**UNITEDSTATESSECURITIES 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 October 2, 2005**

 

**OR**

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

 

**For the Transition Period from             to             **

 

**Commission File Number: Reg no.0-51532**

 

**IKANOSCOMMUNICATIONS, INC.**

(Exact name of registrant as specified in itscharter)

 
| **Delaware**                                                    | ** ** | **94-3326559**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |       | (I.R.S. Employer  Identification No.) |

 

**47669 Fremont Boulevard**

**Fremont, CA 94538**

(Address of principal executive office and zipcode)

 

**(510) 979-0400**

(Registrant’s telephone number including areacode)

 

Indicateby check mark whether registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) had been subject to suchfiling requirements for the past 90 days.    Yes o    No   ý

 

Indicateby check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act).    Yes o    No  ý

 

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

 

Thenumber of shares outstanding of the Registrant’s Common Stock, $0.001 parvalue, was 23,793,945 as of November 14, 2005

 

 

----

 

**IKANOS COMMUNICATIONS, INC.**

 

**FORM 10-Q**

 

**TABLE OF CONTENTS**

 
| ** **        | ** **                                                                                                             | **Page No.** |
|-------------------|------------------------------------------------------------------------------------------------------------------------|-------------------|
| **PART I:**  | FINANCIAL INFORMATION                                                                                                  | 3                 |
|              |                                                                                                                   |              |
| Item 1.      | Financial Statements (unaudited)                                                                                       | 3                 |
|              |                                                                                                                   |              |
|              | Condensed Consolidated  Balance Sheets as of September 30, 2005 and December 31, 2004                        | 3                 |
|              |                                                                                                                   |              |
|              | Condensed Consolidated  Statements of Operations for the three and nine months ended September 30,  2005 and 2004 | 4                 |
|              |                                                                                                                   |              |
|              | Condensed Consolidated  Statements of Cash Flows for the nine months ended September 30, 2005  and 2004           | 5                 |
|              |                                                                                                                   |              |
|              | Notes to Unaudited Condensed  Consolidated Financial Statements                                                        | 6                 |
|              |                                                                                                                   |              |
| Item 2.      | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                            | 12                |
|              |                                                                                                                   |              |
| Item 3.      | Quantitative and Qualitative Disclosures  About Market Risk                                                            | 13                |
|              |                                                                                                                   |              |
| Item 4.      | Controls and Procedures                                                                                                | 27                |
|              |                                                                                                                   |              |
| **PART II:** | **OTHER  INFORMATION**                                                                                                 | 28                |
|              |                                                                                                                   |              |
| Item 2.      | Unregistered  Sales of Equity Securities and Use of Proceeds                                                           | 28                |
|              |                                                                                                                   |              |
| Item 4.      | Submission  of Matters to a Vote of Stockholders                                                                       | 28                |
|              |                                                                                                                   |              |
| Item 5.      | Other Information                                                                                                      | 28                |
|              |                                                                                                                   |              |
| Item 6.      | Exhibits                                                                                                               | 28                |
|              |                                                                                                                   |              |
| Signatures        |                                                                                                                   | 29                |

 

2

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**PART I: FINANCIAL INFORMATION**

 

**Item 1.*FinancialStatements***

 

