**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WashingtonD.C. 20549**

 

**FORM 10-Q**

 

| **(Mark One)**                                        |
|-------------------------------------------------------|
| **ý**                                            | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
| ** **                                            |
| **For the quarterly period ended April 2, 2006** |
| ** **                                            |
| **OR**                                                |
| ** **                                            |
| **o**                                                 | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |

 

**Forthe Transition Period from             to            **

 

**CommissionFile Number: 0-51532**

 

**IKANOS COMMUNICATIONS, INC.**

(Exact name of registrant asspecified in its charter)

 

| **Delaware**                     | ** ** | **73-1721486**       |
|----------------------------------|------------|----------------------|
| (State or  other jurisdiction of |       | (I.R.S.  Employer    |
| incorporation  or organization)  |       | Identification  No.) |

 

**47669Fremont Boulevard**

**Fremont,CA 94538**

(Address of principal executiveoffice and zip code)

 

**(510)979-0400**

(Registrant’s telephone numberincluding area code)

 

Indicate by check mark whether registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) had beensubject to such filing requirements for the past 90 days.  Yes  ý     No  o

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the Exchange Act~~)~~(check one):

Large accelerated filer   o     Acceleratedfiler   o     Non-acceleratedfiler   ý

 

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

 

The number of shares outstanding of the Registrant’s Common Stock, $0.001 par value, was  27,123,827 as of May 15,2006

 

 

----

 

**IKANOSCOMMUNICATIONS, INC.**

 

**FORM 10-Q**

 

**TABLEOF CONTENTS**

 

**IKANOSCOMMUNICATIONS, INC.**

 

**FORM 10-Q**

 

**TABLEOF CONTENTS**

 
| ** **        | ** **                                                                                               | **Page No.** |
|-------------------|----------------------------------------------------------------------------------------------------------|-------------------|
| **PART I:**  | FINANCIAL INFORMATION                                                                                    | 3                 |
|              |                                                                                                     |              |
| Item 1.      | Financial Statements (unaudited)                                                                         | 3                 |
|              |                                                                                                     |              |
|              | Condensed Consolidated Balance Sheets as of March 31, 2006 and December 31,  2005              | 3                 |
|              |                                                                                                     |              |
|              | Condensed Consolidated Statements of Operations for the three months  ended March 31, 2006 and 2005 | 4                 |
|              |                                                                                                     |              |
|              | Condensed Consolidated Statements of Cash Flows for the three months  ended March 31, 2006 and 2005 | 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                                               | 21                |
|              |                                                                                                     |              |
| Item 4.      | Controls and Procedures                                                                                  | 21                |
|              |                                                                                                     |              |
| **PART II:** | **OTHER INFORMATION**                                                                                    | 22                |
|              |                                                                                                     |              |
| Item 1.      | Legal Proceedings                                                                                        | 22                |
|              |                                                                                                     |              |
| Item  1A.    | Risk Factors                                                                                             | 22                |
|              |                                                                                                     |              |
| Item 2.           | Unregistered Sales of Equity Securities and  Use of Proceeds                                             | 35                |
|              |                                                                                                     |              |
| Item 6.      | Exhibits                                                                                                 | 35                |
|              |                                                                                                     |              |
| Signatures        |                                                                                                     | 36                |

 

2

----

 

**PART I:FINANCIAL INFORMATION**

 

**Item 1.*Financial Statements***

 

**IKANOSCOMMUNICATIONS, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS (UNAUDITED)**

**(INTHOUSANDS, EXCEPT SHARE AND PER SHARE DATA)**

 
| ** **                                         | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                         | ** ** | **2006**           | ** ** | **2005**              | ** ** |
| ** **                                         | ** ** | ** **         | ** ** | ** **            | ** ** |
| **ASSETS**                                         | ** ** | ** **         | ** ** | ** **            | ** ** |
| Current assets:                                    |       |               |       |                  |       |
| Cash and  cash equivalents                         |       | $                  | 72,368     |                  | $          | 91,932 |   |
| Short-term  investments                            |       | 42,713             |       | 1,988                 |       |
| Accounts  receivable—trade                    |       | 15,523             |       | 11,015                |       |
| Inventories                                        |       | 17,178             |       | 9,125                 |       |
| Prepaid  expenses and other current assets         |       | 2,303              |       | 2,235                 |       |
| Total  current assets                              |       | 150,085            |       | 116,295               |       |
| Property and equipment, net                        |       | 11,851             |       | 8,384                 |       |
| Goodwill                                           |       | 4,741              |       | —                |       |
| Purchased intangible assets, net                   |       | 16,913             |       | —                |       |
| Other assets                                       |       | 825                |       | 916                   |       |
| Total assets                                       |       | $                  | 184,415    |                  | $          | 125,595 |   |
|                                               |       |               |       |                  |       |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**      | ** ** | ** **         | ** ** | ** **            | ** ** |
| Current liabilities:                               |       |               |       |                  |       |
| Accounts  payable and accrued liabilities          |       | $                  | 28,506     |                  | $          | 19,655 |   |
| Capital  lease obligations, current portion        |       | 405                |       | 315                   |       |
| Notes  payable, current portion                    |       | 708                |       | 698                   |       |
| Other  current liabilities                         |       | 709                |       | —                |       |
| Total  current liabilities                         |       | 30,328             |       | 20,668                |       |
|                                               |       |               |       |                  |       |
| Capital  lease obligations, net of current portion |       | 180                |       | 223                   |       |
| Notes  payable, net of current portion             |       | 547                |       | 728                   |       |
| Total  liabilities                                 |       | 31,055             |       | 21,619                |       |
|                                               |       |               |       |                  |       |
| Stockholders’ equity:                         |       |               |       |                  |       |
| Preferred stock                                    |       | —             |       | —                |       |
| Common stock                                       |       | 27                 |       | 24                    |       |
| Additional paid-in capital                         |       | 241,093            |       | 195,398               |       |
| Warrants                                           |       | 914                |       | 914                   |       |
| Notes receivable from stockholders                 |       | (19                | )          | (19                   | )          |
| Deferred stock-based compensation                  |       | (521               | )          | (5,699                | )          |
| Accumulated other comprehensive loss               |       | (118               | )          | (65                   | )          |
| Accumulated deficit                                |       | (88,016            | )          | (86,577               | )          |
| Total  Stockholders’ equity                   |       | 153,360            |       | 103,976               |       |
| Total  liabilities and stockholders’ equity   |       | $                  | 184,415    |                  | $          | 125,595 |   |
|                                                    |            |                    |            |                       |            |  |  |  |  |

 

The accompanying notes are anintegral part of these unaudited condensed consolidated financialstatements.

 

3

----

 

**IKANOSCOMMUNICATIONS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)**

**(INTHOUSANDS, EXCEPT PER SHARE DATA)**

 
| ** **                                                                             | ** ** | **Three months ended March 31,** | ** ** |
|----------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                             | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| Net revenues                                                                           |       | $                                     | 35,825     |   | $ | 12,286 |   |
| Costs and expenses:                                                                    |       |                                  |       |   |   |
|                                                                                   |       |                                  |       |   |   |
| Cost of  revenue(1)                                                                    |       | 18,560                                |       | 6,255 |   |
|                                                                                   |       |                                  |       |   |   |
| Research and  development (1)                                                          |       | 13,670                                |       | 6,570 |   |
|                                                                                   |       |                                  |       |   |   |
| Selling,  general and administrative (1)                                               |       | 5,564                                 |       | 3,431 |   |
|                                                                                   |       |                                  |       |   |   |
| Common stock  offering expenses                                                        |       | 954                                   |       | — |   |
|                                                                                   |       |                                  |       |   |   |
| Total costs  and expenses                                                              |       | 38,748                                |       | 16,256 |   |
|                                                                                   |       |                                  |       |   |   |
| Loss from operations                                                                   |       | (2,923                                | )          | (3,970 | ) |
|                                                                                   |       |                                  |       |   |   |
| Interest income, net                                                                   |       | 959                                   |       | 95 |   |
|                                                                                   |       |                                  |       |   |   |
| Loss before income taxes                                                               |       | (1,964                                | )          | (3,875 | ) |
|                                                                                   |       |                                  |       |   |   |
| Provision for income taxes                                                             |       | 113                                   |       | — |   |
| Loss before cumulative effect of change in accounting  principle                       |       | (2,077                                | )          | $ | (3,875 | ) |
| Cumulative effect of change in accounting  principle, net of tax                       |       | 638                                   |       | — |   |
|                                                                                   |       |                                  |       |   |   |
| Net loss                                                                               |       | $                                     | (1,439     | ) | $ | (3,875 | ) |
|                                                                                   |       |                                  |       |   |   |
| Basic and diluted net loss per share:                                                  |       |                                  |       |   |   |
| Before  cumulative effect of change in accounting principle, net of tax                |       | $                                     | (0.09      | ) | $ | (2.18 | ) |
| Cumulative  effect of change in accounting principle, net of tax                       |       | 0.03                                  |       | — |   |
| Net loss per share                                                                     |       | $                                     | (0.06      | ) | $ | (2.18 | ) |
| Weighted  average number of shares in calculating basic and diluted net loss per share |       | 24,481                                |       | 1,780 |   |

 

----

(1)          Amounts include stock-based compensation asfollows:

 
| ** **                          | ** ** | **Three months ended  March 31,** | ** ** |
|-------------------------------------|------------|----------------------------------------|------------|
| ** **                          | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| ** **                          | ** ** | ** **                             | ** ** | ** ** | ** ** |
| Cost of revenue                     |       | $                                      | 44         |   | $ | 61 |   |
| Research and development            |       | 899                                    |       | 632 |   |
| Selling, general and administrative |       | 1,009                                  |       | 804 |   |
|                                |       |                                   |       |   |   |
|                                |       | $                                      | 1,952      |   | $ | 1,497 |   |

 

The accompanying notes are anintegral part of these unaudited condensed consolidated financialstatements.

 

4

----

 

**IKANOSCOMMUNICATIONS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)**

**(INTHOUSANDS)**

 
| ** **                                                                                 | ** ** | **Three months ended  March 31,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                 | ** ** | **2006**                               | ** ** | **2005** | ** ** |
|                                                                                       |       |                                   |       |   |   |
| **Cash flows from operating activities**                                                   | ** ** | ** **                             | ** ** | ** ** | ** ** |
| Net loss                                                                                   |       | $                                      | (1,439     | ) | $ | (3,875 | ) |
| Adjustments to reconcile net loss to net  cash provided by (used in) operating activities: |       |                                   |       |   |   |
| Depreciation  of property and equipment                                                    |       | 1,113                                  |       | 666 |   |
| Amortization  of purchased intangibles                                                     |       | 987                                    |       | — |   |
| Stock-based  compensation expense                                                          |       | 1,952                                  |       | 1,497 |   |
| In-process  research and development                                                       |       | 2,900                                  |       | — |   |
| Cumulative  effect of change in accounting principle                                       |       | (638                                   | )          | — |   |
| Changes in  assets and liabilities, net of effect of NPA acquisition:                      |       |                                   |       |   |   |
| Accounts  receivable                                                                       |       | (4,508                                 | )          | (2,918 | ) |
| Inventories                                                                                |       | (2,005                                 | )          | 2,452 |   |
| Prepaid  expenses and other current assets                                                 |       | (68                                    | )          | (403 | ) |
| Other assets                                                                               |       | 91                                     |       | (26 | ) |
| Accounts  payable and accrued liabilities                                                  |       | 8,562                                  |       | (4,901 | ) |
| Other  current liabilities                                                                 |       | 709                                    |       | — |   |
| Net cash  provided by (used in) operating activities                                       |       | 7,656                                  |       | (7,508 | ) |
|                                                                                       |       |                                   |       |   |   |
| **Cash flows from investing activities**                                                   | ** ** | ** **                             | ** ** | ** ** | ** ** |
| Purchase of short-term investments                                                         |       | (58,830                                | )          | — |   |
| Sale of short-term investments                                                             |       | 18,052                                 |       | — |   |
| Business acquisition                                                                       |       | (32,708                                | )          | — |   |
| Purchases of property and equipment                                                        |       | (2,889                                 | )          | (418 | ) |
| Net cash  used in investing activities                                                     |       | (76,375                                | )          | (418 | ) |
|                                                                                       |       |                                   |       |   |   |
| **Cash flows from financing activities**                                                   | ** ** | ** **                             | ** ** | ** ** | ** ** |
| Net proceeds from public offering                                                          |       | 48,562                                 |       | — |   |
| Repayment of notes receivable from  stockholders                                           |       | —                                 |       | 40 |   |
| Proceeds from exercise of stock options                                                    |       | 982                                    |       | 5 |   |
| Payments of obligations under capital lease                                                |       | (217                                   | )          | (286 | ) |
| Repurchase of common stock                                                                 |       | (1                                     | )          | (24 | ) |
| Borrowings under notes payable                                                             |       | —                                 |       | 552 |   |
| Payments on notes payable                                                                  |       | (171                                   | )          | (186 | ) |
| Net cash  provided by financing activities                                                 |       | 49,155                                 |       | 101 |   |
|                                                                                       |       |                                   |       |   |   |
| Effect of exchange rate on cash and cash  equivalents                                      |       | —                                 |       | (4 | ) |
|                                                                                       |       |                                   |       |   |   |
| Net decrease in cash and cash equivalents                                                  |       | (19,564                                | )          | (7,829 | ) |
| Cash and cash equivalents, at beginning of  period                                         |       | 91,932                                 |       | 25,428 |   |
| Cash and cash equivalents, at end of period                                                |       | $                                      | 72,368     |   | $ | 17,599 |   |
|                                                                                       |       |                                   |       |   |   |
| **Supplemental disclosure of cash flow  information:**                                     |       |                                   |       |   |   |
| Cash paid for interest                                                                     |       | 30                                     |       | 48 |   |
| ** **                                                                                 | ** ** | ** **                             | ** ** | ** ** | ** ** |
| **Supplemental disclosure of non-cash  investing and financing activities:**               | ** ** | ** **                             | ** ** | ** ** | ** ** |
| Property and equipment acquired under  capital leases                                      |       | $                                      | 263        |   | $ | — |   |
| Exercise of stock options by notes  receivable                                             |       | —                                 |       | 1 |   |

 

The accompanying notes are anintegral part of these unaudited condensed consolidated financialstatements.

 

5

----

 

**IKANOS COMMUNICATIONS, INC.**

**NOTES TO CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE 1—IKANOS AND SUMMARY OF SIGNIFICANTACCOUNTING POLICIES:**

 

**The Company**

 

Ikanos Communications, Inc. (the “Company”),was incorporated in the state of California in April 1999 andreincorporated in the State of Delaware in September 2005. The Companyprovides highly programmable semiconductors that enable fiber-fast broadbandaccess over telephone companies’ existing copper wires. The Company’s chipsetsintegrate analog, mixed-signal and digital signal processing functions onto asingle chipset.

 

In September 2005, the Company sold6,400,000 shares of its common stock in its initial public offering at anoffering price of $12.00 per share resulting in net proceeds to the Company of$67.9 million, after deducting underwriting discounts and commissions andissuance costs totaling $8.9 million.

 

On February 17, 2006, the Company acquirednetwork processing and ADSL assets, which we refer to as the NPA acquisition,for approximately $32.7 million in cash. This acquisition enables us toenter the growing residential gateway semiconductor market. This acquisitionalso will diversify our product offerings and allow us to sell into new marketsworldwide.

 

In March 2006, the Company sold2,500,000 shares of its common stock in a secondary offering at an offeringprice of $20.75 per share resulting in net proceeds to the Company of $48.6million, after deducting underwriting discounts and commissions and issuancecosts totaling $3.3 million.

 

The Company’s fiscal year ends on the Sundayclosest to December 31. The Company’s fiscal quarters end on the Sundayclosest to the end of the applicable calendar quarter, except in a 53-weekfiscal year, in which case the additional week falls into the fourth quarter ofthat fiscal year. For presentation purposes, the financial statements and noteshave been presented as ending on the last day of the nearest calendar month.

 

**Basis of Presentation**

 

The unaudited condensed consolidatedfinancial statements include the accounts of Ikanos and all of itssubsidiaries. Intercompany transactions and balances have been eliminated inconsolidation.

 

The accompanying condensed consolidatedfinancial statements have been prepared without audit in accordance with the rules andregulations of the Securities and Exchange Commission (the “SEC”). Certaininformation and disclosures normally included in financial statements preparedin accordance with accounting principles generally accepted in the UnitedStates (“GAAP”) have been condensed or omitted in accordance with these rules andregulations. The information in this report should be read in conjunction withour audited financial statements and notes thereto included in our AnnualReport on Form 10-K filed with the SEC on February 27, 2006.

 

In the opinion of management, theaccompanying unaudited condensed consolidated financial statements reflect alladjustments (consisting only of normal recurring adjustments) necessary tostate fairly our financial position, results of operations and cash flows forthe interim periods presented. The operating results for the three month periodended March 31, 2006 are not necessarily indicative of the results that may beexpected for the year ending December 31, 2006 or for any other futureperiod. The balance sheet as of December 31, 2005 is derived from theaudited financial statements as of that date.

 

**Use of Estimates**

 

 The preparation of financial statementsin conformity with GAAP requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenues and expenses during the reporting period.Actual results could differ from those estimates, and such differences couldaffect the results of operations reported in future periods.

 

**Goodwill and intangible assets**

 

Goodwill represents the excess of thepurchase price over the fair value of the net tangible and identifiableintangible assets acquired in a business combination. Intangible assetsresulting from the acquisitions of entities accounted for using the purchasemethod of accounting are estimated by management based on the fair value ofassets received. Identifiable intangible assets are comprised of existing andcore technology, order backlog, customer relationships, trademarks, and otherintangible assets. Identifiable intangible assets that have finite useful livesare being amortized over their useful lives. The Company follows the provisionsof Statement of Financial Accounting Standard No. 142,*Goodwill and Other Intangible Assets* ( “SFAS 142”), under which goodwillis no longer subject to amortization. Rather, goodwill is subject to at leastan annual assessment for impairment, applying a fair-value based test.

