was a decrease of $2.0 million
compared to $21.2 million at December 31, 2010. The decrease in cash and cash equivalents was attributable to the net cash used in operating and investing activities of $1.8 million and $0.3 million, respectively, offset by net cash provided by
financing activities of $0.1 million.

Operating Activities

Net cash used in operating activities for the three months ended March 31, 2011 consisted of a net loss of $2.4 million, adjusted for
non-cash charges totaling $1.2 million and an increase in operating assets totaling $0.5 million. The most significant components of the changes in net operating assets were decreases of $1.1 million in accounts payable, and $1.5 million in accrued
and other liabilities, and an offsetting decrease in inventories of $2.1 million. The decrease in accounts payable related primarily to the timing of vendor payments. The decrease in accrued and other liabilities was comprised of reduced personnel
accruals of $0.5 million, continued reduction of the operating lease liability related to our Largo facility of $0.5 million, and a decrease of $0.5 million in unearned revenue. The decrease in inventories was primarily due to better utilization of
inventory in the current period.

Investing Activities

Net cash used in investing activities for the three months ended March 31, 2011 consisted primarily of purchases of property and
equipment of $0.3 million.

Financing Activities

Net cash provided by financing activities for the three months ended March 31, 2011 consisted of proceeds related to exercises of
stock options of $0.1 million.

Cash Management

Our primary source of liquidity comes from our cash and cash equivalents which totaled $19.2 million at March 31, 2011, and our $25.0
million revolving line of credit and letter of credit facility, or the SVB Facility, with Silicon Valley Bank, or SVB. Our cash and cash equivalents are held in accounts managed by third party financial institutions and consist of invested cash and
cash in our operating accounts. At current revenue levels, we anticipate that some portion of our existing cash and cash equivalents will continue to be consumed by operations.

In March 2011, the SVB Facility was renewed and the aggregate amount available for borrowing remained at $25.0 million as discussed in Note 10 to the condensed consolidated financial statements. Under the
SVB Facility, we have the option of borrowing funds at agreed upon interest rates. The amount that we are able to borrow under the SVB Facility varies based on eligible accounts receivable, as defined in the agreement, as long as the aggregate
principal amount outstanding does not exceed $25.0 million. In addition, under the SVB Facility, we are able to utilize the facility as security for letters of credit.



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Under the SVB Facility, $10.0 million was outstanding at March 31, 2011. In addition,
$7.3 million was committed as security under various letters of credit and $7.7 million was unused and available for borrowing as of March 31, 2011. The amounts borrowed under the SVB Facility bear interest, payable monthly, at a floating rate
equal to the Wall Street Journal Prime Rate plus a margin of 0.0%-1.0% depending on our quarterly EBITDA as defined in the agreement. The interest rate on our SVB Facility was 4.25% at March 31, 2011.

Our obligations under the SVB Facility are secured by substantially all of our personal property assets and those of our subsidiaries,
including our intellectual property. The SVB Facility contains certain financial covenants, and customary affirmative covenants and negative covenants. If we do not comply with the various covenants and other requirements under the SVB Facility, SVB
is entitled to, among other things, require the immediate repayment of all outstanding amounts and sell our assets to satisfy the obligations under the SVB Facility. As of March 31, 2011, we were in compliance with these covenants. We make no
assurances that we will be in compliance with these covenants in the future.

Future Requirements and Funding Sources

Our fixed commitments for cash expenditures consist primarily of payments under operating leases, inventory purchase
commitments, and payments of principal and interest for debt obligations. As a result of the Paradyne acquisition in 2005, we assumed a lease commitment for facilities in Largo, Florida. The term of the lease expires in June 2012 and had an
estimated remaining obligation of approximately $5.4 million as of March 31, 2011. We intend to continue to occupy only a portion of these facilities and are evaluating our options to exit the excess portion of the lease. We have recorded a
liability of $2.3 million as of March 31, 2011, which we believe is adequate to cover costs incurred to exit the excess portion of these facilities, net of estimated sublease income. Our operating lease commitments also include $2.8 million of
future minimum lease payments spread over the five-year lease term under the lease agreement we entered into with LBA Realty, LLC, or LBA Realty, in September 2010 with respect to our Oakland, California campus following the sale of our campus to
LBA Realty in a sale-leaseback transaction.