**IKANOS COMMUNICATIONS, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)**

**(IN THOUSANDS)**

 
| ** **                                                                                       | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                                       | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                       |       |                         |       |                        |       |
| Current assets:                                                                                  |       |                         |       |                        |       |
| Cash and cash equivalents                                                                        |       | $                            | 98,711     |                        | $          | 25,428 |   |
| Accounts receivable - trade, net                                                                 |       | 4,275                        |       | 127                         |       |
| Inventories                                                                                      |       | 5,346                        |       | 7,994                       |       |
| Prepaid expenses and other current assets                                                        |       | 1,214                        |       | 460                         |       |
| Total current assets                                                                             |       | 109,546                      |       | 34,009                      |       |
|                                                                                             |       |                         |       |                        |       |
| Property and equipment, net                                                                      |       | 6,089                        |       | 5,813                       |       |
| Other assets                                                                                     |       | 339                          |       | 2,209                       |       |
|                                                                                             |       |                         |       |                        |       |
| Total assets                                                                                     |       | $                            | 115,974    |                        | $          | 42,031 |   |
|                                                                                             |       |                         |       |                        |       |
| **LIABILITIES, REDEEMABLE  CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY (DEFICIT)** |       |                         |       |                        |       |
| Current liabilities:                                                                             |       |                         |       |                        |       |
| Accounts payable and accrued liabilities                                                         |       | $                            | 15,981     |                        | $          | 14,388 |   |
| Capital lease obligations, current portion                                                       |       | 494                          |       | 838                         |       |
| Notes payable, current portion                                                                   |       | 687                          |       | 486                         |       |
| Total current liabilities                                                                        |       | 17,162                       |       | 15,712                      |       |
|                                                                                             |       |                         |       |                        |       |
| Capital lease obligations, net of current portion                                                |       | 264                          |       | 355                         |       |
| Notes payable, net of current portion                                                            |       | 906                          |       | 1,016                       |       |
| Total liabilities                                                                                |       | 18,332                       |       | 17,083                      |       |
|                                                                                             |       |                         |       |                        |       |
| Redeemable convertible preferred stock                                                           |       | —                       |       | 101,633                     |       |
|                                                                                             |       |                         |       |                        |       |
| Stockholders’ equity (deficit):                                                             |       |                         |       |                        |       |
| Common stock                                                                                     |       | 24                           |       | 2                           |       |
| Additional paid-in capital                                                                       |       | 194,634                      |       | 17,045                      |       |
| Notes receivable from stockholders                                                               |       | (71                          | )          | (137                        | )          |
| Deferred stock-based compensation                                                                |       | (6,328                       | )          | (4,255                      | )          |
| Accumulated other comprehensive loss                                                             |       | (58                          | )          | (21                         | )          |
| Accumulated deficit                                                                              |       | (90,559                      | )          | (89,319                     | )          |
|                                                                                             |       |                         |       |                        |       |
| Total stockholders’ equity (deficit)                                                        |       | 97,642                       |       | (76,685                     | )          |
|                                                                                             |       |                         |       |                        |       |
| Total liabilities, convertible preferred stock  and stockholders’ equity (deficit)          |       | $                            | 115,974    |                        | $          | 42,031 |   |

 

Theaccompanying notes are an integral part of these unaudited condensed consolidatedfinancial statements.

 

3

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**IKANOSCOMMUNICATIONS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)**

**(IN THOUSANDS,EXCEPT PER SHARE DATA)**

 
| ** **                                                                     | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended********September 30,** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                     | ** ** | **2005**                                   | ** ** | **2004**                                        | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                     | ** ** | ** **                                 | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Net  revenue**                                                               |       | $                                          | 25,010     |                                            | $          | 18,037 |   | $ | 56,539 |   | $ | 48,228 |   |
|                                                                           |       |                                       |       |                                            |       |   |   |   |   |
| **Costs  and expenses:**                                                       |       |                                       |       |                                            |       |   |   |   |   |
| Cost of revenue (1)                                                            |       | 10,894                                     |       | 9,532                                           |       | 25,867 |   | 30,542 |   |
| Research and development (1)                                                   |       | 6,085                                      |       | 5,666                                           |       | 17,820 |   | 15,176 |   |
| Selling, general and administrative (1)                                        |       | 2,958                                      |       | 2,411                                           |       | 8,395 |   | 6,750 |   |
| Stock-based compensation                                                       |       | 2,079                                      |       | 1,320                                           |       | 5,959 |   | 3,826 |   |
| Total costs and expenses                                                       |       | 22,016                                     |       | 18,929                                          |       | 58,041 |   | 56,294 |   |
|                                                                           |       |                                       |       |                                            |       |   |   |   |   |
| Operating income (loss)                                                        |       | 2,994                                      |       | (892                                            | )          | (1,502 | ) | (8,066 | ) |
|                                                                           |       |                                       |       |                                            |       |   |   |   |   |
| Interest and other income, net                                                 |       | 77                                         |       | 48                                              |       | 262 |   | 68 |   |
| Net income (loss)                                                              |       | $                                          | 3,071      |                                            | $          | (844 | ) | $ | (1,240 | ) | $ | (7,998 | ) |
|                                                                           |       |                                       |       |                                            |       |   |   |   |   |
| Basic net income (loss) per share                                              |       | $                                          | 0.17       |                                            | $          | (0.53 | ) | $ | (0.44 | ) | $ | (5.54 | ) |
| Diluted net income (loss) per share                                            |       | $                                          | 0.15       |                                            | $          | (0.53 | ) | $ | (0.44 | ) | $ | (5.54 | ) |
| Weighted-average number of shares in calculating net income (loss) per  share: |       |                                       |       |                                            |       |   |   |   |   |
| Basic                                                                          |       | 18,074                                     |       | 1,604                                           |       | 2,803 |   | 1,444 |   |
| Diluted                                                                        |       | 20,328                                     |       | 1,604                                           |       | 2,803 |   | 1,444 |   |