 

6

----

 

**Concentration of Credit Risk**

 

Financial instruments that potentiallysubject the Company to significant concentrations of credit risk consist ofcash, cash equivalents and accounts receivable. Cash and cash equivalents areheld with a limited number of financial institutions. Deposits held with thesefinancial institutions may exceed the amount of insurance provided on suchdeposits. Management believes that the financial institutions that hold theCompany’s investments are credit worthy and, accordingly, minimal credit riskexists with respect to those investments. Short-term investments consist of adiversified portfolio of commercial paper, and government agency bonds withmaturities less than one year or specifically identified to fund current operations.All investments are classified as available-for-sale. The Company does not holdor issue financial instruments for trading purposes.

 

Credit risk with respect to accountsreceivable is concentrated due to the number of large orders recorded in anyparticular reporting period. Four customers represented 31.9%, 23.6%, 16.2% and12.5% of accounts receivable at March 31, 2006. Three customersrepresented 33.0%, 30.0% and 29.6%of accounts receivable at December 31,2005. The Company reviews credit evaluations of its customers but does notrequire collateral or other security to support customer receivables. Threecustomers accounted for 31.8%, 25.4% and 24.0%, respectively, of net revenuesfor the period ended March 31, 2006. Three customers accounted for 43.2 %,36.2%, and 11.8 % of net revenues for the three months ended March 31,2005.

 

**Concentrationof Other Risk**

 

The semiconductor industryis characterized by rapid technological change, competitive pricing pressures,and cyclical market patterns. The Company’s results of operations are affectedby a wide variety of factors, including general economic conditions ; economicconditions specific to the semiconductor industry; demand for the Company’sproducts; the timely introduction of new products; implementation of newmanufacturing technologies; manufacturing capacity; the availability ofmaterials and supplies; competition; the ability to safeguard patents andintellectual property in a rapidly evolving market; and reliance on assemblyand wafer fabrication subcontractors and on independent distributors and salesrepresentatives. As a result, the Company may experience substantialperiod-to-period fluctuations in future periods due to the factors mentionedabove or other factors.

 

**NOTE 2 — STOCK-BASED COMPENSATION**

 

On December 16, 2004, the FinancialAccounting Standards Board (FASB) issued SFAS 123 (revised 2004),*Share-Based Payment* (SFAS 123R). SFAS123R supersedes APB Opinion No. 25,*Accounting for Stock Issued to Employees*, and amends SFAS No. 95,*Statement of Cash Flows*. Generally, theapproach in SFAS 123R is similar to the approach described in SFAS 123.However, SFAS 123R requires all share-based payments to employees, includinggrants of employee stock options, to be recognized in the income statementbased on their fair values at the date of grant. Pro forma disclosure is nolonger an alternative.

 

On January 2, 2006 (the first day of its2006 fiscal year), the Company adopted SFAS 123R using the modified prospectivemethod as permitted under SFAS 123R. Under this transition method, compensationcost recognized in the first quarter of fiscal 2006 included: (a) compensationcost for all share-based payments granted prior to but not yet vested as of January 1,2006, based on the grant-date fair value estimated in accordance with theprovisions of SFAS 123, and (b) compensation cost for all share-basedpayments granted subsequent to January 1, 2006, based on the grant-datefair value estimated in accordance with the provisions of SFAS 123R. Inaccordance with the modified prospective method of adoption, the Company’sresults of operations and financial position for prior periods have not beenrestated.

 

**EquityCompensation Plans**

 

The Company currently grants stock options under the following equitycompensation plans:

 

***1999 Stock OptionPlan***

 

On September 24, 1999, the Companyadopted the 1999 Stock Plan (the “Plan”) under which 5,716,833 shares of theCompany’s common stock were reserved for issuance to employees, directors andconsultants. Options granted under the Plan may be incentive stock optionsor non statutory stock options. Incentive stock options may only begranted to employees. Options to purchase shares of the Company’s common stockare granted at a price equal to the fair market value of the stock at the dateof grant, as determined by the board of directors. Options generally vest at arate of 25.0% on the first anniversary of the grant date and 1/48 per monththereafter. Generally, options terminate ten years after the date of grant.Incentive stock options granted to employees who own more than ten percent ofthe total combined voting power of all classes of stock of the Companyterminate five years from the date of the grant. Should an employeesubsequently leave, the Company has the right to repurchase the shares that hadnot vested at the departure date. Upon completion of the Company’s initialpublic offering in September 2005, the 1999 Plan was terminated and noshares are available for future issuance under the 1999 Plan.

 

***2004 Equity IncentivePlan***

 

On September 21, 2005, the Companyadopted the 2004 Equity Incentive Plan, (the “2004 Plan”), upon the closing ofits initial public offering. The 2004 Plan allows for the issuance of incentiveand nonqualified stock options, restricted stock, stock appreciation

 

7

----

 

rights, deferred stock units, performance units and performance sharesto the Company’s employees, directors and consultants. Options generally vestat a rate of 25% on the first anniversary of the grant date and 1/48 per monththereafter. Generally, options terminate ten years after the date of grant. Theterm of an incentive stock option may not exceed ten years, except thatwith respect to any participant who owns 10% of the voting power of all classesof our outstanding stock, the term must not exceed five years and the exerciseprice must equal at least 110% of the fair market value on the grant date.

 

The 2004 Equity Incentive Plan provides forthe automatic grant of nonstatutory stock options to our non-employeedirectors. Each non-employee director appointed to the board will receive aninitial option to purchase 30,000 shares upon such appointment except for thosedirectors who become non-employee directors by ceasing to be employeedirectors. Initial option grants shall vest as to 25% of the shares on thefirst anniversary of the date of grant and as to 1/48th of the shares eachmonth thereafter, subject to the director continuing to serve as a director oneach vesting date. In addition, non-employee directors who have been directorsfor at least six months will receive a subsequent option to purchase 12,000shares on the date of each annual meeting of our stockholders. These subsequentoption grants shall vest as to 1/12th of the shares each month following thedate of grant, subject to the director continuing to serve as a director oneach vesting date. All options granted under these automatic grant provisionshave a term of ten years and an exercise price equal to the fair market valueof our common stock on the date of grant.******

 

***2004 Employee StockPurchase Plan***

 

On September 21, 2005, the Companyadopted the 2004 Employee Stock Purchase Plan, (the “ESPP”), upon the closingof its initial public offering. A total of 1,000,000 shares of the Company’scommon stock will be made available for sale under the ESPP. All of the Company’semployees are eligible to participate if they are customarily employed by theCompany or any participating subsidiary for at least 20 hours per week andmore than 5 months in any calendar year. The Company’s 2004 ESPP isintended to qualify under Section 423 of the Internal Revenue Code andprovides for consecutive, overlapping 24-month offering periods. Each offeringperiod includes four 6-month purchase periods. The offering periods generallystart on the first trading day on or after May 1 and November 1 ofeach year, except that the first offering period commenced on the first tradingday on after the Company’s initial offering and will end on the earlier of (1) thefirst trading day on or after November 1, 2006 and (2) twenty-sevenmonths after the offering period commences, and the second offering period willcommence on the first trading day on or after May 1, 2005.

 

***Grant-Date FairValue***

 

The Company uses the Black-Scholes optionpricing model to calculate the grant-date fair value of an award. The fairvalue of options granted during the first quarter of fiscal 2006 and the firstquarter of fiscal 2005 were calculated using the following estimated weightedaverage assumptions:

 

The fair value of the Company’s stock-basedawards to employees was estimated using the following weighted-averageassumptions:

 
| ** **                             | ** ** | **Stock Option Plans  Three months ended March 31,** | ** ** | **Stock Purchase Plan  March 31, 2006** | ** ** |
|----------------------------------------|------------|-----------------------------------------------------------|------------|----------------------------------------------|------------|
| **2006**                               | ** ** | **2005**                                                  |
| Dividend yield                         |       | 0                                                         | %          | 0                                            | %          | 0 | % |
| Expected term (years)                  |       | 4.8 years                                            |       | 4.0 years                                    |       | 0.58 years |   |
| Expected volatility                    |       | 60                                                        | %          | —                                       |       | 60 | % |
| Weighted average volatility            |       | —                                                    |       | 90                                           | %          | — |   |
| Risk-free interest rate                |       | 4.6                                                       | %          | 3.9                                          | %          | 4.7 | % |
| Weighted average grant date fair value |       | $                                                         | 19.27      |                                         | $          | 7.08 |   | $ | 3.76 |   |
|                                        |            |                                                           |            |                                              |            |  |  |  |  |  |

 

Expected volatility – The expected volatilityis based on a blend of the Company’s peer group in the industry in which itdoes business and the Company’s historical volatility.

 

Expected term –  The expected term isbased on several factors including historical observations of employee exercisepatterns during the Company’s history, peer company employee exercise behavior,and expectations of employee exercise behavior in the future givingconsideration to the contractual terms of the stock-based awards. The expectedterm of options granted is derived from the average midpoint between vestingand the contractual term, as described in the SEC’s Staff Accounting Bulletin No. 107,Share-Based Payment.

 

Risk-free interest rate – The yield onzero-coupon U.S. Treasury securities for a period that is commensurate with theexpected term assumption for each group of employees is used as the risk-freeinterest rate.

 

Expected dividend yield – Expected dividendyield is calculated by annualizing the cash dividend declared by the Company’sBoard of Directors for the current quarter and dividing that result by theclosing stock price on the date of grant. Until such time as the Company’sBoard of Directors declares a cash dividend the dividend yield assumption willbe zero.

 

Pre-vesting forfeitures –  Estimates of pre-vesting option forfeituresare based on Company experience and industry trends. The Company will adjustits estimate of forfeitures over the requisite service period based on theextent to which actual forfeitures differ.

 

8

----

 

***Expense***

 

The Company used the graded attributionmethod to recognize expense for all options granted prior to the adoption ofSFAS 123R. Upon adoption of SFAS 123R on January 1, 2006, the Companyswitched to the straight-line attribution method to recognize expense foroptions granted after January 1, 2006. The expense associated with theunvested portion of the pre-adoption grants will continue to be expensed usingthe graded attribution method.

 

The amount of stock-based compensationrecognized during a period is based on the value of the portion of the awardsthat are ultimately expected to vest. SFAS 123R requires forfeitures to beestimated at the time of grant and revised, if necessary, in subsequent periodsif actual forfeitures differ from those estimates.

 

The following table details the effect on netloss and earnings per share had stock-based compensation expense been recordedfor the first three months of fiscal 2005 based on the fair-value method underSFAS 123,*Accounting for Stock-BasedCompensation.* The reported and pro forma net loss and earnings pershare for the first quarter of fiscal 2006 are the same since stock-basedcompensation expense was calculated under the provisions of SFAS 123R.

 
| ** **                                                                                                                               | ** ** | **Three Months  Ended  March 31, 2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|
| Net loss, as reported                                                                                                                    |       | $                                            | (3,875     | ) |
| Add:  Stock-based employee compensation expense included in reported net income,  net of related tax effects                             |       | 1,406                                        |       |
| Deduct:  Total stock-based compensation expense determined under the fair value based  method for all awards, net of related tax effects |       | (1,324                                       | )          |
| Pro forma net loss                                                                                                                       |       | $                                            | (3,793     | ) |
|                                                                                                                                     |       |                                         |       |
| Earnings per share:                                                                                                                      |       |                                         |       |
| Basic and diluted – as reported                                                                                                     |       | $                                            | (2.18      | ) |
| Basic and diluted – pro forma                                                                                                       |       | $                                            | (2.13      | ) |

 

**Impact of the adoption of SFAS No. 123(R)**

 

The Companyadopted SFAS 123(R) using the modified prospective transition methodbeginning January 1, 2006. Accordingly, during the three-month periodended March 31, 2006, we recorded stock-based compensation expense forawards granted prior to, but not yet vested, as of January 1, 2006, as ifthe fair value method required for pro forma disclosure under SFAS 123were in effect for expense recognition purposes, adjusted for estimated forfeitures.For these awards, the Company has continued to recognize compensation expenseusing the accelerated amortization method. For stock-based awards granted afterJanuary 1, 2006, compensation expense has been recognized based on theestimated grant date fair value method using the Black-Scholes valuation model.For these awards, the Company has recognized compensation expense using astraight-line amortization method. As FAS 123(R) requires that stock-basedcompensation expense be based on awards that are ultimately expected to vest,stock-based compensation for the three-month period ended March 31, 2006has been reduced for estimated forfeitures. When estimating forfeitures, theCompany considers voluntary termination behaviors as well as trends of actualoption forfeitures. The impact on the results of operations of recordingstock-based compensation for the three-month period ended March 31, 2006was as follows (in thousands):

 
| Cost of  revenue                |   | $     | 44     |   |
|---------------------------------|--------|-------|--------|--------|
| Research and development        |   | 899   |   |
| Selling, general administrative |   | 1,009 |   |
|                            |   | $     | 1,952  |   |

 

Prior to theadoption of SFAS 123(R), the intrinsic value of unvested common stockoptions issued prior to the initial public offering were recorded as unearnedstock-based compensation as of December 31, 2005. Upon the adoption ofSFAS 123(R) in January 2006, the unearned stock-based compensationbalance of approximately $4.5 million was reclassified toadditional-paid-in-capital.

 

The adoptionof SFAS 123(R) resulted in a cumulative benefit from accounting change of$638,000, which reflects the net cumulative impact of estimating futureforfeitures in the determination of period expense, rather than recordingforfeitures when they occur as previously permitted.

 

9

----

 

*Option Activity*

 

A summary of the activity under the Plan andStand-Alone Stock Option Agreements is as follows (in thousands, except pershare amounts):

 
| ** **                       | ** ** | **Options  Available  for Future  Issuance** | ** ** | **Outstanding  Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|----------------------------------|------------|----------------------------------------------|------------|-------------------------|------------|----------------------------------------|------------|
| Balances, December 31, 2005 |       | 106                                          |       | 3,945                   |       | $                                      | 3.92       |   |
| Authorized                       |       | 1,047                                        |       | —                  |       | —                                 |       |
| Granted                          |       | (44                                          | )          | 44                      |       | 19.27                                  |       |
| Unvested  shares repurchased     |       | 2                                            |       | —                  |       | 0.48                                   |       |
| Exercised                        |       |                                         |       | (592                    | )          | 1.66                                   |       |
| Forfeited                        |       | 122                                          |       | (122                    | )          | 6.68                                   |       |
|                             |       |                                         |       |                    |       |                                   |       |
| Balances, March 31, 2006    |       | 1,233                                        |       | 3,275                   |       | $                                      | 4.43       |   |

 

Option grants outstanding as of March 31,2006 and the related weighted average price and contractual life informationare as follows (shares and aggregate intrinsic value in thousands):

 
| ** **      | ** ** | **Options Outstanding** | ** ** | ** **            | ** ** | **Options Vested** | ** ** |
|-----------------|------------|------------------------------|------------|-----------------------|------------|-------------------------|------------|
| ** **      | ** ** | ** **                   | ** ** | **Weighted**          | ** ** | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Weighted**    | ** ** | ** **                   | ** ** | **Average**           | ** ** | **Weighted**            | ** ** | ** ** | ** ** | **Options** | ** ** | **Weighted** | ** ** | ** ** | ** ** |
| **Average**     | ** ** | **Options at**          | ** ** | **Remaining**         | ** ** | **Average**             | ** ** | **Aggregate** | ** ** | **Vested at** | ** ** | **Average** | ** ** | **Aggregate** | ** ** |
| **Exercise**    | ** ** | **March 31,**           | ** ** | **Contractual**       | ** ** | **Exercise**            | ** ** | **Intrinsic** | ** ** | **March 31,** | ** ** | **Exercise** | ** ** | **Intrinsic** | ** ** |
| **Price**       | ** ** | **2006**                     | ** ** | **Life (Years)** | ** ** | **Price**               | ** ** | **Value** | ** ** | **2006** | ** ** | **Price** | ** ** | **Value** | ** ** |
|            |       |                         |       |                  |       |                    |       |   |   |   |   |   |   |   |   |
| $0.36 - $0.48   |       | 1,144                        |       | 7.45                  |       | $                       | 0.48       |   | $ | 22,004 |   | 765 |   | $ | 0.48 |   | $ | 14,719 |   |
| $1.08 - $3.84   |       | 1,216                        |       | 7.68                  |       | 3.45                    |       | 19,772 |   | 449 |   | 3.45 |   | 7,601 |   |
| $4.80 - $9.85   |       | 61                           |       | 8.52                  |       | 5.62                    |       | 844 |   | 19 |   | 5.06 |   | 279 |   |
| $10.20 - $22.00 |       | 842                          |       | 9.37                  |       | 11.13                   |       | 7,217 |   | 132 |   | 10.21 |   | 1,252 |   |
|            |       | 3,263                        |       |                  |       |                    |       | $ | 49,837 |   | 1,365 |   |   |   | $ | 23,851 |   |
|                 |            |                              |            |                       |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

As of March 31, 2006 and 2005, optionsto purchase 3,110,048 and 1,075,525 shares respectively were exercisable. Inaddition, at March 31, 2006, 12,000 restricted stock units were alsooutstanding.

 

During the three months ended March 31,2006, the total intrinsic value of options exercised (i.e. the differencebetween the market price at exercise and the price paid by the employee toexercise the options) was $10.5 million and the total amount of cashreceived from exercise of these options was $982,000. No income tax benefitshave been realized from exercised stock options. The Company issues new sharesof common stock upon exercise of stock options.

 

As of March 31, 2006, there was $6.7million of total unrecognized compensation cost, as determined by SFAS No. 123(R),related to unvested share-based awards. That cost is expected to be recognizedover an estimated weighted-average period of 3.0 years.

 

**NOTE 3 – BUSINESS COMBINATION**

 

On February 17, 2006,the Company acquired the network processing and ADSL assets of Analog Devices, Inc.(the “NPA acquisition”) for $32.7 million in cash, including transaction costsof $1.8 million. The acquisition has been accounted for as a purchasebusiness combination. The results of operations from the assets acquired in theNPA acquisition were included in the Company’s Condensed Consolidated Statementof Operations from the date of the acquisition.