Our accounts receivable, while not considered a primary source of liquidity,
represent a concentration of credit risk because a significant portion of the accounts receivable balance at any point in time typically consists of a relatively small number of customer account balances. As of March 31, 2011, Etisalat
accounted for 43% of net accounts receivable, and receivables from customers in countries other than the United States of America represented 72% of net accounts receivable. We do not currently have any material commitments for capital expenditures,
or any other material commitments aside from operating leases for our facilities, inventory purchase commitments and debt.

We
expect that operating losses and negative cash flows from operations may continue. In order to meet our liquidity needs and finance our capital expenditures and working capital needs for our business, we may be required to sell assets, issue debt or
equity securities or borrow on unfavorable terms. Continued uncertainty regarding financial institutions ability and inclination to lend may negatively impact our ability to access debt financing or to refinance existing indebtedness in the
future on favorable terms, or at all. We may be unable to sell assets, issue securities or access additional indebtedness to meet these needs on favorable terms, or at all. If additional capital is raised through the issuance of debt securities or
other debt financing, the terms of such debt may include covenants, restrictions and financial ratios that may restrict our ability to operate our business. Likewise, any equity financing could result in additional dilution of our stockholders. If
we are unable to obtain additional capital or are required to obtain additional capital on terms that are not favorable to us, we may be required to reduce the scope of our planned product development and sales and marketing efforts beyond the
reductions we have previously taken. Based on our current plans and business conditions, we believe that our existing cash, cash equivalents and available credit facilities will be sufficient to satisfy our anticipated cash requirements for the
foreseeable future.

Contractual Commitments and Off-Balance Sheet Arrangements

At March 31, 2011, our future contractual commitments by fiscal year were as follows (in thousands):



|                                     |  |       |        |  |                        |   |        |      |  |   |       |  |  |      |     |  |                     |   |     |  |  |   |     | 
|------------------------------------ |  | ----- | ------ |  | ---------------------- | - | ------ | ---- |  | - | ----- |  |  | ---- | --- |  | ------------------- | - | --- |  |  | - | --- | 
|                                     |  |       |        |  | Payments due by period |  
|                                     |  | Total |        |  | 2011                   |   |        | 2012 |  |   | 2013  |  |  | 2014 |     |  | 2015 and Thereafter |  
|Operating leases                     |  | $     | 9,031  |  |                        | $ | 3,982  |      |  | $ | 3,021 |  |  | $    | 804 |  |                     | $ | 738 |  |  | $ | 486 | 
|Purchase commitments                 |  |       | 6,283  |  |                        |   | 6,283  |      |  |   |      |  |  |      |    |  |                     |   |    |  |  |   |    | 
|Line of credit                       |  |       | 10,000 |  |                        |   | 10,000 |      |  |   |      |  |  |      |    |  |                     |   |    |  |  |   |    | 
|                                     |  |       |        |  |                        |   |        |      |  |   |       |  |  |      |     |  |                     |   |     |  |  |   |     | 
|Total future contractual commitments |  | $     | 25,314 |  |                        | $ | 20,265 |      |  | $ | 3,021 |  |  | $    | 804 |  |                     | $ | 738 |  |  | $ | 486 | 
|                                     |  |       |        |  |                        |   |        |      |  |   |       |  |  |      |     |  |                     |   |     |  |  |   |     | 



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Operating Leases

The operating lease amounts shown above represent primarily off-balance sheet arrangements. For operating lease commitments, a liability
is generally not recorded on our balance sheet unless the facility represents an excess facility for which an estimate of the facility exit costs has been recorded on our balance sheet, net of estimated sublease income. For operating leases that
include contractual commitments for operating expenses and maintenance, estimates of such amounts are included based on current rates. Payments made under operating leases will be treated as rent expense for the facilities currently being utilized.
Of the total $9.0 million operating lease amount, $2.3 million has been recorded as a liability on our balance sheet as of March 31, 2011.

Purchase Commitments

The purchase commitments shown above represent
non-cancellable inventory purchase commitments as of March 31, 2011. The inventory purchase commitments typically allow for cancellation of orders 30 days in advance of the required inventory availability date as set by us at time of order.

Line of Credit

The line of credit obligation has been recorded as a liability on our balance sheet. The line of credit obligation amount shown above represents the scheduled principal repayment, but not the associated
interest payments which may vary based on changes in market interest rates. Although our line of credit under the SVB Facility matures in 2012, we have the right to repay anytime before the maturity date and intend to repay outstanding borrowings
within the current year. At March 31, 2011, the interest rate under the SVB Facility was 4.25%. See above under Cash Management for further information about the SVB Facility.