 

----

(1)          Amountsexclude stock-based compensation as follows:

 
| ** **                          | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended********September 30,** | ** ** |
|-------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                          | ** ** | **2005**                                   | ** ** | **2004**                                        | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                          | ** ** | ** **                                 | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cost of revenue                     |       | 56                                         |       | 10                                              |       | 179 |   | 32 |   |
| Research and development            |       | 1,023                                      |       | 332                                             |       | 2,710 |   | 802 |   |
| Selling, general and administrative |       | 1,000                                      |       | 978                                             |       | 3,070 |   | 2,992 |   |
|                                |       |                                       |       |                                            |       |   |   |   |   |
|                                |       | $                                          | 2,079      |                                            | $          | 1,320 |   | $ | 5,959 |   | $ | 3,826 |   |
|                                     |            |                                            |            |                                                 |            |  |  |  |  |  |  |  |  |

 

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

 

4

----

 

**IKANOS COMMUNICATIONS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)**

**(IN THOUSANDS)**

 
| ** **                                                                       | ** ** | **Nine months ended********September 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                       | ** ** | **2005**                                        | ** ** | **2004** | ** ** |
|                                                                             |       |                                            |       |   |   |
| **Cash  flows from operating activities**                                        |       |                                            |       |   |   |
| Net loss                                                                         |       | $                                               | (1,240     | ) | $ | (7,998 | ) |
| Adjustments to reconcile net loss to net cash provided by operating  activities: |       |                                            |       |   |   |
| Depreciation of property and equipment                                           |       | 2,031                                           |       | 1,256 |   |
| Stock-based compensation expense                                                 |       | 5,959                                           |       | 3,826 |   |
| Changes in current assets and liabilities:                                       |       |                                            |       |   |   |
| Accounts receivable                                                              |       | (4,148                                          | )          | (2,942 | ) |
| Inventories                                                                      |       | 2,648                                           |       | 1,335 |   |
| Prepaid expenses and other current assets                                        |       | (797                                            | )          | (65 | ) |
| Other assets                                                                     |       | 1,849                                           |       | (1,447 | ) |
| Accounts payable and accrued liabilities                                         |       | 1,657                                           |       | 6,481 |   |
| Net cash provided by operating activities                                        |       | 7,959                                           |       | 446 |   |
|                                                                             |       |                                            |       |   |   |
| **Cash  flows from investing activities**                                        |       |                                            |       |   |   |
| Purchases of property and equipment                                              |       | (2,052                                          | )          | (2,657 | ) |
| Net cash used in investing activities                                            |       | (2,052                                          | )          | (2,657 | ) |
|                                                                             |       |                                            |       |   |   |
| **Cash  flows from financing activities**                                        |       |                                            |       |   |   |
| Proceeds from redeemable convertible preferred stock issuance, net               |       | —                                          |       | 16,670 |   |
| Proceeds from initial public offering, net of issuance costs of $8.9  million    |       | 67,907                                          |       | — |   |
| Repayment of notes receivable                                                    |       | 67                                              |       | 115 |   |
| Proceeds from exercise of stock options                                          |       | 42                                              |       | 739 |   |
| Payments of obligations under capital lease                                      |       | (690                                            | )          | (1,130 | ) |
| Repurchase of common stock                                                       |       | (25                                             | )          | (1 | ) |
| Borrowings under notes payable                                                   |       | 552                                             |       | — |   |
| Payments on notes payable                                                        |       | (461                                            | )          | — |   |
| Net cash provided by financing activities                                        |       | 67,392                                          |       | 16,393 |   |
|                                                                             |       |                                            |       |   |   |
| Effect of exchange rate on cash and cash equivalents                             |       | (16                                             | )          | (8 | ) |
|                                                                             |       |                                            |       |   |   |
| Net increase in cash and cash equivalents                                        |       | 73,283                                          |       | 14,174 |   |
| Cash and cash equivalents, at beginning of period                                |       | 25,428                                          |       | 11,236 |   |
| Cash and cash equivalents, at end of period                                      |       | $                                               | 98,711     |   | $ | 25,410 |   |
|                                                                             |       |                                            |       |   |   |
| **Supplemental  disclosure of non-cash investing and financing activities:**     |       |                                            |       |   |   |
| Property and equipment acquired under capital leases                             |       | $                                               | 255        |   | $ | 457 |   |
| Conversion of redeemable convertible preferred stock into common stock           |       | 101,633                                         |       | — |   |

 

Theaccompanying notes are an integral part of these unaudited condensedconsolidated financial statements.