 

Under the purchase method ofaccounting, the total estimated purchase price as shown in the table has beenallocated to the net tangible and intangible assets acquired based on theirestimated fair values as of the date of the completion of the NPA acquisition. 

 
| ** **                              | ** ** | **(in thousands)** | ** ** |
|-----------------------------------------|------------|--------------------|------------|
| Tangible assets                         |       | $                  | 7,475      |   |
| Liability for severance payment assumed |       | (308               | )          |
| Goodwill                                |       | 4,741              |       |
| Amortizable intangible assets:          |       |               |       |
| Existing  technology                    |       | 4,600              |       |
| Patents/core  technology                |       | 2,000              |       |
| Trademarks                              |       | 1,000              |       |
| Customer  relationships                 |       | 3,000              |       |
| Order  backlog                          |       | 1,200              |       |
| Non-competition  agreement              |       | 100                |       |
| Transition  services                    |       | 1,000              |       |
| Favorable  supply arrangement           |       | 5,000              |       |
|                                    |       |               |       |
| Total  intangibles                      |       | 17,900             |       |
| In-process research and development     |       | 2,900              |       |
|                                    |       |               |       |
| Total purchase price                    |       | $                  | 32,708     |   |

 

10

----

 

**Amortizable Intangible Assets**

 

Existing technologycomprises products that have reached technological feasibility and includes theEagle and Fusiv products. The Company valued the existing technology utilizinga discounted cash flow, or DCF, model, which uses forecasts of future revenuesand expenses related to the intangible asset. The Company utilized a discountrate of 20% for existing technology and is amortizing on a straight-line basisthe intangible assets over their estimated useful life of three to four years.

 

Patents/core technologyrepresents a series of awarded patents, filed patent applications, andcore architectures that are used in the products and form a major part ofthe architecture of both current and planned future releases. The Companyvalued patents/core technology using the royalty savings method, whichrepresents the benefit of owning this intangible asset rather than payingroyalties for its use. The Company utilized a royalty rate of 2% and a discountrate of 26% for the patents/core technology and is amortizing on astraight-line basis this intangible asset over its estimated useful life offour years.

 

The trademark assets weredetermined using the royalty savings method, which represents the benefit ofowning an intangible asset rather than paying royalties for its use. TheCompany utilized a royalty rate of 0.5% and a discount rate of 22% for thetrademark and is amortizing on a straight-line basis this intangible asset overits estimated useful life of three to five years.

 

The customer relationshipsasset relates to the ability to sell existing and future versions of productsto existing customers and has been estimated using the income method. The Companyvalued customer relationships utilizing a DCF model and a discount rate of 22%and are amortizing on a straight-line basis the intangible asset over itsestimated useful life of five years.

 

The order backlog assetrepresents the value of the sales and marketing costs required to establish theorder backlog and was valued using the cost savings approach. The Companyexpects these orders to be delivered and billed within three to six months. Theorder backlog will be amortized in proportion to the value of the backlogshipped.

 

The Company valued thenon-competition agreement with ADI by estimating the effect on our future netrevenues and cash flows if a non-compete were not in place, thereby allowingADI to re-enter the market and compete with us. The Company utilized a discountrate of 22% for the non-compete agreement and are amortizing the intangibleasset on a straight-line basis over the three year term of the agreement.

 

The transition servicesasset represents the $1.0 million of transition services that the Companyis entitled to receive from ADI with no obligation to pay and is expected to befully utilized over the next nine to 12 months.

 

The favorable supplyarrangement represents a $5.0 million credit for future purchases from asupplier and will be amortized in proportion to the value of related purchasesfrom that supplier, and is expected to be utilized over nine to 12 months.

 

Of the total purchase price,$2.9 million has been allocated to in-process research and development, orIPRD, and was expensed in the quarter ended March 31, 2006. Projects thatqualify as IPRD represent those that have not yet reached technologicalfeasibility and which have no alternative future use. Technological feasibilityis established when an enterprise has completed all planning, designing,coding, and testing activities that are necessary to establish that a productcan be produced to meet its design specifications including functions,features, and technical performance requirements. The value of IPRD was determinedby considering the importance of each project to our overall development plan,estimating costs to develop the purchased IPRD into commercially viableproducts, estimating the resulting net cash flows from the projects whencompleted and discounting the net cash flows to their present value based onthe percentage of completion of the IPRD projects. The Company utilized the DCFmodel to value the IPRD using discount rates ranging from 28% to 35%, dependingon the estimated useful life of the technology.

 

**Goodwill**

 

Goodwill represents theexcess of the purchase price over the fair value of the net tangible andintangible assets acquired. In accordance with SFAS No. 142 goodwillresulting from business combinations will not be amortized but instead will betested for impairment at least annually (more frequently if certain indicatorsare present). In the event that management determines that the value ofgoodwill has become impaired, the combined company will incur an accountingcharge for the amount of impairment during the fiscal quarter in which thedetermination is made.

 

The following unaudited pro forma financialinformation presents the combined results of operations of Ikanos and thebusiness of the network processing and ADSL assets as if the NPA acquisitionhad occurred as of the beginning of fiscal 2005, after giving effect to certainadjustments, including amortization of intangibles. The IPRD charge of $2.9million is not reflected in the information below. The unaudited pro formafinancial information does not necessarily reflect the results of operationsthat would have occurred had the combined businesses constituted a singleentity during such periods, and is not necessarily indicative of results which may beobtained in the future.

 

11

----

 
| **In thousands except for per share data:** | ** ** | **Year Ended December 31,  2005** | ** ** |
|---------------------------------------------|------------|----------------------------------------|------------|
|                                        |       |                                   |       |
| Pro forma revenues                          |       | $                                      | 138,311    |   |
|                                        |       |                                   |       |
| Pro forma net loss                          |       | $                                      | (12,324    | ) |
|                                        |       |                                   |       |
| Pro forma net loss per share:               |       |                                   |       |
| Basic and  Diluted                          |       | $                                      | (0.65      | ) |

 

**NOTE 4 – GOODWILL AND PURCHASED INTANGIBLEASSETS**

 

SFAS 142 requires purchased intangible assetsother than goodwill to be amortized over their expected useful lives unlessthese lives are determined to be indefinite. Purchased intangible assets arecarried at cost less accumulated amortization. Amortization is computed overthe estimated useful lives of the respective assets.

 

Intangible assets at March 31, 2006 wereas follows (in thousands):

 
| ** **                   | ** ** | **Carrying  Amount** | ** ** | **Accumulated Amortization** | ** ** | **Net** | ** ** | **Weighted  average  useful life  (Years)** | ** ** |
|------------------------------|------------|----------------------|------------|------------------------------|------------|---------|------------|---------------------------------------------|------------|
| Existing technology          |       | $                    | 4,600      |                         | $          | (153    | )          | $                                           | 4,447      |   | 3 |   |
| Patents/core technology      |       | 2,000                |       | (63                          | )          | 1,937   |       | 4                                           |       |
| Trademarks                   |       | 1,000                |       | (27                          | )          | 973     |       | 3                                           |       |
| Customer relationships       |       | 3,000                |       | (75                          | )          | 2,925   |       | 5                                           |       |
| Order backlog                |       | 1,200                |       | (494                         | )          | 706     |       | 1                                           |       |
| Non-competition agreement    |       | 100                  |       | (4                           | )          | 96      |       | 1                                           |       |
| Transition services          |       | 1,000                |       | (171                         | )          | 829     |       | 1                                           |       |
| Favorable supply arrangement |       | 5,000                |       | —                       |       | 5,000   |       | 1                                           |       |
| Total  intangible assets     |       | $                    | 17,900     |                         | $          | (987    | )          | $                                           | 16,913     |   |   |   |

 

For the three months ended March 31,2006, amortization of intangible assets was $987,000. The estimated futureamortization expense of purchased intangible assets as of March 31, 2006is as follows (in thousands):

 
| **Year ending December 31,** | ** ** | **Amount** | ** ** |
|-----------------------------------|------------|------------|------------|
| 2006 (remaining nine months)      |       | $          | 8,463      |   |
| 2007                              |       | 2,572      |       |
| 2008                              |       | 2,572      |       |
| 2009                              |       | 2,251      |       |
| 2010                              |       | 958        |       |
| 2011                              |       | 97         |       |
| Total                             |       | $          | 16,913     |   |

 

**NOTE 5 – NET INCOME (LOSS) PER SHARE**

 

Basic net income (loss) per share is computedby dividing net income (loss) by the weighted average number of common sharesoutstanding during the period. Basic net income (loss) per share excludes thedilutive effect of stock options, warrants and unvested common shares subjectto repurchase.

 

12

----

 

The following table sets forth thecomputation of basic and diluted net loss per common share (in thousands,except per share data):

 
| ** **                                          | ** ** | **Three months ended  March 31,** | ** ** |
|-----------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                          | ** ** | **2006**                               | ** ** | **2005** | ** ** |
|                                                |       |                                   |       |   |   |
| Numerator:                                          |       |                                   |       |   |   |
| Net loss                                            |       | $                                      | (1,439     | ) | $ | (3,875 | ) |
|                                                |       |                                   |       |   |   |
| Denominator:                                        |       |                                   |       |   |   |
| Weighted-average common shares outstanding          |       | 24,533                                 |       | 1,967 |   |
| Less: Unvested common shares subject to  repurchase |       | (52                                    | )          | (187 | ) |
|                                                |       |                                   |       |   |   |
| Total shares, basic                                 |       | 24,481                                 |       | 1,780 |   |
|                                                |       |                                   |       |   |   |
| Net loss per share:                                 |       |                                   |       |   |   |
| Basic and diluted                                   |       | $                                      | (0.06      | ) | $ | (2.18 | ) |

 

The potential shares, which are excluded fromthe determination of basic and diluted net loss per share as their effect isanti-dilutive, are as follows (in thousands):

 
| ** **                                               | ** ** | **Three months ended  March 31,** | ** ** |
|----------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                               | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| ** **                                               | ** ** | ** **                             | ** ** | ** ** | ** ** |
| Weighted-average redeemable convertible  preferred stock |       | —                                 |       | 15,312 |   |
| Warrants to purchase common stock                        |       | 6                                      |       | 45 |   |
| Restricted stock units                                   |       | 12                                     |       | — |   |
| Options to purchase common stock                         |       | 3,263                                  |       | 3,038 |   |

 

**NOTE 6—RELATED PARTY TRANSACTIONS:**

 

The Company has a consulting agreement withTexan Ventures, LLC entered into in the first quarter of 2006. The ConsultingAgreement is effective as of March 30, 2006. Pursuant to the ConsultingAgreement, G. Venkatesh, who is both the Managing Member of Texan Ventures, LLCand a member of the Ikanos board of directors, will provide consulting serviceswith respect to, among other things, general business advice relating to theoperation of a public company, guidance and strategic advice in analyzingacquisition opportunities, assisting in negotiations of acquisition agreementsand providing assistance and guidance in the integration of acquired companies.The term of the Consulting Agreement will expire on December 31, 2006.Prior to this Consulting Agreement, the Company also had an agreement withTexan Ventures, LLC entered into on November 7, 2001.

 

Under the Consulting Agreement, TexanVentures, LLC is entitled to $3,000 per month and reimbursement for reasonableexpenses. The Company paid Texan Ventures, LLC $9,000 in the three months endedMarch 31, 2006 for consulting services.

 

**NOTE 7—BALANCE SHEET COMPONENTS:**

 

**Short-Term Investments**

 

Short-term investments included the followingavailable-for-sale securities at March 31, 2006 and December 31, 2005(in thousands):

 
| ** **                                        | ** ** | **Cost  basis** | ** ** | **March 31, 2006  Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
|---------------------------------------------------|------------|-----------------|------------|----------------------------------------------------|------------|-----------------|------------|
| U.S. Treasury and other U.S. government  agencies |       | $               | 7,516      |                                               | $          | (53             | )          | $ | 7,463 |   |
| Auction rate securities                           |       | 35,250          |       | —                                             |       | 35,250          |       |
| Total available-for-sale securities               |       | $               | 42,766     |                                               | $          | (53             | )          | $ | 42,713 |   |

 

13

----

 
| ** **                                        | ** ** | **Cost  basis** | ** ** | **December 31, 2005  Gross  Unrealized  gains** | ** ** | **Fair  Value** | ** ** |
|---------------------------------------------------|------------|-----------------|------------|------------------------------------------------------|------------|-----------------|------------|
| U.S.  Treasury and other U.S. government agencies |       | $               | 1,973      |                                                 | $          | 15              |       | $ | 1,988 |   |
|                                              |       |            |       |                                                 |       |            |       |
| Total  available-for-sale securities              |       | $               | 1,973      |                                                 | $          | 15              |       | $ | 1,988 |   |

 

Interest income on marketable securitiesamounted to $832,000 for the three months ended March 31, 2006.

Interestincome on marketable securities was insignificant for the year ended December 31,2005.

 

Asignificant portion of Ikanos’ available-for-sale portfolio is composed ofauction rate securities. Even though the stated maturity dates of theseinvestments may be one year or more beyond the balance sheet dates, Ikanoshas classified these securities as short-term investments. In accordance withAccounting Research Bulletin No. 43, Chapter 3A, “Working Capital- CurrentAssets and Current Liabilities,” Ikanos views its available-for-sale portfolioas available for use in its current operations. Based upon historicalexperience in the financial markets as well as Ikanos’ specific experience withthese investments, Ikanos believes there is a reasonable expectation ofcompleting a successful auction with the subsequent twelve-month period. Duringits history of investing in these securities, Ikanos has not been unable tosell its holdings of these investments. Accordingly, Ikanos believes that therisk of non-redemption of these investments within a year is minimal.

 

**Inventory**

 
| ** **                        | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|-----------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                        | ** ** | **(in thousands)**       | ** ** |
|                              |       |                     |       |                        |       |
| **Inventory:**                    | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Finished Goods                    |       | $                        | 4,804      |                        | $          | 1,955 |   |
| Work-in-Process                   |       | 9,608                    |       | 4,762                       |       |
| Purchased parts and raw materials |       | 2,766                    |       | 2,408                       |       |
|                              |       | $                        | 17,178     |                        | $          | 9,125 |   |

 

**Warranty**

 

The following table summarizes the activityrelated to the product warranty liability, which is included within accountspayable and accrued liabilities in the Company’s consolidated balance sheets,at March 31, 2006 and December 31, 2005(in thousands):

 
| ** **                               | ** ** | **Three months ended  March 31** | ** ** |
|------------------------------------------|------------|---------------------------------------|------------|
| ** **                               | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| ** **                               | ** ** | **(in thousands)**               | ** ** |
| Balance, beginning of period             |       | $                                     | 2,189      |   | $ | 1,084 |   |
|                                     |       |                                  |       |   |   |
| Accrual for warranties during the period |       | 82                                    |       | 253 |   |
| Settlements made during the period       |       | (456                                  | )          | (19 | ) |
|                                     |       |                                  |       |   |   |
| Balance, end of period                   |       | $                                     | 1,815      |   | $ | 1,318 |   |
|                                          |            |                                       |            |  |  |  |  |  |  |  |

 

**NOTE 8—BORROWINGS:**

 

On October 21, 2004, the Company enteredinto a loan agreement with Silicon Valley Bank that provides the Company theability to finance up to $5,000,000 of working capital requirements (subject tocertain limitations) and $2,000,000 of equipment purchases. The working capitalline of credit matures on October 21, 2006 and Silicon Valley Bank’scommitment to extend working capital loans terminates. Borrowings under theagreement are capitalized by a first priority lien on substantially all of theassets of the Company, excluding intellectual property. The loan agreement wasamended on March 31, 2006. Pursuant to the Amendment, the provisions ofthe loan and security agreement relating to the financial covenant regardingthe profitability of Ikanos was amended to exclude stock-based compensation andcertain expenses and charges resulting from the NPA acquisition for each of thequarters in 2006.

 

As of March 31, 2006, no balance wasoutstanding under the working capital facility and $1.3 million was outstandingunder the equipment financing facility. Interest on borrowings under theworking capital line is payable monthly and is calculated at a floating rate ofinterest equal to Silicon Valley Bank’s prime rate plus 0.50%, while intereston the equipment financing facility is payable monthly at a fixed rate ofinterest equal to Silicon Valley Bank’s prime rate plus 1.0%, Interest rates onthe amounts drawn under the equipment financing facility range from 5.95% to6.31%.

 

**NOTE 9—OPERATING SEGMENT AND GEOGRAPHICINFORMATION:**

 

The Company operates in one segment,comprising the design, development and marketing of semiconductors.