As of March 31, 2011, we had $10.0 million outstanding under our line of credit under the SVB Facility and an additional $7.3 million
committed as security for various letters of credit, as discussed in Note 10 to the condensed consolidated financial statements.

Sale-leaseback of Oakland, California Campus

On September 28,
2010, we sold our Oakland, California campus, consisting of land and three buildings, to LBA Realty for approximately $18.8 million. As part of the sale transaction, LBA Realty agreed to settle our secured real estate debt which was secured by the
Oakland, California campus for a net sum of $17.6 million.

In connection with the sale, we entered into a Multi-Tenant
Commercial/Industrial Lease Agreement, or the Lease Agreement, to rent one of the buildings from LBA Realty for a five-year term, commencing from the closing of the sale. The initial annual rent under the Lease Agreement is approximately $0.6
million, with periodic rent escalations at a rate of approximately 2% per annum. Under the Lease Agreement, in October 2010, we also received a non-refundable tenant improvement allowance of $1.7 million for the required alterations to the
property being leased back. The tenant improvement allowance amount will be amortized over the term of the lease as an offset to rent expense.



|Item 3. | Quantitative and Qualitative Disclosures about Market Risk
|------- | ----------------------------------------------------------

Cash, Cash Equivalents and Short-Term Investments

Cash and cash
equivalents consisted of the following as of March 31, 2011 and December 31, 2010 (in thousands):



|                   |  |               |        |  |                  |   |        | 
|------------------ |  | ------------- | ------ |  | ---------------- | - | ------ | 
|                   |  | March 31,2011 |        |  | December 31,2010 |  
|Cash               |  | $             | 18,962 |  |                  | $ | 16,957 | 
|Money Market Funds |  |               | 217    |  |                  |   | 4,217  | 
|                   |  |               |        |  |                  |   |        | 
|                   |  | $             | 19,179 |  |                  | $ | 21,174 | 
|                   |  |               |        |  |                  |   |        | 

Concentration of Credit Risk

Financial instruments which potentially subject us to concentrations of credit risk consist primarily of cash and cash equivalents, and accounts receivable. Cash and cash equivalents consist principally
of demand deposit and money market accounts. Cash and cash equivalents are principally held with various domestic financial institutions with high credit standing. We perform ongoing credit evaluations of our customers and generally do not require
collateral. Allowances are maintained for potential doubtful accounts. For the three months ended March 31, 2011, Etisalat accounted for 22% of net revenue. For the three months ended March 31, 2010, the same customer accounted for 34% of
net revenue.



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As of March 31, 2011, Etisalat receivables, which are denominated in United Arab
Emirates Dirhams, a currency that tracks to the U.S. dollar, accounted for 43% of net accounts receivable. As of December 31, 2010, the same customer accounted for 30% of net accounts receivable.

As of March 31, 2011 and December 31, 2010, receivables from customers in countries other than the United States represented 72%
and 74%, respectively, of net accounts receivable.

Interest Rate Risk

Our exposure to market risk for changes in interest rates relates primarily to our outstanding debt. As of March 31, 2011, our
outstanding debt balance was $10.0 million, which was comprised of our total principal amount of outstanding debt under our SVB Facility. Interest on the line of credit under the SVB Facility accrues at the Wall Street Journal Prime rate plus a
margin of 0.0%-1.0% depending on our quarterly EBITDA as defined in the agreement. The interest rate on our SVB Facility was 4.25% as of March 31, 2011. Assuming the outstanding balance on our variable rate debt remains constant over a year, a
2% increase in the interest rate would decrease pre-tax income and cash flow by approximately $0.2 million.

Foreign Currency Exchange Risk

We transact business in various foreign countries. Substantially all of our assets are located in the United States. We
have sales operations throughout Europe, Asia, the Middle East and Latin America. We are exposed to foreign currency exchange rate risk associated with foreign currency denominated assets and liabilities, primarily inter-company receivables and
payables. Accordingly, our operating results are exposed to changes in exchange rates between the U.S. dollar and those currencies. During 2011 and 2010, we did not hedge any of our foreign currency exposure.