 

5

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**IKANOSCOMMUNICATIONS, INC.**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(UNAUDITED)**

 

**NOTE 1—BASIS OF PRESENTATION:**

 

**TheCompany**

 

Ikanos Communications, Inc.(the “Company”), was incorporated in the state of California in April 1999and reincorporated 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 sold 6,400,000 shares ofits common stock in its initial public offering at an offering price of $12.00per share resulting in net proceeds of $67.9 million.

 

The Company’s fiscal yearends on the Sunday closest to December 31. The Company’s fiscal quartersend on the Sunday closest to the end of the applicable calendar quarter, exceptin a 53-week fiscal year, in which case the additional week falls into thefourth quarter of that fiscal year. For presentation purposes, the financialstatements and notes have been presented as ending on the last day of thenearest calendar month.

 

**Basis ofPresentation**

 

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

 

The accompanyingcondensed consolidated financial statements have been prepared without audit inaccordance with the rules and regulations of the Securities and ExchangeCommission (the “SEC”). Certain information and disclosures normally includedin financial statements prepared in accordance with accounting principlesgenerally accepted in the United States (GAAP) have been condensed or omittedin accordance with these rules and regulations. The information in thisreport should be read in conjunction with our audited financial statements andnotes thereto included in our prospectus filed with the SEC pursuant to Rule424(6)(4) (File No. 333-116880) on September 21, 2005.

 

In the opinion of management,the accompanying unaudited condensed consolidated financial statements reflectall adjustments (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 and ninemonth periods ended September 30, 2005 are not necessarily indicative ofthe results that may be expected for the year ending December 31, 2005 orfor any other future period. The balance sheet as of December 31, 2004 isderived from the audited financial statements as of and for the year thenended.

 

On September 20,2005, the Company filed an amendment to its Amended and Restated Certificate ofIncorporation to effect a 1-for-12 reverse stock split of its common andpreferred stock. All information related to common stock, preferred stock,options and warrants to purchase preferred stock and earnings (loss) per shareincluded in the accompanying condensed consolidated financial statements hasbeen retroactively adjusted to give effect to the reverse stock split.

 

**RecentAccounting Pronouncements**

 

In May 2005, theFinancial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS”) No. 154, “Accounting Changes and ErrorCorrections.” SFAS No. 154 replaces APB Opinion No. 20, “AccountingChanges,” and SFAS No. 3, “Reporting Accounting Changes in InterimFinancial Statements,” and changes the requirements for the accounting for andreporting of a change in accounting principle. The Company is required to adoptSFAS No. 154 for accounting changes and error corrections in 2006. TheCompany’s results of operations and financial condition will only be impactedby SFAS No. 154 if it implements changes in accounting principle that areaddressed by the standard or corrects accounting errors in future periods.

 

In December 2004,the FASB issued SFAS No. 123(R), “Share-Based Payment,” which replacesSFAS No. 123 and supersedes APB Opinion No. 25. Under SFAS No. 123(R),companies are required to measure the compensation costs of share-basedcompensation arrangements based on the grant-date fair value and recognize thecosts in the financial statements over the period during which employees arerequired to provide services. Share-based compensation arrangements includestock options, restricted share plans, performance-based awards, shareappreciation rights and employee share purchase plans. Public companies will berequired to apply SFAS No. 123(R) as of the first interim or annualreporting period beginning after June 15, 2005. The Company expects toadopt SFAS No. 123(R) in the first quarter of fiscal 2006. SFAS No. 123(R)permits public companies to adopt its requirements using one of two methods.The Company is currently evaluating which method to adopt. In addition, the SECissued Staff Accounting Bulletin No. 107, or SAB 107, in March 2005.SAB 107 includes interpretive guidance for the initial implementation of SFAS123(R).

 

6

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**Use ofEstimates**

 

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting period. Actual results could differ from those estimates, and suchdifferences could affect the results of operations reported in future periods.