 

14

----

 

The following table summarizes net revenue ona percentage basis by geographic region, based on the country in which thecustomer is located:

 
| ** **    | ** ** | **Three months ended  March 31,** | ** ** |
|---------------|------------|----------------------------------------|------------|
| ** **    | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| ** **    | ** ** | ** **                             | ** ** | ** ** | ** ** |
| Japan         |       | 49.4                                   | %          | 55.0 | % |
| Korea         |       | 31.8                                   |       | 36.2 |   |
| Other         |       | 18.8                                   |       | 8.8 |   |
|          |       |                                   |       |   |   |
| Total revenue |       | 100                                    | %          | 100 | % |

 

The distribution of long lived assets, net asof March 31, 2006 and 2005 was as follows (in thousands):

 
| ** **    | ** ** | **March 31, 2006** | ** ** | **December 31, 2005** | ** ** |
|---------------|------------|-------------------------|------------|----------------------------|------------|
| ** **    | ** ** | ** **              | ** ** | ** **                 | ** ** |
| United States |       | $                       | 6,108      |                       | $          | 4,082 |   |
| Taiwan        |       | 4,042                   |       | 3,329                      |       |
| Other         |       | 1,701                   |       | 973                        |       |
|          |       | $                       | 11,851     |                       | $          | 8,384 |   |

 

15

----

 

**Item 2.Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

**MANAGEMENT’SDISCUSSION AND ANALYSIS**

**OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

*This discussioncontains forward-looking statements within the meaning of Section 27A ofthe Securities Act of 1933 and Section 21E of the Securities Exchange Actof 1934. Actual results could differ materially from those projected in theforward-looking statements as a result of a number of factors, risks anduncertainties, including the risk factors set forth in this discussion, as morefully described in the  ”Risk Factors” section in this Form 10-Q.Generally, the words “anticipate”, “expect”, “intend”, “believe” and similarexpressions identify forward-looking statements. These forward-lookingstatements include, without limitation, our expectation that the majority ofour net revenue will continue to be represented by sales to customers outsidethe United States; our expectation that research and development expenses willincrease; compliance with bank covenants based on expected future operatingresults; future costs and expenses and financing requirements. Theforward-looking statements made in this Form 10-Q are made as of thefiling date with the Securities and Exchange Commission and future events orcircumstances could cause results that differ significantly from theforward-looking statements included here. Accordingly, we caution readers notto place undue reliance on these statements and, except as required by law, weassume no obligation to update any such forward-looking statements.*

 

*The followingdiscussion and analysis should be read in conjunction with the condensedfinancial statements and notes thereto in Item 1 above and with our financialstatements and notes thereto for the year ended December 31, 2005,contained in our Annual Report on Form 10-K filed on February 27,2006.*

 

**Overview**

 

We are a leading developerand provider of highly programmable semiconductors that enable fiber-fastbroadband services over carriers’ existing copper lines. We have developedthese semiconductors using our proprietary semiconductor designs, specificpurpose digital signal processor and advanced mixed-signal semiconductor designcapabilities. We recently acquired network processing and ADSL assets, which werefer to as the NPA acquisition, and began deriving revenues relating tonetwork processing and ADSL products in the first quarter of 2006. We offermultiple product lines that are designed to address different segments of thefiber-fast broadband communications semiconductor market for both carriernetworks and subscriber premise equipment. We outsource all of oursemiconductor fabrication, assembly and test functions, which enables us tofocus on design, development, sales and marketing of our products and reducesthe level of our capital investment. Our customers are original equipmentmanufacturers (“OEMs”), who in turn sell our chipsets as part of theirproduct solutions to carriers.

 

We were incorporated in April 1999and through December 31, 2001, we were engaged principally in research anddevelopment. We began commercial shipment of our products in the fourth quarterof 2002. Over the last three years, we have experienced significant net revenuegrowth, primarily due to a rapid rise in deployments of our products in Japanand Korea. Our net revenue has increased from $29.0 million in 2003 to$85.1 million in 2005. Our net revenue, however, can fluctuatesignificantly on a quarterly basis. For instance, in the first quarter of 2005,our net revenue decreased $6.2 million or 33.4% from the fourth quarter of2004, yet in the second quarter of 2005, our net revenue increased$7.0 million or 56.6% from the first quarter of 2005. Quarterlyfluctuations in net revenue are characteristic of our industry, as carriers purchaseequipment based on expected deployment and OEMs may occasionallymanufacture equipment at rates higher than equipment is deployed. As a result,periodically and usually without significant notice, carriers will reduceorders with OEMs for new equipment and OEMs in turn will reduce orders for ourproducts, which will adversely impact the quarterly demand for our products,even when deployment rates may be increasing. We believe that our rate ofgrowth in net revenue in the last four quarters ended March 31, 2006 may bein excess of carrier deployments. The net revenue growth rates in each of thelast four fiscal quarters were 56.6%, 30.0%, 14.1% and 25.6% quarter overquarter. We do not expect similar net revenue growth rates in future periods.

 

In September 2005, wesold 6,400,000 shares of our common stock in our initial public offering at$12.00 per share. Aggregate net proceeds from our initial public offering,after deducting underwriting discounts and commissions and issuance costs, were$67.9 million. We also had 15,311,840 shares of redeemable convertiblepreferred stock outstanding that automatically converted into 15,311,840 sharesof our common stock upon the closing of our initial public offering.

 

On February 17, 2006,we completed the NPA acquisition for approximately $32.7 million in cash.This acquisition enables us to enter the growing residential gatewaysemiconductor market. This acquisition also will diversify our productofferings and allow us to sell into new markets worldwide. As a result of theNPA acquisition, we expect to experience a net loss in 2006, primarily due tonon-cash acquisition-related charges.

 

In March 2006, we sold2,500,000 shares of our common stock in a follow-on offering at $20.75 pershare. Aggregate net proceeds from the follow-on offering, after deductingunderwriting discounts and commissions and issuance costs, were $48.6 million.In the follow-on offering, selling stockholders including members of our seniormanagement sold 3,250,000 shares of common stock held by them. Ikanos did notreceive any proceeds from the sale of shares by the selling stockholders.

 

*Net loss.* As of March 31, 2006, we had anaccumulated deficit of $88.0 million and a total stockholders’ equity of $153.4million. For the three month period ended March 31, 2006 as compared tothe three month period ended March 31, 2005, our net loss decreased as ournet revenue increased while our research and development and selling, generaland administrative expenses decreased as a percentage of revenue.

 

16

----

 

*Net revenue.*Ournet revenue is primarily derived from sales of our chipset products. Netrevenue from product sales are generally recognized upon shipment, net of salesreturns, rebates and allowances. As is typical in our industry, the sellingprices of our products generally decline over time. Therefore, our ability toincrease net revenue is dependent upon our ability to increase unit salesvolumes of existing products and to introduce and sell new products in greaterquantities. Our ability to increase unit sales volume is dependent primarilyupon our ability to increase and fulfill current customer demand and obtain newcustomers.

 

We sell our products to OEMs through acombination of our direct sales force and third-party sales representatives.Sales are generally made under short-term non-cancelable purchase orders. Wealso have volume purchase agreements with certain customers who provide us withnon-binding forecasts. Although our OEM customers may provide us withrolling forecasts, our ability to predict future sales in any given period islimited and subject to change based on demand for our OEM customers’ systemsand their supply chain decisions.

 

Historically, a small number of customershave accounted for a substantial portion of our net revenue, and we expect thatsignificant customer concentration will continue for the foreseeable future. Weexpect that a small group of OEM customers, the composition of which has variedover time, will continue to account for a substantial portion of our netrevenue in the foreseeable future. The following OEMs accounted for morethan 10% of our net revenue for the periods indicated. Sales made to theseOEMs were made through the indicated third-party sales representatives:

 
| ** **                         | ** ** | ** **               | ** ** | **Percentage of our net  revenue for three  months  ended March 31,** | ** ** |
|------------------------------------|------------|--------------------------|------------|----------------------------------------------------------------------------|------------|
| **OEM Customer**                   | ** ** | **Sales Representative** | ** ** | **2006**                                                                   | ** ** | **2005** | ** ** |
| NEC Corporation (Magnus)           |       | NEC Corporation (USA)    |       | 25.8                                                                       | %          | 43.2 | % |
| Sumitomo Electric Industries, Ltd. |       | Altima                   |       | 24.3                                                                       |       | 11.8 |   |
| Dasan Networks, Inc.          |       | Uniquest Corporation     |       | 20.3                                                                       |       | 25.5 |   |

 

Moreover, through the NPA acquisition, weexpect to continue to sell network processing and ADSL products to the existingcustomer base for these products. The SAFRAN Group, of which Sagem Communicationis a subsidiary, represented 73% of net sales for the acquired business for thetwelve months ended October 29, 2005.

 

Historically, substantially all of our salesare to customers outside the United States. Sales to customers in Asiaaccounted for 85.4 % and 95.5% for the three months ended March 31,2006 and 2005, respectively. Net sales of the business acquired in the NPAacquisition to customers in Europe and Asia accounted for 72.2% and 26.7% oftotal sales of the business, respectively, for the twelve months ended October 29,2005. We anticipate that a majority of our net revenue will continue to berepresented by sales to customers outside the United States.

 

**Critical Accounting Policies and Estimates**

 

Our discussion and analysis of our financialcondition and the results of operations are based on our consolidated financialstatements that have been prepared in accordance with accounting principlesgenerally accepted in the United States, or GAAP. The preparation of theseconsolidated financial statements requires us to make estimates and judgmentsthat affect the reported amounts of assets, liabilities, revenues and expenses.On an ongoing basis, we evaluate our estimates, including those related torevenue recognition, bad debts, warranty obligations, inventories, stock-basedcompensation and income taxes. We base our estimates on historical experienceand on various other assumptions that we believe to be reasonable under thecircumstances, the results of which form the basis for making judgmentsabout the carrying values of assets and liabilities that are not readilyapparent from other sources. Actual results may differ from theseestimates under different assumptions or conditions.

 

**Stock-basedCompensation**

 

During thefirst quarter of 2006, we implemented the following new critical accountingpolicy related to our stock-based compensation. Beginning on January 1,2006, we began accounting for stock options and ESPP shares under theprovisions of Financial Accounting Standards No. 123 (revised 2004), “*Share-Based Payment*” (“FAS 123(R)”), which requires therecognition of the fair value of stock-based compensation. Under the fair valuerecognition provisions for FAS 123(R), stock-based compensation cost isestimated at the grant date based on the fair value of the awards expected tovest and recognized as expense ratably over the requisite service period of theaward. We have used the Black-Scholes valuation model, or BSM, to estimate fairvalue of our stock-based awards which requires various judgmental assumptionsincluding estimating stock price volatility, forfeiture rates, and expectedlife. Our computation of expected volatility is based on a combination ofhistorical and market-based implied volatility. In addition, we consider manyfactors when estimating expected forfeitures and expected life, including typesof awards, employee class, and historical experience. If any of the assumptionsused in the BSM model change significantly, stock-based compensation expense may differmaterially in the future from that recorded in the current period.

 

We adoptedFAS 123(R) using the modified prospective method which requires theapplication of the accounting standard as of January 1, 2006. Ourconsolidated financial statements as of and for the first quarter of 2006reflect the impact of FAS 123(R). In

 

17

----

 

accordance with the modified prospectivemethod, the consolidated financial statements for prior periods have not beenrestated to reflect, and do not include, the impact of FAS 123(R).

 

The adoptionof SFAS 123(R) resulted in a cumulative benefit from accounting change of$638,000, which reflects the net cumulative impact of estimating futureforfeitures in the determination of period expense, rather than recordingforfeitures when they occur as previously permitted.

 

Except for stock-based compensation treatmentas described above, there have been no significant changes in our criticalaccounting policies during the three months ended March 31, 2006 comparedto what was previously disclosed in Item 7. “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” included in ourAnnual Report on Form 10-K for the year ended December 31, 2005.

 

**Results of Operations**

 

The following table sets forth our financialresults, as a percentage of net revenue, for the three months ended March 31,2006 and 2005:

 
| ** **                                                      | ** ** | **Three months Ended  March 31** | ** ** |
|-----------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                      | ** ** | **2006**                              | ** ** | **2005** | ** ** |
| ** **                                                      | ** ** | ** **                            | ** ** | ** ** | ** ** |
| Net revenue                                                     |       | 100                                   | %          | 100 | % |
| Costs and expenses:                                             |       |                                  |       |   |   |
|  Cost  of revenue                                          |       | 51.8                                  |       | 50.9 |   |
|  Research and development                                  |       | 38.2                                  |       | 53.5 |   |
|  Selling, general and administrative                       |       | 15.5                                  |       | 27.9 |   |
|  Common stock offering expenses                            |       | 2.7                                   |       | — |   |
| Operating loss                                                  |       | (8.2                                  | )          | (32.3 | ) |
|  Interest and other income, net                            |       | 2.7                                   |       | 0.8 |   |
|  Cumulative effect of change in accounting  principle, net |       | 1.8                                   |       | — |   |
| Net loss                                                        |       | (4.0                                  | )          | (31.5 | ) |

 

**Comparison of Three Months Ended March 31,2006 to Three Months ended March 31, 2005**

 

*Net revenue.*Netrevenue was $35.8 million for the three months ended March 31, 2006 ascompared to $12.3  million for the threemonths ended March 31, 2005, an increase of $23.5 million, or 191%. Theincrease in our net revenue was the result of increased port shipments offsetby decreases in average selling prices per port and revenue from the sales ofproducts from the NPA acquisition, which was completed on February 17,2006. In the quarter ended March 31, 2005, our net revenue decreased by$6.2 million, or 33.4%, from the previous quarter ended December 31,2004, but then increased by $7.0 million, or 56.6%, in the next quarter,ended June 30, 2005.

 

 *Costof revenue.*Cost of revenue for the three months ended March 31,2006 was $18.6 million as compared to $6.3 million for the threemonths ended March 31, 2005, an increase of $12.3 million. This increasewas primarily the result of an increase in net revenue in the three monthsended March 31, 2006. As a percentage of net revenue, cost of revenue was51.8% in the three months ended March 31, 2006 as compared to 50.9% inthree months ended March 31, 2005. Gross margin was 48.2% for the threemonths ended March 31, 2006 as compared to 49.1% for the three monthsended March 31, 2005. In connection with the NPA acquisition, we recordedamortization of intangible assets of $449,000 including $286,000 representing afair value adjustment to inventory acquired as part of the acquisition.

 

*Research anddevelopment expenses.*Research and developmentexpenses were $13.7 million for the three months ended March 31, 2006 ascompared to $6.6 million for the three months ended March 31, 2005, anincrease of $7.1 million, or 107.6%. In connection with the NPA acquisition, weexpensed $2.9 million of in-process research and development. We incurredstock-based compensation expense associated with research and developmentpersonnel of $899,000 and $632,000 in the three months ended March 31,2006 and 2005, respectively. Depreciation expense increased by $400,000 in thethree months ended March 31, 2006 as compared to the corresponding periodin 2005 due to $9.1 million in purchases of fixed assets subsequent to March 31,2005. Personnel expenses increased by $1.1 million due to an increase inheadcount of 33% in the three months ended March 31, 2006 as compared tothe corresponding period in 2005.

 

*Selling, general andadministrative expenses.*Selling, general andadministrative expenses were $5.6 million for the three months ended March 31,2006 as compared to $3.4 million for the three months ended March 31,2005, an increase of $2.2 million, or 64.7%. We incurred stock-basedcompensation expense associated with sales, marketing and administrativepersonnel of $1.0 million and $804,000 in the three months ended March 31,2006 and 2005, respectively. In connection with the NPA acquisition, werecorded amortization of intangible assets of $675,000. Personnel expensesincreased by $600,000 due to a 30% increase in headcount in the three monthsended March 31, 2006 as compared to the corresponding period in 2005. Wealso incurred additional costs in the three months ended March 31, 2006 asa result of being a public company.

 

*Common stock offering expenses.*Common stock offering expenses for the three months ended March 31, 2006 were$954,000 as compared to $0 for the three months ended March 31, 2005. Theseexpenses relate to the proportionate share of expenses incurred by the companyon behalf of the selling stockholders.

 

*Interest and otherincome, net.*Net interest income was $959,000 in thethree months ended March 31, 2006 as compared to net interest income of$95,000 in the three months ended March 31, 2005. The increase was due tohigher average balances of cash and cash

 

18

----

 

equivalents resulting from our common stock offerings and cash flowgenerated from operations, and was offset by cash paid for the NPA acquisition.

 

*Net loss.*Netloss was $1.4 million in the three months ended March 31, 2006 as comparedto a net loss of $3.9 million in the three months ended March 31, 2005, adecrease of $2.5 million.

 

**Liquidity and Capital Resources**

 

We ended the first quarter of 2006 with$115.1 million in cash, cash equivalents and short-term investments as comparedto $93.9 million at December 31, 2005, an increase of $21.2 million. Thisincrease was primarily due to the $48.6 million of net proceeds raised in ourfollow-on offering and $7.9 million generated from operations, and waspartially offset by the completion of the NPA acquisition for $32.7 million. Webelieve there will be additional working capital requirements to fund andoperate the networking processing and ADSL business we acquired as well as ourbusiness prior to the NPA Acquisition. We expect to finance our operationsprimarily through operating cash flows and cash balances.

 

We expect to grow our operating expenses aswe continue to execute our business strategy. This increase in operatingexpenses may not result in an increase in our net revenues and ouranticipated net revenues may not be sufficient to support these increasedexpenditures. We anticipate that operating expenses and working capital willconstitute a material use of our cash and cash equivalents.

 

The following table summarizes our statementof cash flows for the three months ended March 31, 2006 and 2005:

 
| ** **                                             | ** ** | **March 31,  2006** | ** ** | **March 31,  2005** | ** ** |
|--------------------------------------------------------|------------|--------------------------|------------|--------------------------|------------|
| ** **                                             | ** ** | **(in thousands)**       | ** ** |
| **Statements of Cash Flows Data:**                     | ** ** | ** **               | ** ** | ** **               | ** ** |
| Net cash provided by (used in) operating  activities   |       | $                        | 7,656      |                     | $          | (7,508 | ) |
| Net cash used in investing activities                  |       | (76,375                  | )          | (418                     | )          |
| Net cash provided by financing activities              |       | 49,155                   |       | 101                      |       |
| Effect of exchange rates on cash and cash  equivalents |       | —                   |       | (4                       | )          |
| Net decrease in cash and cash equivalents              |       | (19,564                  | )          | (7,829                   | )          |
| Cash and cash equivalents—Beginning of  period    |       | 91,932                   |       | 25,428                   |       |
| Cash and cash equivalents—End of period           |       | $                        | 72,368     |                     | $          | 17,599 |   |

 

*Operating Activities*

 

For the three months ended March 31,2006, net cash provided by operating activities of $7.6 million resulted from anet loss of $1.4 million that was offset by $1.9 million of non-cash chargesfor amortization of stock-based compensation, $2.9 million for in-processresearch and development, $987,000 for amortization of purchased intangiblesand $1.1 million for depreciation of property and equipment. In addition, for the three months endedMarch 31, 2006, cash was used in operating activities to fund increases inaccounts receivable of $4.5 million due primarily to the timing of our salesand subsequent collections and increases in inventories of $2.0 million as aresult of increase in net revenues. This was offset by an increase in accountspayable and accrued liabilities of $8.6 million due to timing of inventorypurchases. We anticipate that accounts receivable, inventory and accountspayable will increase.