We have performed sensitivity analyses as of March 31, 2011 using a modeling technique that measures the impact arising from a
hypothetical 10% adverse movement in the levels of foreign currency exchange rates relative to the U.S. dollar, with all other variables held constant. The sensitivity analyses indicated that a hypothetical 10% adverse movement in foreign currency
exchange rates would result in a foreign exchange loss of $0.3 million at March 31, 2011. This sensitivity analysis assumes a parallel adverse shift in foreign currency exchange rates, which do not always move in the same direction. Actual
results may differ materially.



|Item 4. | Controls and Procedures
|------- | -----------------------

Disclosure
Controls and Procedures

We conducted an evaluation of the effectiveness of the design and operation of our disclosure
controls and procedures as of the end of the period covered by this report. The controls evaluation was done under the supervision and with the participation of management, including our Chief Executive Officer and our Chief Financial Officer. Based
upon this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, subject to the limitations noted in this Part I, Item 4, as of the end of the period covered by this report, our disclosure controls and
procedures were effective to provide reasonable assurance that information required to be disclosed in our reports under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified by the
SEC, and that material information relating to Zhone and its consolidated subsidiaries is made known to management, including our Chief Executive Officer and Chief Financial Officer, particularly during the period when our periodic reports are being
prepared.

Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting that occurred during our last fiscal quarter that have materially
affected, or are reasonably likely to materially affect, our internal control over financial reporting.



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Inherent Limitations on Effectiveness of Controls

Our management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls and
procedures or our internal control over financial reporting will prevent or detect all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control
systems objectives will be met. The design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Further, because of the inherent limitations in
all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the company have been detected. These inherent
limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more
people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated
goals under all potential future conditions. Projections of any evaluation of controls effectiveness to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of
compliance with policies or procedures.

PART II. OTHER INFORMATION



|Item 1. | Legal Proceedings
|------- | -----------------

We are
subject to legal proceedings, claims and litigation arising in the ordinary course of business. While the outcome of these matters is currently not determinable, management does not expect that the ultimate costs to resolve these matters will have a
material adverse effect on our consolidated financial position or results of operations. However, litigation is subject to inherent uncertainties, and unfavorable rulings could occur. If an unfavorable ruling were to occur, there exists the
possibility of a material adverse impact on the results of operations of the period in which the ruling occurs, or future periods.



|Item 1A. | Risk Factors
|-------- | ------------

In addition
to the other information set forth in this report, you should carefully consider the factors discussed in Part I, Item 1A. Risk Factors in our Annual Report on Form 10-K for the year ended December 31, 2010, which could
materially affect our business, financial condition or future results. There have been no material changes to the risk factors described in the Risk Factors section in our Annual Report on Form 10-K for the year ended December 31,
2010. The risks described in our Annual Report on Form 10-K are not the only risks facing our company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect
our business, financial condition and/or operating results.



|Item 6. | Exhibits
|------- | --------

The Exhibit
Index on page 27 is incorporated herein by reference as the list of exhibits required as part of this report.



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SIGNATURES

Pursuant to the retirements 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.



|                  |  |  |  |                          |  |                        
|----------------- |  |  |  | ------------------------ |  | -----------------------
|                  |  |  |  | ZHONE TECHNOLOGIES, INC.
|                  |  |  | 
|Date: May 6, 2011 |  |  |  | By:                      |  | /S/    MORTEZA
EJABAT  
|                  |  |  |  | Name:                    |  | Morteza Ejabat         
|                  |  |  |  | Title:                   |  | Chief Executive Officer
|                  |  |  | 
|                  |  |  |  | By:                      |  | /S/    KIRK
MISAKA     
|                  |  |  |  | Name:                    |  | Kirk Misaka            
|                  |  |  |  | Title:                   |  | Chief Financial Officer



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EXHIBIT INDEX



|               |  |                                                                                                                                                                                                                                                                                                                 
|-------------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Description                                                                                                                                                                                                                                                                                                     
|               | 
|10.1           |  | January 2011 Amendment with an effective date of January 19, 2011 among Zhone Technologies, Inc., ZTI Merger Subsidiary III, Inc. and Silicon Valley Bank
(incorporated by reference to Exhibit 10.22 of registrants Annual Report on Form 10-K for the year ended December 31, 2010 filed on March 15, 2011)
|               | 
|10.2           |  | March 2011 Amendment with an effective date of March 14, 2011 among Zhone Technologies, Inc., ZTI Merger Subsidiary III, Inc. and Silicon Valley Bank (incorporated
by reference to Exhibit 10.23 of registrants Annual Report on Form 10-K for the year ended December 31, 2010 filed on March 15, 2011)    
|               | 
|31.1           |  | Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a)                                                                                                                                                                                                                                   
|               | 
|31.2           |  | Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a)                                                                                                                                                                                                                                   
|               | 
|32.1           |  | Section 1350 Certification of Chief Executive Officer and Chief Financial Officer                                                                                                                                                                                                                               



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