 

**Concentrationof Credit Risk**

 

Financial instrumentsthat potentially subject the Company to significant concentrations of creditrisk consist of cash, cash equivalents and accounts receivable. Cash and cashequivalents are held with a limited number of financial institutions. Depositsheld with these financial institutions may exceed the amount of insuranceprovided on such deposits. Management believes that the financial institutions thathold the Company’s investments are financially credit worthy and, accordingly,minimal credit risk exists with respect to those investments.

 

Three customers represent50.1%, 29.0% and 12.1% of gross accounts receivable at September 30, 2005.Three customers represented 49.7%, 12.0% and 11.8%, respectively, of gross accountsreceivable at December 31, 2004. The Company reviews credit evaluations ofits customers but does not require collateral or other security to supportcustomer receivables. Three customers accounted for 46.0%, 26.6%, and 23.7% ofnet revenue for the nine months ended September 30, 2005. Three customersaccounted for 46.2%, 26.7% and 20.6% respectively of net revenue for the ninemonths ended September 30, 2004.

 

**Stock-basedCompensation**

 

The Company accounts forstock-based employee compensation arrangements in accordance with theprovisions of Accounting Principles Board Opinion (“APB”) Opinion No. 25,Accounting for Stock Issued to Employees, and Financial Accounting StandardsBoard Interpretation (“FIN”) No. 28, Accounting for Stock AppreciationRights and Other Variable Stock Option or Award Plans, and complies with thedisclosure provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123,Accounting for Stock-Based Compensation. Under APB Opinion No. 25,compensation cost is recognized based on the difference, if any, on the date ofgrant between the fair value of the Company’s stock and the amount an employeemust pay to acquire the stock. SFAS No. 123 defines a “fair value” basedmethod of accounting for an employee stock option or similar equity investment.The Company accounts for equity instruments issued to non-employees inaccordance with the provisions of SFAS No. 123 and Emerging Issues TaskForce (“EITF”) No. 96-18, Accounting for Equity Instruments That AreIssued to Other Than Employees for Acquiring, or in Conjunction with SellingGoods or Services and complies with the disclosure provisions of SFAS 148,Accounting for Stock-Based Compensation—an Amendment of SFAS 123. TheCompany amortizes deferred stock-based compensation on the graded vestingmethod over the vesting periods of the stock options, generally four years. Thegraded vesting method provides for vesting of portions of the overall awards atinterim dates and results in accelerated vesting as compared to thestraight-line method. Had compensation cost for the Company’s stockcompensation plans been determined based on the fair value at the grant dates,as prescribed in SFAS 123, the Company’s net income (loss) would have beendecreased (increased) to the pro forma amounts indicated below (in thousands,except per share data):

 
| ** **                                                                                | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                      |       |                                       |       |                                      |       |   |   |   |   |
| Net income (loss) as reported                                                             |       | $                                          | 3,071      |                                      | $          | (844 | ) | $ | (1,240 | ) | $ | (7,998 | ) |
| Add: Employee stock-based compensation expense  included in net loss                      |       | 1,905                                      |       | 1,137                                     |       | 5,524 |   | 3,482 |   |
| Deduct: Employee stock-based compensation expense  determined under the fair value method |       | (2,709                                     | )          | (1,311                                    | )          | (5,593 | ) | (3,713 | ) |
|                                                                                      |       |                                       |       |                                      |       |   |   |   |   |
| Pro forma net income (loss)                                                               |       | 2,267                                      |       | (1,018                                    | )          | (1,309 | ) | (8,229 | ) |
|                                                                                      |       |                                       |       |                                      |       |   |   |   |   |
| Pro forma net income (loss) per share                                                     |       |                                       |       |                                      |       |   |   |   |   |
| Basic                                                                                     |       | $                                          | 0.13       |                                      | $          | (0.63 | ) | $ | (0.47 | ) | $ | (5.70 | ) |
| Diluted                                                                                   |       | $                                          | 0.11       |                                      | $          | (0.63 | ) | $ | (0.47 | ) | $ | (5.70 | ) |
|                                                                                      |       |                                       |       |                                      |       | — |   | — |   |
| Net income (loss) per share                                                               |       |                                       |       |                                      |       |   |   |   |   |
| Basic                                                                                     |       | $                                          | 0.17       |                                      | $          | (0.53 | ) | $ | (0.44 | ) | $ | (5.54 | ) |
| Diluted                                                                                   |       | $                                          | 0.15       |                                      | $          | (0.53 | ) | $ | (0.44 | ) | $ | (5.54 | ) |
|                                                                                      |       |                                       |       |                                      |       |   |   |   |   |
| Basic                                                                                     |       | 18,074                                     |       | 1,605                                     |       | 2,803 |   | 1,444 |   |
| Diluted                                                                                   |       | 20,328                                     |       | 1,605                                     |       | 2,803 |   | 1,444 |   |
|                                                                                           |            |                                            |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

7

----

 

Through June 25,2004, the date of the Company’s initial filing with the SEC related to itsproposed initial public offering, the Company used the minimum value method toestimate the fair value of options granted to employees. Options grantedsubsequent to June 25, 2004 were valued using the Black-Scholes valuationmodel using an estimated volatility of 90%.