 

*Investing Activities*

 

Our investing activities used net cash of$76.4 million in the three months ended March 31, 2006 as compared to$418,000 during the three months ended March 31, 2005. Cash used ininvesting activities in the three months ended March 31, 2006  related primarily to the NPA acquisition of$32.7 million, and the purchase of property and equipment and the net purchaseof short-term investments totaling $43.7 million. We anticipate that ourcapital expenditures will be approximately $15.0 to $20.0 million over the next12 months.

 

*Financing Activities*

 

Our financing activities provided $49.2million in the three months ended March 31, 2006 as compared to $101,000during the three months ended March 31, 2005. Cash generated by financingactivities during the three months ended March 31, 2006 was primarily dueto the completion of our secondary public offering in which we raised $48.6million of net proceeds.

 

On October 21, 2004, we entered into aloan and security agreement with Silicon Valley Bank that provides for an up to$5.0 million revolving line of credit and a $2.0 million equipmentfinancing facility. As of March 31, 2006, we had no balance outstandingunder the revolving line of credit and $1.3 million outstanding under theequipment financing facility which bear interest rates from 5.95% to 6.31%.

 

The revolving line of credit can be used to (1) borrowrevolving loans for working capital requirements, (2) issue letters ofcredit, (3) enter into foreign exchange forward contracts and (4) supportcash management services. Revolving loans will bear interest at a floating rateof interest equal to Silicon Valley Bank’s prime rate plus 0.50%. Equipmentloans bear interest at a fixed rate of interest 

 

19

----

 

equal to Silicon Valley Bank’s prime rate at the time of borrowing plus1.00%. So long as the amount of our unrestricted cash and cash equivalents lessoutstanding indebtedness under the loan and security agreement exceeds$35.0 million, a maximum of $5.0 million will be available forborrowing under the revolving line of credit. Otherwise, the maximum amountavailable for borrowing under the revolving line of credit is an amount equalto the lesser of $5.0 million or 80% of our accounts receivable eligibleunder the terms of the loan and security agreement.

 

On October 21, 2006, the revolving lineof credit matures and Silicon Valley Bank’s commitment to extend revolvingloans terminates. Principal and interest on the equipment facility is payablemonthly and bears interest at a fixed rate. The outstanding equipmentfacilities will be paid in full by February 2007.

 

The revolving and equipment loans under theloan and security agreement are collateralized by a first priority lien onsubstantially all of our assets, excluding intellectual property. The loan andsecurity agreement requires us to maintain a profitability covenant and aminimum quick ratio of not less than 1.15 to 1.00. Quick ratio means the ratioof the sum of unrestricted cash and cash equivalents and accounts receivable tocurrent liabilities. In addition, we are required to comply with covenants thatlimit our ability to, among other things, dispose of assets, make acquisitions,be acquired, incur indebtedness, grant liens, make investments, pay dividendsor repurchase stock.

 

The loan and security agreement includesevents of default that, include among other things, non-payment of principal,interest or fees, violation of covenants, inaccuracy of representations andwarranties, cross-default to certain other indebtedness, bankruptcy andinsolvency events, change of control and material judgments. The occurrence ofan event of default could result in the acceleration of our obligations underthe loan and security agreement and foreclosure on the collateral securing ourobligations under the loan and security agreement. We were not in compliancewith the minimum profitability financial covenant during the quarter ended March 31,2005. Silicon Valley Bank agreed to forebear its rights to call the equipmentfinancing facility as a result of the non-compliance. This forbearance pertainsto the covenant violation during the quarter ended March 31, 2005 inperpetuity; however, it does not extend to any future non-compliance withcovenants. Based on expected future operating results, we believe we willcontinue to be in full compliance with the amended covenants for at least12 months from the balance sheet date. Accordingly, we have classified theamounts due under the facility beyond 12 months from the balance sheetdate as non-current.

 

The loan agreement was amended on March 31,2006. Pursuant to the Amendment, the provisions of the loan and securityagreement relating to the financial covenant regarding the profitability ofIkanos was amended to exclude stock-based compensation and certain expenses andcharges resulting from the NPA acquisition for each of the quarters in 2006.

 

We believe that our existing cash, cashequivalents and cash flow expected to be generated from future operations willbe sufficient to meet our anticipated cash needs for at least the next12 months. Our future capital requirements will depend on many factorsincluding our rate of net revenue growth, the timing and extent of spending tosupport development efforts, the expansion of sales and marketing activities,the timing of introductions of new products and enhancements to existingproducts, the costs to ensure access to adequate manufacturing capacity and thecontinuing market acceptance of our products. Although we are currently not aparty to any agreement with respect to potential investments in, oracquisitions of, complementary businesses, products or technologies, we may enterinto these types of arrangements in the future, which could also require us toseek additional equity or debt financing. The sale of additional equitysecurities or convertible debt securities would result in additional dilutionto our stockholders. Additional debt would result in increased interestexpenses and could result in covenants that would restrict our operations. Wehave not made arrangements to obtain additional financing and there is noassurance that such financing, if required, will be available in amounts or onterms acceptable to us, if at all.

 

**ContractualCommitments and off-balance sheet arrangements**

 

As of March 31, 2006, we have nooff-balance sheet arrangements as defined in Item 303(a)(4) of theSEC’s Regulation S-K.

 

The following table summarizes ourcontractual obligations at March 31, 2006 and the effect those obligationsare expected to have on our liquidity and cash flow in future periods:

 
| ** **                     | ** ** | **Payment due by period** | ** ** |
|--------------------------------|------------|---------------------------|------------|
| ** **                     | ** ** | **Total**                 | ** ** | **Less than 1  year** | ** ** | **1 to 3 years** | ** ** | **After 3 years** | ** ** |
| ** **                     | ** ** | **(in thousands)**        | ** ** |
|                           |       |                      |       |   |   |   |   |   |   |
| Capital lease obligations      |       | $                         | 627        |   | $ | 405 |   | $ | 150 |   | $ | 72 |   |
| Operating leases               |       | 4,420                     |       | 635 |   | 2,027 |   | 1,758 |   |
| Notes payable                  |       | 1,325                     |       | 573 |   | 752 |   | — |   |
| Inventory purchase obligations |       | 6,384                     |       | 6,384 |   | — |   | — |   |
|                           |       |                      |       |   |   |   |   |   |   |
| Total                          |       | $                         | 10,819     |   | $ | 8,291 |   | $ | 2,148 |   | $ | 380 |   |

 

For the purpose of this table, purchaseobligations for the purchase of goods or services are defined as agreementsthat are enforceable and legally binding and that specify all significantterms, including: fixed or minimum quantities to be purchased; fixed, minimumor variable price provisions; and the approximate timing of the transaction.Our purchase orders are based on our current manufacturing needs and arefulfilled by our vendors within short time horizons. In addition, we havepurchase orders that represent 

 

20

----

 

authorizations to purchase rather than binding agreements. We do nothave significant agreements for the purchase of raw materials or other goodsspecifying minimum quantities or set prices that exceed our expectedrequirements.

 

**Factors Affecting Future Operating Results**

 

A description of the risk factors associated withour business is included under Part II, Item 1A. “Risk Factors” in thisQuarterly Report on Form 10-Q.

 

**Item 3. Quantitativeand Qualitative Disclosures About Market Risk**

 

**ForeignCurrency Exchange Risk**

 

Our net revenue and our costs and expenses,including subcontractor manufacturing expenses, are denominated in U.S.dollars. An increase of the U.S. dollar relative to the currencies of thecountries that our customers operate in would make our products more expensiveto them and increase pricing pressure or reduce demand for our products. We donot currently enter into forward exchange contracts to hedge exposuredenominated in foreign currencies or any other derivative financial instrumentsfor trading or speculative purposes. In the future, if we feel our foreigncurrency exposure has increased, we may consider entering into hedgingtransactions to help mitigate that risk. We expect that our foreign currencyexposure will increase as our operations in India and other countries expand.

 

**InterestRate Sensitivity**

 

We had cash, cash equivalents and short-terminvestments totaling $115.1 million at March 31, 2006. These amounts wereinvested primarily in money market funds and short-term investments and areheld for working capital purposes. We do not enter into investments for tradingor speculative purposes. Due to the short-term nature of these investments, wedo not believe that a 10% change in interest rates would have a material impacton our financial position and results of operations. However, declines ininterest rates will reduce future investment income. During October 2004we entered into a loan agreement with Silicon Valley Bank. Interest iscalculated at Silicon Valley Bank’s prime rate plus 0.5 percentage points. Thebalance outstanding on this working capital line facility at March 31,2006 was $1.3 million and bears interest rates from 5.95% to 6.31%. A 10%change in interest rates (0.45%) would not have a material impact on ourfinancial position or results of operations.

 

**Item 4. Controls andProcedures**

 

**Evaluationof disclosure controls and procedures.**

 

Based on their evaluation as of March 31,2006, our Chief Executive Officer and Chief Financial Officer, have concludedthat our disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended) weresufficiently effective to ensure that the information required to be disclosedby us in this Quarterly Report on Form 10-Q was recorded, processed,summarized and reported within the time periods specified in the Securities andExchange Commission’s rules and Form 10-Q and that such informationis accumulated and communicated to management as appropriate to allow timelydecisions regarding required disclosures.

 

**Changes ininternal controls.**

 

There were no changes in our internal controlover financial reporting during the quarter ended March 31, 2006 that havematerially affected, or are reasonably likely to materially affect, ourinternal controls over financial reporting.

 

**Limitationson the effectiveness of controls.**

 

In designing and evaluating our disclosurecontrols and procedures, management recognized that disclosure controls andprocedures, no matter how well conceived and operated, can provide onlyreasonable, not absolute, assurance that the objectives of the disclosurecontrols and procedures are met. Additionally, in designing disclosure controlsand procedures, our management necessarily was required to apply its judgmentin evaluating the cost-benefit relationship of possible disclosure controls andprocedures. The design of any disclosure controls and procedures also is basedin part upon certain assumptions about the likelihood of future events,and there can be no assurance that any design will succeed in achieving itsstated goals under all potential future conditions.

 

21

----

 

**PART II.OTHER INFORMATION**

 

**Item 1. LegalProceedings**

 

**Legal Proceedings**

 

From time to time we are involved in legalproceedings and litigation arising in the ordinary course of business. We arenot currently a party to any litigation or other legal proceedings that webelieve would have a material adverse effect on our business, financialcondition, results of operations and cash flows.

 

**Item 1A. Risk Factors**

 

*Investing in ourcommon stock involves a high degree of risk. You should carefully consider the followingrisk factors, as well as the other information in this Quarterly Report on Form10-Q, before deciding whether to invest in shares of our common stock.*

 

***RisksRelated to Our Business***

 

**We have a limited operating history and ourquarterly operating results may fluctuate significantly. As a result, we may failto meet or exceed our forecasts or the expectations of securities analysts orinvestors, which could cause our stock price to decline. In addition, we haveexperienced high growth rates in our net revenue in recent fiscal quarters. Wedo not expect similar net revenue growth rates in future periods.**

 

We have a limited operating history whichmakes it difficult to evaluate our prospects. While our commercial operationsbegan in 1999, we did not begin commercial shipments of our products until thefourth quarter of 2002. Since then, our quarterly net revenue and operatingresults have varied significantly and are likely to continue to vary fromquarter to quarter due to a number of factors, many of which are not within ourcontrol. For example, in the quarter ended March 31, 2005, our net revenuedecreased by $6.2 million, or 33.4%, from the previous quarter, ended December 31,2004, but then increased by $7.0 million, or 56.6%, in the next quarter,ended June 30, 2005. Quarterly fluctuations in revenue are typical in ourindustry, and are likely to continue in the future. In addition, our expensesare also subject to quarterly fluctuations resulting from factors including thecosts related to new product releases.. If our operating results do not meetthe expectations of securities analysts or investors for any quarter or otherreporting period, the market price of our common stock may decline.Fluctuations in our operating results may be due to a number of factors,including, but not limited to, those identified throughout this “Risk Factors”section. As a result, you should not rely on quarter to quarter comparisons ofour operating results as an indicator of future performance. In addition, inour last four fiscal quarters ended March 31, 2006, our net revenue hasgrown 56.6%, 30.0%, 14.1% and 25.6% quarter over quarter. We do not expectsimilar net revenue growth rates in future periods.

 

**We recently completed the NPAacquisition and if we are not successful in establishing relationships withexisting customers and suppliers, integrating the technology and employees fromthe acquisition into our existing business, then our operating results may beharmed.**

 

In February 2006, wecompleted the NPA acquisition. Through this acquisition, we added 47 employeesin Hyderabad, India, 12 in Toronto, Canada and 18 in San Jose, California.This is our first acquisition and we face numerous challenges in integratingthese employees into our organization as well as integrating the newly acquiredtechnologies we purchased into our existing broadband solutions.

 

The net revenue from theacquired business has been highly concentrated among customers. We did not havea prior relationship with many of these customers. The success of our businessis dependent in part upon our ability to develop strong relationships withthese customers and for the customers to continue to order network processingproducts from us.

 

The NPA business relies on alimited number of suppliers for certain key components and materials. We arecurrently engaged in efforts to ensure a continuing supply of certain keycomponents and materials from one particular supplier that has not yetcommitted to provide us with the full amount of supply we have requested. Ifthis supplier is unable to supply us with components and materials in thevolumes we require, at the prices we have budgeted or in the timeframes we haverequested, our financial results will be negatively impacted. Further, if we donot obtain the components and materials as needed to meet customer demand,customer relationships may be harmed, and this could impact our future businessand financial results.

 

We may experience moredifficulty and costs than we anticipate in integrating the technology weacquired in the NPA acquisition. Although we do have certain rights to seekindemnification from the seller in the event third parties make claims withrespect to ownership of these technologies, these types of claims, if filed,are inherently costly to litigate and distract management from the operation ofthe business. In addition, we may not be successful in defending ourselvesagainst any such claims. If customer demand for the network processing productswe acquired in the NPA acquisition does not meet our expectations, or we do notreceive sufficient supply capacity to supply such products, we will haveexpended significant management and financial resources on assets that will notrealize their revenue potential. If any of these risks were to be realized, ouroperating results would be harmed. We expect our working capital requirementsto increase significantly as a result of the NPA acquisition as that businesshas historically been, and may continue to be, operated on different, andfrequently less favorable, terms than those we have historically negotiated tooperate our fiber-fast broadband business. For example, payment terms onproducts shipped were generally on longer terms than we customarily provide.

 

22

----

 

Additionally, purchasing decisions were frequentlymade in advance of receiving customer forecasts. As a result, we have a higherrisk of excess inventory with respect to this business. If we are unsuccessfulin addressing these challenges, our operating results may be harmed.

 

**We have a history of losses, andfuture losses may cause the market price of our common stock to decline.We may not be able to generate sufficient net revenue in the future toachieve or sustain profitability.**

 

Since inception, we haveonly been profitable in the third and fourth fiscal quarter of 2005. Weincurred significant net losses prior to such quarters, and we incurred asignificant loss our most recent quarter. As a result of the NPA acquisition,we expect to experience a net loss in 2006 primarily relating to non-cashacquisition-related charges. As of March 31, 2006, we had an accumulateddeficit of $88.0 million. To achieve profitability again, we will need togenerate and sustain higher net revenue while maintaining reasonable cost andexpense levels. We expect to increase expense levels to support increasedresearch and development efforts related to new and existing productdevelopment, to increase sales and marketing efforts, and to support administrativeefforts related to costs of being a public company and managing an increasingcomplex business, as well as to support the recently acquired NPA assets.Because many of our expenses are fixed in the short term, or are incurred inadvance of anticipated sales, we may not be able to decrease our costs andexpenses in a timely manner to offset any shortfall of sales. Although we haveachieved profitability in the last two quarters of 2005, we may not beable regain or sustain profitability on a quarterly or an annual basis in thefuture.

 

**If demand for our chipsets declinesor does not grow, we will be unable to increase or sustain our net revenue andour operating results will be harmed.**

 

We currently expect ourchipsets to account for substantially all of our net revenue for theforeseeable future. We began deriving revenues in the first quarter of 2006from products related to the NPA acquisition. If we are unable to develop newproducts or successfully integrate the newly acquired products to meet ourcustomers’ demand in a timely manner or demand for our chipsets declines orfails to grow as a result of competition or technological changes, it wouldharm our business. The markets for our products are characterized by frequentintroduction of new chipsets, short product life cycles and significant pricecompetition. If we or our OEM customers are unable to manage producttransitions in a timely and cost-effective manner, our net revenue wouldsuffer. In addition, frequent technology changes and introduction of nextgeneration products may result in inventory obsolescence, which wouldincrease our cost of revenue and adversely affect our operating performance.

 

**The average selling prices of ourproducts are subject to rapid declines, which may harm our net revenue andprofitability.**

 

The products we develop andsell are used for high volume applications and are subject to rapid declines inaverage selling prices. We have lowered our prices significantly at times togain market share, and we expect that we will continue to reduce prices in thefuture. Offering reduced prices to one customer could impact our averageselling prices to all customers. Our financial results will suffer if we areunable to offset any future reductions in our average selling prices byincreasing our sales volumes, or if we are unable to reduce our costs andexpenses or develop new or enhanced products on a timely basis with higherselling prices.