 

The fair value of theCompany’s stock-based awards to employees was as follows and was estimatedusing the following weighted-average assumptions:

 
| ** **                                         | ** ** | **Three months ended********September 30,** | ** ** | **Nine months ended********September 30,** | ** ** |
|----------------------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                         | ** ** | **2005**                                         | ** ** | **2004**                                        | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                         | ** ** | ** **                                       | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Dividend yield                                     |       | 0                                                | %          | 0                                               | %          | 0 | % | 0 | % |
| Expected life (years)                              |       | 4.0                                              |       | 4.0                                             |       | 4.0 |   | 4.2 |   |
| Expected annualized volatility                     |       | 90                                               | %          | 90                                              | %          | 90 | % | 90 | % |
| Risk-free interest rate                            |       | 4.0                                              | %          | 3.2                                             | %          | 4.0 | % | 3.0 | % |
|                                               |       |                                             |       |                                            |       |   |   |   |   |
| Weighted average fair value of stock option grants |       | $                                                | 7.65       |                                            | $          | 6.72 |   | $ | 7.48 |   | $ | 4.08 |   |
|                                                    |            |                                                  |            |                                                 |            |  |  |  |  |  |  |  |  |

 

**Net income(loss) per share**

 

In accordance with SFAS No. 128,“Earnings Per Share,” the Company computes basic net income (loss) per share bydividing net income (loss)  available tocommon stockholders by the weighted average number of common shares andparticipating redeemable convertible preferred shares (only if the effect isdilutive) outstanding during the period. Basic net income (loss) per shareexcludes the dilutive effect of stock options, warrants and unvested commonshares. Diluted income per share reflects the dilution of potential common sharesoutstanding during the period. In computing diluted income per share, theCompany adjusts share count by assuming that all in-the-money options andwarrants are exercised and that we repurchase shares with the proceeds of thesehypothetical exercises. The Company further assumes that any unamortizeddeferred stock-based compensation is also used to repurchase shares. Indetermining the hypothetical shares repurchased, we use the average stock pricefor the period.

 

8

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The following table setsforth the computation of basic and diluted net income (loss) per common share(in thousands, except per share data):

 
| ** **                                                     | ** ** | **Three months ended********September 30,** | ** ** | **Nine months ended********September 30,** | ** ** |
|----------------------------------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                     | ** ** | **2005**                                         | ** ** | **2004**                                        | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                           |       |                                             |       |                                            |       |   |   |   |   |
| Numerator:                                                     |       |                                             |       |                                            |       |   |   |   |   |
| Net income (loss)                                              |       | $                                                | 3,071      |                                            | $          | (844 | ) | $ | (1,240 | ) | $ | (7,998 | ) |
|                                                           |       |                                             |       |                                            |       |   |   |   |   |
| Denominator:                                                   |       |                                             |       |                                            |       |   |   |   |   |
| Weighted-average common shares outstanding                     |       | 4,901                                            |       | 1,951                                           |       | 2,923 |   | 1,791 |   |
| Less: Unvested common shares subject to  repurchase            |       | (120                                             | )          | (348                                            | )          | (120 | ) | (348 | ) |
| Redeemable convertible preferred participating  stock          |       | 13,293                                           |       |                                            |       |   |   |   |   |
|                                                           |       |                                             |       |                                            |       |   |   |   |   |
| Total shares, basic                                            |       | 18,074                                           |       | 1,604                                           |       | 2,803 |   | 1,444 |   |
|                                                           |       |                                             |       |                                            |       |   |   |   |   |
| Effect of dilutive securities                                  |       |                                             |       |                                            |       |   |   |   |   |
| Stock options and warrants                                     |       | 2,100                                            |       | —                                          |       | — |   | — |   |
| Unvested common shares subject to repurchase                   |       | 120                                              |       | —                                          |       | — |   | — |   |
| Redeemable convertible preferred participating  stock warrants |       | 34                                               |       | —                                          |       | — |   | — |   |
|                                                           |       |                                             |       |                                            |       |   |   |   |   |
| Total shares, diluted                                          |       | 20,328                                           |       | 1,604                                           |       | 2,803 |   | 1,444 |   |
| Net income (loss) per share:                                   |       |                                             |       |                                            |       |   |   |   |   |
| Basic                                                          |       | $                                                | 0.17       |                                            | $          | (0.53 | ) | $ | (0.44 | ) | $ | (5.54 | ) |
| Diluted                                                        |       | $                                                | 0.15       |                                            | $          | (0.53 | ) | $ | (0.44 | ) | $ | (5.54 | ) |
|                                                                |            |                                                  |            |                                                 |            |  |  |  |  |  |  |  |  |  |  |

 

The potential shares,which are excluded from the determination of basic and diluted net income (loss)per share as their effect is anti-dilutive, are as follows (in thousands):

 
| ** **                            | ** ** | **Three months ended********September 30,** | ** ** | **Nine months ended********September 30,** | ** ** |
|---------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                            | ** ** | **2005**                                         | ** ** | **2004**                                        | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                            | ** ** | ** **                                       | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Weighted-average redeemable           |       |                                             |       |                                            |       |   |   |   |   |
| convertible preferred stock           |       | —                                           |       | 15,296                                          |       | 14,639 |   | 14,683 |   |
| Warrants to purchase convertible      |       |                                             |       |                                            |       |   |   |   |   |
| preferred stock (assuming conversion) |       | —                                           |       | 48                                              |       | 43 |   | 45 |   |
| Options to purchase common stock      |       | —                                           |       | 2,612                                           |       | 1,937 |   | 2,612 |   |

 

**NOTE 2—RELATED PARTY TRANSACTIONS:**

 

At September 30,2005, the Company held full recourse notes receivable from three employees witha total balance of $71,000. The interest rates on these notes range from 5.1%to 5.9% per annum. The notes have a term of 5 years.

 

The Company has aconsulting agreement with Texan Ventures, LLC entered into on November 7,2001. G. Venkatesh, who is also a member of the Company’s board of directors,is the Managing Member of Texan Ventures, LLC. Under the consulting agreement,Texan Ventures, LLC is entitled to $3,000 per month and reimbursement forreasonable expenses, and an option grant of 13,333 shares that vested monthlyover a period of 12 months commencing on November 7, 2001. TheCompany paid Texan Ventures, LLC $30,000 in the nine months ended September 30,2005 for consulting services.

 

9

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**NOTE 3—BALANCE SHEETCOMPONENTS:**

 
| ** **                        | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|-----------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                        | ** ** | **(in thousands)**           | ** ** |
|                              |       |                         |       |                        |       |
| **Inventory:**                    |       |                         |       |                        |       |
| Finished Goods                    |       | $                            | 1,314      |                        | $          | 4,623 |   |
| Work-in-Process                   |       | 2,827                        |       | 3,231                       |       |
| Purchased parts and raw materials |       | 1,205                        |       | 140                         |       |
|                              |       | $                            | 5,346      |                        | $          | 7,994 |   |

 

Thefollowing table summarizes the activity related to the product warrantyliability, which was included in accounts payable and accrued liabilities inthe Company’s consolidated balance sheets, at September 30, 2005 and 2004(inthousands):

 
| ** **                               | ** ** | **Nine months ended  September 30,** | ** ** |
|------------------------------------------|------------|-------------------------------------------|------------|
| ** **                               | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
|                                     |       |                                      |       |   |   |
| Balance, beginning of period             |       | $                                         | 1,084      |   | $ | 126 |   |
|                                     |       |                                      |       |   |   |
| Accrual for warranties during the period |       | 1,074                                     |       | 972 |   |
| Settlements made during the period       |       | 415                                       |       | 329 |   |
|                                     |       |                                      |       |   |   |
| Balance, end of period                   |       | $                                         | 1,743      |   | $ | 769 |   |

 

**NOTE 4—REDEEMABLECONVERTIBLE PREFERRED STOCK:**

 

The Company had15,311,840 shares of redeemable convertible preferred stock outstanding thatautomatically converted into 15,311,840 shares of common stock upon the closingof its initial public offering in September 2005.