 

**Because we depend on a few significantcustomers for a substantial portion of our net revenue, the loss of any of ourkey customers, our inability to continue to sell existing and new products toour key customers in significant quantities or our failure to attract newsignificant customers could adversely impact our net revenue and harm ourbusiness.**

 

We derive a substantial portion of our netrevenue from sales to a relatively small number of customers. As a result, theloss of any significant customer or a decline in business with any significantcustomer would materially and adversely affect our financial condition andresults of operations. The following OEM customers accounted for more than 10%of our net revenue for any one of the periods indicated. Sales made to theseOEMs were made through the indicated third-party sales representatives:

 
| ** **                          | ** ** | ** **               | ** ** | **Percentage of our net  revenue for three  months  ended March 31,** | ** ** |
|-------------------------------------|------------|--------------------------|------------|----------------------------------------------------------------------------|------------|
| **OEM Customer**                    | ** ** | **Sales Representative** | ** ** | **2006**                                                                   | ** ** | **2005** | ** ** |
| NEC  Corporation (Magnus)           |       | NEC  Corporation (USA)   |       | 25.8                                                                       | %          | 43.2 | % |
| Sumitomo  Electric Industries, Ltd. |       | Altima                   |       | 24.3                                                                       |       | 11.8 |   |
| Dasan  Networks, Inc.          |       | Uniquest  Corporation    |       | 20.3                                                                       |       | 25.5 |   |

 

We expect that a small group of OEMcustomers, the composition of which has varied over time, will continue toaccount for a substantial portion of our net revenue in 2006 and in theforeseeable future. In addition, we expect to continue to sell the networkprocessing and ADSL products acquired in the NPA acquisition to the existingcustomer base for these products. The SAFRAN Group of, which SagemCommunication is a subsidiary, represented 73% of net sales for the acquiredbusiness for the twelve months ended October 29, 2005. Accordingly, ourfuture operating results will continue to depend on the success of our largestOEM customers and on our ability to sell existing and new products to thesecustomers in significant quantities. Demand for our chipset products is basedon carrier demand for our OEM customers’ systems products. Accordingly, areduction in growth of carrier deployment of fiber-fast broadband serviceswould adversely affect our product sales and business.

 

In addition, our longstanding relationshipswith some of our larger OEM customers may also deter other potentialcustomers who compete with these customers from buying our products. To attractnew customers or retain existing OEM customers, we have offered 

 

23

----

 

and may continue to offer certain customers favorable prices onour products. If these prices are lower than the prices paid by our existingOEM customers, we may have to offer the same lower prices to certain ofour customers. In that event, our average selling prices would decline. Theloss of a key customer, a reduction in sales to any major customer or ourinability to attract new significant customers could harm our business.

 

**Because of the rapid nature oftechnological development in our industry and the intense competition we face,our products become outmoded in a relatively short period of time, whichrequires us to provide frequent updates and/or replacements to existing products.If we do not successfully manage the transition process to next generationchipset products, our operating results may be harmed.**

 

Our industry ischaracterized by rapid technological innovation and intense competition.Accordingly, our success depends in part on our ability to develop nextgeneration chipset products in a timely and cost-effective manner. Thedevelopment of new chipset products is expensive, complex and time consuming.If we do not rapidly develop our next generation chipset products ahead of ourcompetitors, we may lose both existing and potential customers to ourcompetitors. Conversely, even if we are successful in rapidly developing newchipset products ahead of our competitors and we do not cost-effectively manageour inventory levels of existing products when making the transition to the newchipset products, our financial results may be negatively affected by highlevels of obsolete inventory. If either of the foregoing were to occur, thenour operating results would be harmed.

 

**We rely on a limited number of independentsubcontractors to manufacture, package and test our current products, and ourfailure to secure and maintain sufficient capacity with these subcontractorscould impair our relationships with customers and decrease sales, which wouldnegatively impact our market share and operating results.**

 

We are a fabless semiconductor company inthat we do not own or operate a fabrication or manufacturing facility. Sevenoutside factory subcontractors located in Taiwan, Austria, Malaysia, Singapore,Korea and China manufacture, assemble and test all of our semiconductor devicesin current production, two of which are also our wafer foundries. In addition,in connection with the NPA acquisition, ADI did not have any specific supplycontracts, thus will need to form relationships with the suppliers of keycomponents for network processing and ADSL products. We do not have existingrelationships with some of these suppliers and have no assurances from thesuppliers that these suppliers will continue to provide supplies under the sameor similar terms as they had done prior to the NPA acquisition. In past periodsof high demand in the semiconductor market, we have experienced delays inmeeting our capacity demand and as a result were unable to deliver products toour customers on a timely basis. In addition, we have experienced similardelays due to technical and quality control problems at our subcontractors’facilities. In the future, if any of these events occur, or if these facilitiessuffer any damage, power outages, financial difficulties or any otherdisruption, we may be unable to meet our customer demand on a timelybasis, or at all, and may need to successfully qualify an alternativefacility in a timely manner in order to not disrupt our business. We typicallyrequire several months or more to qualify a new facility or process before wecan begin shipping products. If we cannot accomplish this qualification in atimely manner, we would experience a significant interruption in supply of theaffected products. If we are unable to secure sufficient capacity at oursubcontractors’ existing facilities, or in the event of a closure orsignificant delay at any of these facilities, our relationships with ourcustomers would be harmed and our market share and operating results wouldsuffer as a result. In addition, we do not have formal pricing agreements withour subcontractors regarding the pricing for the products and services thatthey provide us. If their pricing for the products and services they provideincreases and we are unable to pass along such increases to our OEM customers,our operating results would be adversely affected.

 

**When demand for manufacturing capacity ishigh, we may take various actions to try to secure sufficient capacity,which may be costly and negatively impact our operating results.**

 

The ability of each of our subcontractors’manufacturing facilities to provide us with semiconductors is limited by itsavailable capacity and existing obligations. Although we have purchase ordercommitments to supply specified levels of products to our OEM customers, we donot have a guaranteed level of production capacity from any of oursubcontractors’ facilities that we depend on to produce our semiconductors.Facility capacity may not be available when we need it or at reasonableprices. We place our orders on the basis of our OEM customers’ purchase ordersor our forecast of customer demand, and our subcontractors may not be ableto meet our requirements in a timely manner. For example, in 2003 and the firstnine months of 2004 as well as the second half of 2005, the first quarter of2006 and continuing, general market conditions in the semiconductor industryresulted in a significant increase in demand at these facilities. The demandfor our OEM customers’ products increased significantly and we were asked toproduce significantly higher quantities than in the past and to deliver onshort notice. In addition, our subcontractors have also allocated capacity tothe production of other companies’ products and reduced deliveries to us onshort notice. It is possible that our subcontractors’ other customers that arelarger and better financed than we are, or that have long-term agreements withour subcontractors, may have induced our subcontractors to reallocatecapacity to them. If this reallocation were to occur again, it would impair ourability to deliver products on a timely basis.

 

Although we use two independent waferfoundries to manufacture all of our semiconductor products, each of ourproducts is designed to be manufactured in a specific process at only one ofthese wafer foundries. Accordingly, if one of these wafer foundries were unableto provide us with semiconductors as needed, we could experience significant delaysin securing sufficient supplies of those semiconductors. We cannot assure youthat any of the existing or new wafer foundries that we use will be able toproduce semiconductor devices with acceptable manufacturing yields, or that thewafer foundries will be able to deliver enough devices to us on a timely basis,or at reasonable prices. This could impair our ability to meet our OEMcustomers’ needs.

 

24

----

 

In order to secure sufficient manufacturingfacility capacity when demand is high and mitigate the risks described in theforegoing paragraphs, we may enter into various arrangements withsubcontractors that could be costly and harm our operating results, including:

 

•option payments or other prepayments to a subcontractor;

 

•nonrefundabledeposits with or loans to subcontractors in exchange for capacity commitments;

 

•contractsthat commit us to purchase specified quantities of components over extendedperiods;

 

•purchaseof testing equipment for specific use at our subcontractors’ facilities;

 

•issuance of our equity securities to a subcontractor; and

 

•other contractual relationships with subcontractors.

 

We may not be able to make any sucharrangements in a timely fashion or at all, and any arrangements may becostly, reduce our financial flexibility and not be on terms favorable to us.Moreover, if we are able to secure facility capacity, we may be obligatedto use all of that capacity or incur penalties. These penalties and obligationsmay be expensive and require significant capital and could harm ourbusiness.

 

**In the event we seek to use new waferfoundries to manufacture a portion of our semiconductor products, we may notbe able to bring the new foundries on-line rapidly enough and may notachieve the anticipated cost reductions.**

 

As indicated, we use two independent wafer foundriesto manufacture all of our semiconductor products, which exposes us to asubstantial risk of delay, increased costs and customer dissatisfaction in theevent that either one of these foundries were unable to provide us with oursemiconductor requirements. Particularly during times when semiconductorcapacity is limited, we may seek to qualify additional wafer foundries tomeet our requirements. In order to bring these new foundries on-line, ourcustomers would need to qualify the new facility, which process could take aslong as several months. Once qualified, these new foundries would then requirean additional number of months to actually begin producing semiconductors tomeet our needs, by which time our perceived need for additional capacity may havepassed or the opportunities we previously identified may have been lost toour competitors. Furthermore, even if these new foundries offer better pricingthan our existing manufacturers, if they prove to be less reliable than ourexisting manufacturers, we would not achieve some or all of our anticipatedcost reductions.

 

**If our subcontractors’ manufacturingfacilities do not achieve satisfactory yields or quality, our relationshipswith our customers and our reputation will be harmed and, if this were tooccur, our net revenue and operating results could decline and our cost ofrevenue as a percentage of net revenue could increase.**

 

The fabrication of semiconductors is a complexand technically demanding process. Minor deviations in the manufacturingprocess can cause substantial decreases in yields, and in some cases, causeproduction to be stopped or suspended. Although we work closely with oursubcontractors to minimize the likelihood of reduced manufacturing yields,their facilities have from time to time experienced lower than anticipatedmanufacturing yields that have resulted in our inability to meet our customerdemand. It is not uncommon for yields in semiconductor fabrication facilitiesto decrease in times of high demand, in addition to reduced yields that may resultfrom normal wafer lot loss due to workmanship or operational problems at thesefacilities. When these events occur, especially simultaneously, as happens fromtime to time, we may be unable to supply our customers’ demand. Many ofthese problems are difficult to detect at an early stage of the manufacturingprocess and may be time consuming and expensive to correct. In addition,because we purchase wafers, our exposure to low wafer yields from oursubcontractors’ wafer foundries is increased. Poor yields from the waferfoundries or defects, integration issues or other performance problems in ourproducts could cause us significant customer relations and business reputationproblems, or force us to sell our products at lower gross margins and thereforeharm our financial results. Conversely, unexpected yield improvements couldresult in us holding excess inventory that would also negatively impact ourgross margins. In addition, manufacturing defects may not be detected bythe testing process performed by our subcontractors. If defects are discoveredafter we have shipped our products, our reputation would be harmed and our netrevenue and operating income could decline and our cost of revenue as apercentage of net revenue could increase.

 

**We base orders for inventory on our forecastsof our OEM customers’ demand and if our forecasts are inaccurate, our financialcondition and liquidity would suffer.**

 

We place orders with our suppliers based onour forecasts of our OEM customers’ demand. Our forecasts are based on multipleassumptions, each of which may introduce errors into our estimates. In thepast, when the demand for our OEM customers’ products increased significantly,we were not able to meet demand on a timely basis, and we expended asignificant amount of time working with our customers to allocate limitedsupply and maintain positive customer relations. If we underestimate customerdemand, we may forego revenue opportunities, lose market share and damageour customer relationships. Conversely, if we overestimate customer demand, we may allocateresources to manufacturing products that we may not be able to sell whenwe expect to or at all. As a result, we would have excess or obsoleteinventory, resulting in a decline in the value of our inventory, which wouldincrease our cost of revenue and create a drain on our liquidity. Our failureto accurately manage inventory against demand would adversely affect ourfinancial results.

 

**To remain competitive, we need tocontinue to transition our semiconductor chips to increasingly smaller sizes,and our failure to do so may harm our business.**

 

We periodically evaluate thebenefits, on a product-by-product basis, of migrating to smaller chips, whichare measured in microns and referred to as geometry processes. We have designedour products to be manufactured in 0.8 micron, 0.25 micron, 0.18 micron and0.13 micron geometry processes. We are currently migrating some of our productsto even smaller 90-nanometer geometry process

 

25

----

 

technology, and over time, we are likely to migrateto even smaller geometries. The smaller chip size reduces our production andpackaging costs, which enables us to be competitive in our pricing. Thetransition to smaller geometries requires us to work with our subcontractors tomodify the manufacturing processes for our products and to redesign someproducts. In the past, we have experienced some difficulties in shifting tosmaller geometry process technologies or new manufacturing processes, whichresulted in reduced manufacturing yields, delays in product deliveries andincreased expenses. We may face similar difficulties, delays and expensesas we continue to transition our products to smaller geometry processes, all ofwhich could harm our relationships with our customers, and our failure to do sowould impact our ability to provide competitive prices to our customers, whichwould have a negative impact on our sales.

 

**We face intense competition in thesemiconductor industry and the broadband communications markets, which couldreduce our market share and negatively impact our net revenue.**

 

The semiconductor industry and the broadbandcommunications markets are intensely competitive. We currently compete orexpect to compete with, among others, Broadcom Corporation, CentilliumCommunications, Inc., Conexant Systems, Inc., Infineon TechnologiesA.G., Marvell Technology Group Ltd., Metalink Ltd.,STMicroelectronics N.V. and Texas Instruments Incorporated, which companies, webelieve, have experience in very-high-bit-rate-digital subscriber line, orVDSL, or VDSL-like, technology. We also expect to compete with FreescaleSemiconductor, Inc., Intel Corporation, Marvell Technology Group Ltd.,PMC-Sierra, Inc. and Realtek Semiconductor Corp., in the networkprocessing market. We expect competition to continue to increase. Competitionhas resulted and may continue to result in declining average sellingprices for our products and market share.

 

We consider other companies that have accessto discrete multi-tone, or DMT, technology as potential competitors in thefuture, and we also may face competition from newly establishedcompetitors, suppliers of products based on new or emerging technologies andcustomers who choose to develop their own chipsets. To remain competitive, weneed to provide products that are designed to meet our customers’ needs. Ourproducts must:

 

•achieve optimal product performance;

 

•comply with industry standards;

 

•be cost-effective for our customers’ use in their systems;

 

•meet functional specifications;

 

•be introduced timely to the market; and

 

•be supported by a high-level of customer service and support.

 

Many of our competitors operate their ownfabrication facilities or have stronger manufacturing partner relationshipsthan we have. In addition, many of our competitors have extensive technologylibraries that could enable them to incorporate fiber-fast broadband or networkprocessing technologies into a more attractive product line than ours. Many ofthem also have longer operating histories, greater name recognition, largercustomer bases, and significantly greater financial, sales and marketing,manufacturing, distribution, technical and other resources than we do. Thesecompetitors may be able to adapt more quickly to new or emergingtechnologies and changes in customer requirements. In addition, current andpotential competitors have established or may establish financial orstrategic relationships among themselves or with existing or potentialcustomers, resellers or other third parties. Accordingly, new competitors oralliances among competitors could emerge and rapidly acquire significant marketshare. Existing or new competitors may also develop technologies that moreeffectively address our markets with products that offer enhanced features andfunctionality, lower power requirements, greater levels of semiconductorintegration or lower cost. We cannot assure you that we will be able to competesuccessfully against current or new competitors, in which case we may losemarket share in our existing markets and our net revenue may fail toincrease or may decline.

 

**Other data transmissiontechnologies and network processing technologies may compete effectivelywith the carrier services addressed by our products, which could adverselyaffect our product sales and business.**

 

Our net revenue is dependenton the increase in demand for carrier services that use integrated residentialgateways. Residential gateways compete against a variety of different datatransmission technologies, including other DMT-based technologies, cable modemand satellite and other wireless technologies. If any of these competingtechnologies proves to be more reliable, faster or less expensive than, or hasany other advantages over, the fiber-fast broadband technologies we provide,the demand for our products may decrease and our business would be harmed.

 

**We rely on third-party technologies for thedevelopment of our products and our inability to use such technologies in thefuture would harm our ability to remain competitive.**

 

We rely on third parties for technologiesthat are integrated into some of our products, including memory cells, input/outputcells and core processor logic. If we are unable to continue to use or licensethese technologies on reasonable terms, or if these technologies fail tooperate properly, we may not be able to secure alternatives in a timelymanner and our ability to remain competitive would be 

 

26

----

 

harmed. In addition, if we are unable to successfully licensetechnology from third parties to develop future products, we may not beable to develop such products in a timely manner or at all.

 

**We may be unable to attract,retain and motivate key senior management and technical personnel, which couldharm our development of technology and ability to be competitive.**

 

Our future success dependsto a significant extent upon the continued service of our key personnel,including our President and Chief Executive Officer, Rajesh Vashist, and ourother senior executives and key technical personnel. Except for Mr. Vashist,we do not have employment agreements with any of these executives or any otherkey employees that govern the length of their service. The loss of the servicesof Mr. Vashist or other senior management or technical personnel couldharm our business. Furthermore, our future success depends on our ability tocontinue to attract, retain and motivate other senior management and qualifiedtechnical personnel, particularly software engineers, digital circuitdesigners, mixed-signal circuit designers and systems and algorithms engineers,and we are currently in the process of trying to hire a vice president ofengineering and a general manager. Competition for these employees is intense.Stock options and other equity incentives generally comprise a significantportion of our compensation packages for all employees, and the expectedvolatility in the price of our common stock may make it more difficult forus to attract and retain key employees, which could harm our ability to providetechnologically competitive products.

 

**If we are unable to develop, introduce or toachieve market acceptance of our new chipset products, our operating resultswould be adversely affected.**

 

Our future success depends on our ability todevelop new chipset products and transition to new products, introduce theseproducts in a cost-effective and timely manner and convince OEMs to select ourproducts for design into their new systems. Our historical quarterly resultshave been, and we expect that our future results will continue to be, dependenton the introduction of a relatively small number of new products and the timelycompletion and delivery of those products to customers. The development of newchipset products is complex, and from time to time we have experienced delaysin completing the development and introduction of new products. We have in thepast invested substantial resources in emerging technologies that did notachieve the market acceptance that we had expected. Our ability to develop anddeliver new chipset products successfully will depend on various factors,including our ability to:

 

•successfully integrate the technologies acquired in the NPA acquisition intoour product lines;

 

•accurately predict market requirements and evolving industry standards;

 

•accurately define new chipset products;

 

•timely complete and introduce new product designs;

 

•timely qualify and obtain industry interoperability certification of ourproducts and the equipment into which our products will be incorporated;

 

•ensure that our subcontractors have sufficient foundry capacity and packagingmaterials and achieve acceptable manufacturing yields;

 

•shift our products to smaller geometry process technologies to achieve lowercost and higher levels of design integration; and

 

•gain market acceptance of our products and our OEM customers’ products.

 

If we are unable to develop and introduce newchipset products successfully and in a cost-effective and timely manner, wewill not be able to attract new customers or retain our existing customers,which would harm our business.

 

**Our success is dependent on achieving designwins into commercially successful OEM systems.**

 

Our products are generally incorporated intoour OEMs customers’ systems at the design stage. As a result, we rely on OEMsto select our products to be designed into their systems, which we refer to asa design win. We often incur significant expenditures on the development of anew product without any assurance that an OEM will select our product fordesign into its own system. Additionally, in some instances, we are dependenton third parties to obtain or provide information that we need to achieve adesign win. Some of these third parties may not supply this information tous on a timely basis, if at all. Furthermore, even if an OEM designs one of ourproducts into its system offering, we cannot be assured that its equipment willbe commercially successful or that we will receive any net revenue as a resultof that design win. Our OEM customers are typically not obligated to purchaseour products and can choose at any time to stop using our products if their ownsystems are not commercially successful, if they decide to pursue other systemsstrategies, or for any other reason. If we are unable to achieve design wins orif our OEM customers’ systems incorporating our products are not commercially successful,our net revenue would suffer.

 

27

----

 

**Acquisitions, strategicpartnerships, joint ventures or investments may impair our capital andequity resources, divert our management’s attention or otherwise negativelyimpact our operating results.**

 

We intend to continue toactively pursue acquisitions, strategic partnerships and joint ventures that webelieve may allow us to complement our growth strategy, increase marketshare in our current markets and expand into adjacent markets, broaden ourtechnology and intellectual property and strengthen our relationships withcarriers and OEMs. Any future acquisition, partnership joint venture orinvestment may require that we pay significant cash, issue stock or incursubstantial debt. Acquisitions, partnerships or joint ventures may alsoresult in the loss of key personnel and the dilution of existing stockholdersas a result of issuing equity securities. In addition, acquisitions,partnerships or joint ventures require significant managerial attention, which may bediverted from our other operations. These capital, equity and managerialcommitments may impair the operation of our business. Furthermore,acquired businesses may not be effectively integrated, may be unableto maintain key pre-acquisition business relationships, may contribute toincreased fixed costs and may expose us to unanticipated liabilities andotherwise harm our operating results.

 

**We rely on third-party salesrepresentatives to assist in selling our products, and the failure of theserepresentatives to perform as expected could reduce our future sales.**

 

We sell our products to someof our OEM customers through third-party sales representatives. Ourrelationships with some of our third-party sales representatives have beenestablished within the last three years, and we are unable to predict theextent to which our third-party sales representatives will be successful inmarketing and selling our products. Moreover, many of our third-party sales representativesalso market and sell competing products. Our third-party sales representatives may terminatetheir relationships with us at any time. Our future performance will alsodepend, in part, on our ability to attract additional third-party sales representativesthat will be able to market and support our products effectively, especially inmarkets in which we have not previously distributed our products. If we cannotretain our current third-party sales representatives or recruit additional orreplacement third-party sales representatives, our sales and operating resultscould be harmed.

 

**Rapidly changing standards and regulationscould make our products obsolete, which would cause our sales and operatingresults to suffer.**

 

We design our products to conform toregulations established by governments and to standards set by industrystandards bodies such as The American National Standards Institute (ANSI) andThe Committee T1E1.4 in North America, European Telecommunications StandardsInstitute (ETSI) in Europe and ITU-T and the Institute of Electrical andElectronics Engineers, Inc. (IEEE) worldwide. Because our products aredesigned to conform to current specific industry standards, if competingstandards emerge that are preferred by our customers, we would have to makesignificant expenditures to develop new products. If our customers adopt new orcompeting industry standards with which our products are not compatible, or theindustry groups adopt standards or governments issue regulations with which ourproducts are not compatible, our existing products would become less desirableto our customers and our sales and operating results would suffer.

 

**If we fail to secure or protect ourintellectual property rights, competitors may be able to use our technologies,which could weaken our competitive position, reduce our net revenue or increaseour costs.**

 

Our success will depend, in part, on ourability to protect our intellectual property. We rely on a combination ofpatent, copyright, trademark and trade secret laws, confidentiality proceduresand licensing arrangements to establish and protect our proprietary rights inthe United States. We do not currently have any applications on file in anyforeign jurisdictions with respect to our intellectual property notwithstandingthe fact that a significant portion of our net revenue is generated abroad. Ourpending patent applications may not result in issued patents, and ourexisting and future patents may not be sufficiently broad to protect ourproprietary technologies or may be held invalid or unenforceable in court.While we are not currently aware of misappropriation of our existingtechnology, policing unauthorized use of our technology is difficult and wecannot be certain that the steps we have taken will prevent themisappropriation or unauthorized use of our technologies, particularly inforeign countries where we have not applied for patent protections and, even ifsuch protections were available, the laws may not protect our proprietaryrights as fully as U.S. law. The patents we have obtained or licensed, or may obtainor license in the future, may not be adequate to protect our proprietaryrights. Our competitors may independently develop or may have alreadydeveloped technology similar to ours, duplicate our products or design aroundany patents issued to us or our other intellectual property. In addition, we may berequired to license our patents as a result of our participation in variousstandards organizations. If competitors appropriate our technology and we arenot adequately protected, our competitive position would be harmed, our legalcosts would increase and our net revenue would be harmed.

 

**Third-party claims of infringement or otherclaims against us could adversely affect our ability to market our products,require us to redesign our products or seek licenses from third parties, andharm our business. In addition, any litigation required to defend such claimscould result in significant costs and diversion of our resources.**

 

Companies in the semiconductor industry oftenaggressively protect and pursue their intellectual property rights. From timeto time, we receive, and may continue to receive in the future, noticesthat claim we have infringed upon, misappropriated or misused other parties’ proprietaryrights. While we are not aware that we are currently infringing on theproprietary rights of third parties, we may in the future be engaged inlitigation with parties who claim that we have infringed their patents ormisappropriated or misused their trade secrets or who may seek toinvalidate one or more of our patents, and it is possible that we would notprevail in any future lawsuits. An adverse determination in any of these typesof claims could prevent us from manufacturing or selling some of our products,could increase our costs of products and could expose us to significantliability. Any of these claims could harm our business. For example, in apatent or trade secret action, a court could issue a preliminary or permanentinjunction that would require us to withdraw or recall certain products fromthe market or redesign certain products offered for sale or that are underdevelopment. In addition, we may be liable for damages for pastinfringement and royalties for future use of the technology and we may beliable for treble damages if

 

28

----

 

infringement is found to have been willful. Even if claims against usare not valid or successfully asserted, these claims could result insignificant costs and a diversion of management and personnel resources todefend.

 

**Any potential dispute involving ourpatents or other intellectual property could also include our manufacturingsubcontractors and OEM customers, which could trigger our indemnification obligationsto them and result in substantial expense to us.**

 

In any potential disputeinvolving our patents or other intellectual property, our manufacturingsubcontractors and OEM customers could also become the target of litigation.Because we often indemnify our customers for intellectual property claims madeagainst them for products incorporating our technology, any litigation couldtrigger technical support and indemnification obligations in some of ourlicense agreements, which could result in substantial expenses. While to datenone of our OEM customers has made an indemnification claim against us, in theevent an indemnification claim were made, it could adversely affect ourrelationships with our OEM customers and result in substantial costs to us.

 

**Our products typically have lengthysales cycles, which may cause our operating results to fluctuate andresult in volatility in the price of our common stock. An OEM customer or acarrier may decide to cancel or change its product plans, which couldcause us to lose anticipated sales.**

 

After we have delivered aproduct to an OEM customer, the OEM will usually test and evaluate our productwith its carrier customer prior to the OEM completing the design of its ownequipment that will incorporate our product. Our OEM customers and the carriersmay need three to more than six months to test, evaluate and adopt ourproduct and an additional three to more than nine months to begin volumeproduction of equipment that incorporates our product. Due to this lengthy salescycle, we may experience significant delays from the time we increase ouroperating expenses and make investments in inventory until the time that wegenerate net revenue from these products. It is possible that we may nevergenerate any net revenue from these products after incurring these expendituresand investments. Even if an OEM customer selects our product to incorporateinto its equipment, we have no assurances that the customer will ultimatelymarket and sell its equipment or that such efforts by our customer will besuccessful. The delays inherent in our lengthy sales cycle increase the riskthat an OEM customer or carrier will decide to cancel or change its productplans. From time to time, we have experienced changes and cancellations in thepurchase plans of our OEM customers. A cancellation or change in plans by anOEM customer or carrier could cause us to not achieve anticipated net revenueand result in volatility of the price of our common stock. In addition, ouranticipated sales could be lost or substantially reduced if a significant OEMcustomer or carrier reduces or delays orders during our sales cycle or choosesnot to release equipment that contains our products.

 

**As our international manufacturing, sales andresearch and development operations expand, we will be increasingly exposed tovarious legal, business, political and economic risks associated with ourinternational operations.**

 

We currently obtain substantially all of ourmanufacturing, assembly and testing services from suppliers and subcontractorslocated outside the United States, and have a significant portion of ourresearch and development team located in Bangalore and Hyderabad, India. Inaddition, 98.7% of our net revenue for the three months ended March 31,2006 and 99.7% of our net revenue for the three months ended March 31,2005 was derived from sales to customers outside the United States.Additionally, 98.9% of the net sales for the twelve-month period ended October 29,2005 of the network processing business we acquired in the NPA acquisition werederived from sales to customers outside of the United States. We have expandedour international business activities and may open other design andoperational centers abroad. International operations are subject to many otherinherent risks, including but not limited to:

 

•political, social and economic instability, including terrorist acts;

 

•exposure to different legal standards, particularly with respect tointellectual property;

 

•natural disasters and public health emergencies;

 

•trade and travel restrictions;

 

•the imposition of governmental controls and restrictions or unexpected changesin regulatory requirements;

 

•burdens of complying with a variety of foreign laws;

 

•import and export license requirements and restrictions of the United Statesand each other country in which we operate;

 

•foreign technical standards;

 

•changes in tariffs;

 

•difficulties in staffing and managing international operations;

 

•fluctuations in currency exchange rates;

 

•difficulties in collecting receivables from foreign entities or delayed revenuerecognition; and

 

•potentially adverse tax consequences.

 

29

----

 

Because we are currently substantiallydependent on our foreign sales, research and development and operations, any ofthe factors described above could significantly harm our ability to producequality products in a timely and cost effective manner, and increase ormaintain our foreign sales.

 

**Significant fluctuations or a slowdown indeployment of fiber extension over copper and broadband over copper in Asiawould adversely affect our operating results.**

 

Sales to customers locatedin Asia accounted for 85.4% of our net revenue for the three months ended March 31,2006 and 95.4% for the three months ended March 31, 2005. Our sales havebeen dependent on the continuous growth of new fiber extension over copper andbroadband over copper subscribers in Asia. Fluctuations in or a plateau of newsubscribers in Asia could impact our net revenue and a sustained slow down ingrowth of fiber extension over copper and broadband over copper subscribers inAsia may cause our net revenue to decline.

 

**We are in the process of implementing a newERP system, which could disrupt our operations, negatively impact our salesvolume and net revenue and adversely affect our ability to integrate the assetswe acquired in the NPA acquisition.**

 

In January 2006, we completed the firstof many phases of a new comprehensive enterprise resource planning, or ERP,information system to manage our business operations, and subsequentenhancements to this new system could disrupt our operations. We haveexperienced difficulties in the past in implementing new information systems.The process of implementing new information systems could also adversely impactour ability to do the following in a timely manner:

 

•report financial results;

 

•accurately reflect inventory costs;

 

•acceptand process customer orders;

 

•receive inventory and ship products;

 

•invoice and collect receivables;

 

•place purchase orders and pay invoices; and

 

•accurately reflect all other business transactions related to the finance,order entry, purchasing, supply chain and human resource processes within thenew ERP information system.

 

**Fluctuations in exchange rates between theJapanese yen, the Korean won, the Indian rupee, the U.S. dollar, the Canadiandollar and the euro, as well as other currencies in which we do business, may adverselyaffect our operating results.**

 

We transact business in an internationalenvironment. As a result, we may experience foreign exchange gains orlosses due to the volatility of other currencies compared to the U.S. dollar.Our sales have been historically denominated in U.S. dollars and an increase inthe U.S. dollar relative to the currencies of the countries that our customersoperate in could materially affect our Asian customers’ demand for ourproducts, thereby forcing them to reduce their orders, which would adverselyaffect our business. We recently began to generate a portion of our revenuesand expenses in currencies other than the U.S. dollar, including the Japaneseyen, Korean won, Indian rupee, Canadian dollar and the euro. As we report ourresults in U.S. dollars, the difference in exchange rates in one periodcompared to another directly impacts period to period comparisons of ouroperating results. Furthermore, currency exchange rates have been especiallyvolatile in the recent past and these currency fluctuations may make itdifficult for us to predict and/or provide guidance on our results.

 

Currently we have not implemented anystrategies to mitigate risks related to the impact of fluctuations in currencyexchange rates. Even if we were to implement hedging strategies, not everyexposure is or can be hedged, and, where hedges are put in place based onexpected foreign exchange exposure, they are based on forecasts which may varyor which may later prove to have been inaccurate. Failure to hedgesuccessfully or anticipate currency risks properly could adversely affect ouroperating results. We cannot predict future currency exchange rate changes.

 

**We have historically derived a substantialamount of our net revenue from Asia, and with the NPA acquisition, we expect toderive a majority of our network processing revenues from a single customer inEurope. If we fail to diversify the geographic sources and customer base of ournet revenue in the future, our operating results could be harmed.**

 

A substantial portion of our net revenue hashistorically been derived from sales into Japan and Korea, and our net revenuehas been heavily dependent on developments in these markets. As a result, oursales are subject to economic downturns, decrease in demand and

 

30

----

 

overall negative market conditions in Asia. As a result of the NPAacquisition, we expect to continue to sell network processing products to theexisting customer base for these products, of which a substantial majority ofthe revenues are from a single customer in Europe. While part of ourstrategy is to continue to diversify the geographic sources and customer baseof our net revenue, our failure to successfully penetrate markets outside ofJapan and Korea, and to successfully diversify our customer base in Europe,could harm our business and operating results.

 

**The complexity of our products could resultin unforeseen delays or expenses and in undetected defects or bugs, which coulddamage our reputation with current or prospective customers and adverselyaffect the market acceptance of new products.**

 

Highly complex products such as those that weoffer frequently contain defects and bugs, particularly when they are firstintroduced or as new versions are released. In the past we have experienced,and may in the future experience, defects and bugs in our products. If anyof our products contains defects or bugs, or have reliability, quality orcompatibility problems, our reputation may be damaged and our OEMcustomers may be reluctant to buy our products, which could harm ourability to retain existing customers and attract new customers. In addition,these defects or bugs could interrupt or delay sales or shipment of ourproducts to our customers.

 

**Recent changes to environmental laws andregulations applicable to manufacturers of electrical and electronic equipmentare causing us to redesign our products, and may result in increases toour costs and greater exposure to liability.**

 

The implementation of new environmentalregulatory legal requirements, such as lead free initiatives, could impact ourproduct designs and manufacturing processes. The impact of such regulations onour product designs and manufacturing processes could affect the timing ofcompliant product introductions as well as their commercial success. Forexample, a recent directive in the European Union bans the use of lead andother heavy metals in electrical and electronic equipment after July 1,2006. As a result, in advance of this deadline, some of our customers sellingproducts in Europe have begun demanding product from component manufacturersthat do not contain these banned substances. Because most of our existingassembly processes (as well as those of most other manufacturers) utilize atin-lead alloy as a soldering material in the manufacturing process, we mustredesign many of our products if we are to meet customer demand. This redesign may resultin increased research and development and manufacturing and quality controlcosts. In addition, the products that we manufacture that comply with the newregulatory standards may not perform as well as our current products.Moreover, if we are unable to successfully and timely redesign existingproducts and introduce new products that meet the standards set byenvironmental regulation and our customers, sales of our products coulddecline, which could materially adversely affect our business, financialcondition and results of operations.

 

**We have incurred increased costs as a resultof being a public company.**

 

Recently enacted and proposed changes in thelaws and regulations affecting public companies, including the provisions ofthe Sarbanes-Oxley Act of 2002, or Sarbanes-Oxley, and recent rules enactedand proposed by the SEC and the Nasdaq National Market, are resulting in increasedcosts to us as we respond to their requirements. In particular, the costs tocomply with Section 404 of Sarbanes-Oxley, as presently in effect, couldhave an adverse effect on our results of operations. The new rules couldalso make it more difficult for us to obtain certain types of insurance,including director and officer liability insurance, and we may be forcedto accept reduced policy limits and coverage and/or incur substantially highercosts to obtain the same or similar coverage. The impact of these events couldalso make it more difficult for us to attract and retain qualified persons toserve on our board of directors, on committees of our board of directors, or asexecutive officers.

 

**Compliance with the requirements imposed by Section 404of the Sarbanes-Oxley Act could harm our operating results, our ability tooperate our business and investors’ view of us.**

 

Pursuant to Section 404 of theSarbanes-Oxley Act, beginning with our Annual Report on Form 10-K for thefiscal year ending December 31, 2006, we will be required to furnish areport by our management on our internal control over financial reporting. Inorder to achieve compliance with Section 404 of Sarbanes-Oxley within theprescribed period, we have commenced a process to document and evaluate ourinternal control over financial reporting, which will be both costly andchallenging. We can provide no assurance as to our or our independentregistered public accounting firm’s conclusions with respect to theeffectiveness of our internal control over financial reporting under Section 404of Sarbanes-Oxley. There is a risk that neither we nor our independentregistered public accounting firm will be able to conclude that our internalcontrols over financial reporting are effective as required by Section 404of Sarbanes-Oxley.

 

In addition, during the course of our testingwe may identify deficiencies that we may not be able to remediate intime to meet the deadline imposed by Sarbanes-Oxley for compliance with therequirements of Section 404. Furthermore, if we fail to achieve andmaintain the adequacy of our internal controls, as such standards are modified,supplemented or amended from time to time, we may not be able to ensurethat we can conclude on an ongoing basis that we have effective internalcontrol over financial reporting in accordance with Section 404 ofSarbanes-Oxley. Effective internal controls, particularly those related torevenue recognition, are necessary for us to produce reliable financial reportsand are important to helping prevent financial fraud. If we cannot providereliable financial reports or prevent fraud, our business and operating resultscould be harmed, investors could lose confidence in our reported financialinformation, and the trading price of our stock could drop significantly.

 

31

----

 

**Due to the cyclical nature of thesemiconductor and telecommunications industries, our operating results may fluctuatesignificantly, which could adversely affect the market price of our commonstock.**

 

The semiconductor industry is highly cyclicaland subject to rapid change and evolving industry standards and, from time totime, has experienced significant downturns. These downturns are characterizedby decreases in product demand, excess customer inventories and acceleratederosion of prices. These factors could cause substantial fluctuations in ournet revenue and in our operating results. Any downturns in the semiconductor orbroadband communications industry may be severe and prolonged, and anyfailure of this industry or the broadband communications markets to fullyrecover from downturns could harm our business. The semiconductor industry alsoperiodically experiences increased demand and production capacity constraints,which may affect our ability to ship products. Accordingly, our operatingresults may vary significantly as a result of the general conditions inthe semiconductor or broadband communications industry, which could cause ourstock price to decline.

 

In addition, the telecommunications industryfrom time to time has experienced and may again experience a pronounceddownturn. To respond to a downturn, many carriers may be required to slowtheir capital expenditures, cancel or delay new developments, reduce their workforcesand inventories and take a cautious approach to acquiring new equipment andtechnologies from OEMs, which would have a negative impact on our business. Inthe future, a downturn in the telecommunications industry may cause ouroperating results to fluctuate from year to year, which also may tend toincrease the volatility of the price of our common stock and harm our business.

 

**Several of the facilities that manufactureour products, most of our OEM customers and the carriers they serve, and our Californiafacility are located in regions that are subject to earthquakes and othernatural disasters.**

 

Several of our subcontractors’ facilitiesthat manufacture, assemble and test our products, and one of our subcontractor’swafer foundries, are located in Taiwan. Our customers are currently primarilylocated in Japan and Korea. The Asia-Pacific region has experienced significantearthquakes in the past and could be subject to additional seismic activities.Any earthquake or other natural disaster in these areas could significantlydisrupt these manufacturing facilities’ production capabilities and couldresult in our experiencing a significant delay in delivery, or substantialshortage, of wafers in particular, and possibly in higher wafer prices, and ourproducts in general. Our headquarters in California are also located near majorearthquake fault lines. If there is a major earthquake or any other naturaldisaster in a region where one of our facilities is located, it couldsignificantly disrupt our operations.

 

**Changes in our tax rates could affect ourfuture results.**

 

Our future effective tax rates could befavorably or unfavorably affected by the absolute amount and future geographicdistribution of our pre-tax income, our ability to successfully shift ouroperating activities to our foreign operations and the amount and timing ofintercompany payments from our foreign operations subject to U.S. income taxesrelated to the transfer of certain rights and functions.

 

***Risks Related to ourCommon Stock***

 

**Our stock price may be volatile, and youmay not be able to resell shares of our common stock at or above the priceyou paid, or at all.**

 

The market price of our common stock hasfluctuated substantially since our initial public offering and is likely tocontinue to be highly volatile and subject to wide fluctuations. Fluctuationshave occurred and may continue to occur in response to various factors,many of which we cannot control, including:

 

•quarter-to-quarter variations in our operating results;

 

•changes in accounting rules, particularly those related to the expensing ofstock options;

 

•announcements of changes in our senior management;

 

•the gain or loss of one or more significant customers or suppliers;

 

•announcements of technological innovations or new products by our competitors,customers or us;

 

•the gain or loss of market share in any of our markets;

 

•general economic and political conditions and specific conditions in thesemiconductor industry and broadband technology    markets, including seasonality in sales ofconsumer products into which our products are incorporated;

 

•continuing international conflicts and acts of terrorism;

 

•changes in earnings estimates or investment recommendations by analysts;

 

•changes in investor perceptions; or

 

•changesin expectations relating to our products, plans and strategic position or thoseof our competitors or customers.

 

32

----

 

In addition, the market prices of securitiesof semiconductor and other technology companies have been volatile,particularly companies, like ours, with low trading volumes. This volatilityhas significantly affected the market prices of securities of many technologycompanies for reasons frequently unrelated to the operating performance of thespecific companies. Accordingly, you may not be able to resell your sharesof common stock at or above the price you paid. In the past, we and othercompanies that have experienced volatility in the market price of theirsecurities have been, and in the future we may be, the subject ofsecurities class action litigation.

 

**Class action litigation due tostock price volatility or other factors could cause us to incur substantialcosts and divert our management’s attention and resources.**

 

In the past, securities class actionlitigation often has been brought against a company following periods ofvolatility in the market price of its securities. Companies such as ours in thesemiconductor industry and other technology industries are particularlyvulnerable to this kind of litigation due to the high volatility of their stockprices. While we are not aware of any such contemplated class actionlitigation against us, we may in the future be the target of securitieslitigation. Any securities litigation could result in substantial costs andcould divert the attention and resources of our management.

 

**If securities or industry analystsdo not publish research or reports about our business, or if they issue anadverse opinion regarding our stock, our stock price and trading volume coulddecline.**

 

The trading market for ourcommon stock is influenced by the research and reports that industry orsecurities analysts publish about us or our business. If one or more of theanalysts who cover us issue an adverse opinion regarding our stock, our stockprice would likely decline. If one or more of these analysts cease coverage ofour company or fail to regularly publish reports on us, we could losevisibility in the financial markets, which in turn could cause our stock priceor trading volume to decline.

 

**Substantial future sales of ourcommon stock in the public market could cause our stock price to fall.**

 

As of March 31, 2006,we had 26,843,625 shares of common stock outstanding. Of these shares,6,400,000 were sold in our initial public offering in September 2005 andan additional 2,500,000 were recently sold in a follow-on publicoffering, all of which are freely tradable under federal and statesecurities laws without further registration under the Securities Act of 1933,as amended, or the Securities Act, except that any shares held by our “affiliates”(as that term is defined under Rule 144 of the Securities Act) may besold only in compliance with the limitations under Rule 144. The remainingoutstanding shares are “restricted securities” and generally will be availablefor sale in the public market at various times upon qualificationfor exemption pursuant to Rules 144 and/or 701 of the SecuritiesAct. Of these restricted securities, the shares held by ourdirectors, officers and certain stockholders, including the stockholders thatparticipated in our recent follow-on public offering, are subject to lock-upagreements with the underwriters of that offering. The underwritersmay, however, release all or a portion of the shares subject to lock-upagreements at any time without notice. To the extent shares are released beforethe expiration of the lock-up period and the shares are sold into the market,the market price of our common stock could decline. Current employees, otherthan our executive officers, who participated as selling stockholders inour follow-on public offering are permitted to purchase and dispose ofshares they purchase in connection with our employee stock purchase plan duringthe term of the lock-up agreement.

 

In addition, certain ofour stockholders are entitled to rights to cause their shares tobe registered for sale under the Securities Act. Following thecompletion of our recent follow-on public offering, thenumber of shares entitled to registration rights decreased as a result ofthe participation as selling stockholders of these stockholders possessingregistration rights. Registration of these stockholders’ remaining sharesunder the Securities Act would result in these shares, other than sharespurchased by our affiliates, becoming freely tradable without restriction underthe Securities Act immediately upon the effectiveness of the registrationstatement.

 

In the future, we may alsoissue additional shares to our employees, directors or consultants, inconnection with corporate alliances or acquisitions, and in follow-on offeringsto raise additional capital. Due to these factors, sales of a substantialnumber of shares of our common stock in the public market could occur at any time.These sales could reduce the market price of our common stock.

 

**Our corporate actions aresubstantially controlled by our directors, executive officers and theiraffiliated entities who could exert control over our company in a manner that may becontrary to the interests of other investors.**

 

Our directors, executiveofficers and their affiliated entities beneficially own over 30% of ouroutstanding common stock. These stockholders, if they acted together, couldexert substantial control over matters requiring approval by our stockholders,including electing directors and approving mergers or other businesscombination transactions. This concentration of ownership may alsodiscourage, delay or prevent a change in control of our company, which coulddeprive our stockholders of an opportunity to receive a premium for their stockas part of a sale of our company and might reduce our stock price. Theseactions may be taken even if they are opposed by our other stockholders,including those who purchase shares in this offering.

 

33

----

 

**Delaware law and our corporate charter andbylaws contain anti-takeover provisions that could delay or discourage takeoverattempts that stockholders may consider favorable.**

 

Provisions in our certificate ofincorporation may have the effect of delaying or preventing a change ofcontrol or changes in our management. These provisions include the following:

 

• theright of the board of directors to elect a director to fill a vacancy createdby the expansion of the board of directors;

 

•the establishment of a classified board of directors requiring that not allmembers of the board be elected at one time;

 

•the prohibition of cumulative voting in the election of directors which wouldotherwise allow less than a majority of stockholders to elect directorcandidates;

 

•the requirement for advance notice for nominations for election to the board ofdirectors or for proposing matters that can be acted upon at a stockholders’meeting;

 

•the ability of the board of directors to alter our bylaws without obtainingstockholder approval;

 

•the ability of the board of directors to issue, without stockholder approval,up to 5,000,000 shares of preferred stock with terms set by the board ofdirectors, which rights could be senior to those of common stock;

 

•the required approval of holders of at least two-thirds of the shares entitledto vote at an election of directors to adopt, amend or repeal our bylaws oramend or repeal the provisions of our certificate of incorporation regardingthe election and removal of directors and the ability of stockholders to takeaction;

 

•the required approval of holders of a majority of the shares entitled to voteat an election of directors to remove directors for cause; and

 

•the elimination of the right of stockholders to call a special meeting ofstockholders and to take action by written consent.

 

We are also subject to provisions of theDelaware General Corporation Law that, in general, prohibit any business combinationwith a beneficial owner of 15% or more of our common stock for three yearsafter the point in time that such stockholder acquired shares constituting 15%or more of our shares, unless the holder’s acquisition of our stock wasapproved in advance by our board of directors.

 

34

----

 

**Item 2. UnregisteredSales of Equity Securities and Use of Proceeds**

 

Our first registration statement, which wefiled on Form S-1 (File No. 333-113880) under the Securities Act of1933 as amended, was declared effective by the Securities andExchange Commission in connection with the initial public offering of ourcommon stock on September 21, 2005. After deducting the underwriters’commission and the estimated offering costs, we received net proceeds of $67.9million from our initial public offering. To date, we estimate that we haveused approximately $32.7 million of the proceeds for the acquisition of networkprocessing and ADSL assets from Analog Devices, Inc. The remainder ofthe net proceeds of the offering have been applied to temporaryinvestments.

 

The Securities and Exchange Commissiondeclared our second registration statement, which we filed on Form S-1(File No. 333-132067), under the Securities Act of 1933 as amended, in connection with the public offering of our common stock, par value $0.001,effective on March 16, 2006. Citigroup and Lehman Brothers acted as thelead underwriters of the offering. A total of 5,750,000 shares of common stockwere sold in the offering at $20.75 per share. 2,500,000 of the shares ofcommon stock were sold by us and 3,250,000 of the shares of common stock weresold by selling stockholders. The offering terminated after the sale of all ofthe securities registered on the registration statement. After deducting theunderwriters’ commission and the estimated offering costs, we received netproceeds of $48.6 million from the offering. None of the expenses were paid,directly or indirectly, to directors, officers or persons owning 10% or more.To date, we have not used any part of the net proceeds of the offering, all ofwhich have been applied to temporary investments.

 

**Item 6. Exhibits**

 

An Exhibit Index has been attached as part ofthis Quarterly Report on Form 10-Q and is incorporated herein by reference.

 

35

----

 

**SIGNATURE**

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, the Registrant has duly caused this report tobe signed on its behalf by the undersigned thereunto duly authorized.

 
| ** **          | **IKANOS COMMUNICATIONS, INC.** |
|---------------------|--------------------------------------|
| ** **          | ** **                           |
| Dated: May 17, 2006 | By:                                  | /s/ RAJESH VASHIST | ** ** |
| ** **          | ** **                           | Rajesh Vashist |
| ** **          | ** **                           | President, Chief Executive Officer and  Chairman of the Board |
| ** **          | ** **                           | **(Principal Executive Officer)** |
| ** **          | ** **                           |
| Dated: May 17, 2006 | By:                                  | /s/ DANIEL K. ATLER | ** ** |
| ** **          | ** **                           | Daniel K. Atler |
| ** **          | ** **                           | Vice President and Chief Financial Officer |
|                | ** **                           | **(Principal Financial and Accounting  Officer)** |

 

36

----

 

 

**EXHIBIT INDEX**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                        |
|---------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **          | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                             |
| 2.1                 |       | Asset Purchase Agreement, dated January 12,  2006, between the Registrant, Analog Devices, Inc. and Analog Devices  Canada Ltd. Incorporated by reference to Exhibit 2.2 of the Registrant’s  annual report on Form 10-K filed on February 27, 2006 (File No. 000-51532).                                                           |
|                |       |                                                                                                                                                                                                                                                                                                                                                                   |
| 2.2                 |       | Amended and Restated Asset Purchase  Agreement, dated February 17, 2006, between the Registrant, Analog  Devices, Inc., Analog Devices Canada Ltd., and Analog Devices B.V.  Incorporated by reference to Exhibit 2.3 of the Registrant’s annual  report on Form 10-K filed on February 27, 2006 (File No. 000-51532).              |
|                |       |                                                                                                                                                                                                                                                                                                                                                                   |
| 4.1                 |       | Amendment No. 2 to Fourth Amended and  Restated Investor Rights Agreement, dated March 3, 2006, between the  Registrant and the parties named therein. Incorporated by reference to Exhibit 4.3  to Amendment No. 1 of the Registrant’s registration statement on Form S-1  dated March 8, 2006 (Registration No. 333-132067). |
|                |       |                                                                                                                                                                                                                                                                                                                                                                   |
| 10.1                |       | Lease Agreement, dated as of February 7,  2006, between Registrant and ProLogis, and addendums thereto. Incorporated by  reference to Exhibit 10.5 of the Registrant’s annual report on Form 10-K  filed on February 27, 2006 (File No. 000-51532).                                                                                      |

 

37

----

 
| 10.2        |   | Summary of Registrant’s 2006 Executive  Bonus Plan. Incorporated by reference to Exhibit 10.23 of the Registrant’s  annual report on Form 10-K filed on February 27, 2006 (File No. 000-51532).                                                                                                                                                   |
|-------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |   |                                                                                                                                                                                                                                                                                                                                                                            |
| 10.3*† |   | Registrant’s 2006 Sales Compensation Plan.                                                                                                                                                                                                                                                                                                                                 |
|        |   |                                                                                                                                                                                                                                                                                                                                                                            |
| 10.4*† |   | Registrant’s 2006 Stretch Revenue Incentive  Plan.                                                                                                                                                                                                                                                                                                                         |
|        |   |                                                                                                                                                                                                                                                                                                                                                                            |
| 10.5        |   | Form of Notice of Grant of Restricted  Stock Units. Incorporated by reference to Exhibit 10.25 of the  Registrant’s annual report on Form 10-K filed on February 27, 2006  (File No. 000-51532).                                                                                                                                                  |
|        |   |                                                                                                                                                                                                                                                                                                                                                                            |
| 10.6        |   | Lease Agreement, dated as of February 7,  2006, between Registrant and ProLogis, and addendums thereto. Incorporated by  reference to Exhibit 10.26 of the Registrant’s annual report on Form 10-K  filed on February 27, 2006 (File No. 000-51532).                                                                                              |
|        |   |                                                                                                                                                                                                                                                                                                                                                                            |
| 10.7        |   | Patent and Technology License Agreement,  effective as of February 17, 2006, by and among the Registrant and  Analog Devices, Inc. Incorporated by reference to Exhibit 10.27 of  the Registrant’s annual report on Form 10-K filed on February 27,  2006 (File No. 000-51532).                                                              |
|        |   |                                                                                                                                                                                                                                                                                                                                                                            |
| 10.8        |   | Consulting Agreement, effective as of March 30,  2006, between Ikanos and Texan Ventures. Incorporated by reference to Exhibit 10.28  of the Registrant’s current report on Form 8-K filed on April 5,  2006 (File No. 000-51532).                                                                                                                |
|        |   |                                                                                                                                                                                                                                                                                                                                                                            |
| 10.9        |   | Amendment No. 2, dated March 31,  2006, to the Loan and Security Agreement, entered into as of October 21,  2004 and as amended on June 30, 2005, between Ikanos and Silicon Valley  Bank. Incorporated by reference to Exhibit 10.28 of the Registrant’s  current report on Form 8-K filed on April 5, 2006 (File No. 000-51532). |
|        |   |                                                                                                                                                                                                                                                                                                                                                                            |
| 31.1*       |   | Certification of Chief Executive Officer  pursuant to Securities Exchange Act Rules 13a-14(a) and 15d-14(a),  as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                              |
|        |   |                                                                                                                                                                                                                                                                                                                                                                            |
| 31.2*       |   | Certification of Chief Financial Officer  pursuant to Securities Exchange Act Rules 13a-14(a) and 15d-14(a),  as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                              |
|        |   |                                                                                                                                                                                                                                                                                                                                                                            |
| 32.1*       |   | Certification of Chief Executive Officer  and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                      |

 

----

*                                         FiledHerewith.

†                                         Confidentialtreatment has been requested as to certain portions of this Exhibit.

 

38

----