 

**NOTE 5—BORROWINGS:**

 

On October 21, 2004, the Company entered into aloan agreement with Silicon Valley Bank that provides the Company the abilityto finance up to $5,000,000 of working capital requirements (subject to certainlimitations) and $2,000,000 of equipment purchases. Borrowings under theagreement are capitalized by a first priority lien on substantially all of theassets of the Company, excluding intellectual property. The agreement containsfinancial covenants related to liquidity and profitability as well as othernonfinancial covenants. The Company was not in compliance with the minimumprofitability 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, the Company believes itwill be continue to be in full compliance with the amended covenants for atleast 12 months from the balance sheet date. Accordingly, the Company hasclassified the amounts due under the facility beyond 12 months from thebalance sheet date as non-current. Interest on borrowings under the workingcapital line is payable monthly and is calculated at Silicon Valley Bank’sprime rate of 4.0% plus 0.50% percentage points as of December 31, 2004,interest rates ranged from 6% to 9.25%. Borrowings under the working capitalline are due in October 21, 2006, or earlier as required by borrowinglimits defined in the agreement. Principal and interest is payable monthly forborrowings related to equipment purchases. In November 2004 and February 2005,the Company drew down approximately $1.5 million and $550,000,respectively, under this loan and security agreement.

 

**NOTE 6—OPERATINGSEGMENT AND GEOGRAPHIC INFORMATION:**

 

TheCompany operates in one segment, comprising the design, development andmarketing of semiconductors.

 

Long-livedassets outside of the United States are insignificant.

 

10

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Thefollowing table summarizes net revenue on a percentage basis by geographicregion, based on the country in which the customer is located:

 
| ** **    | ** ** | **Three months ended********September 30,** | ** ** | **Nine months ended********September 30,** | ** ** |
|---------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **    | ** ** | **2005**                                         | ** ** | **2004**                                        | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **    | ** ** | ** **                                       | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Japan         |       | 76                                               | %          | 74                                              | %          | 73 | % | 69 | % |
| Korea         |       | 21                                               |       | 22                                              |       | 24 |   | 27 |   |
| Other         |       | 3                                                |       | 4                                               |       | 3 |   | 4 |   |
|          |       |                                             |       |                                            |       |   |   |   |   |
| Total revenue |       | 100                                              | %          | 100                                             | %          | 100 | % | 100 | % |

 

11

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**Item 2:Management’s Discussion and Analysis of Financial Condition and Results ofOperations**

 

**MANAGEMENT’S DISCUSSION AND ANALYSIS**

**OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

*This discussion contains forward-looking statements withinthe meaning of Section 27A of the Securities Act of 1933 and Section 21Eof the Securities Exchange Act of 1934. Actual results could differ materiallyfrom those projected in the forward-looking statements as a result of a numberof factors, risks and uncertainties, including the risk factors set forth inthis discussion, as more fully 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. We expressly disclaim anyobligation to update or alter our forward-looking statements, whether, as aresult of new information, future events or otherwise.*

 

*The following discussion and analysis should be read inconjunction with the condensed financial statements and notes thereto in Item 1above and with our financial statements and notes thereto for the year ended December 31,2004, contained in our Prospectus relating to our recent initial publicoffering of our common stock*

 

**Overview**

 

Weare a leading developer and provider of highly programmable semiconductors thatenable fiber-fast broadband services over carriers’ existing copper lines. Wehave developed these semiconductors using our proprietary semiconductordesigns, specific purpose digital signal processor and advanced mixed-signalsemiconductor design capabilities. We offer multiple product lines that aredesigned to address different segments of the fiber-fast broadbandcommunications semiconductor market for both carrier networks and subscriberpremise equipment. We outsource all of our semiconductor fabrication, assemblyand test functions, which enables us to focus on design, development, sales andmarketing of our products and reduces the level of our capital investment.

 

Wewere incorporated in April 1999 and through December 31, 2001, wewere engaged principally in research and development. We began commercialshipment of our products in the fourth quarter of 2002. Over the last twoyears, we have experienced significant net revenue growth, primarily due to arapid rise in deployments of our products in Japan and Korea. Our net revenuehas increased from $19.1 million for the 12-month period ended September 30,2003, to $61.3 million for the 12-month period ended September 30, 2004and $75.0 million for the 12-month period ended September 30, 2005.Our growth, however, can fluctuate on a quarterly basis. For instance, in thefirst quarter of 2005, our net revenue decreased $6.2 million or 33.4%from the fourth quarter of 2004, yet in the subsequent quarter, the secondquarter of 2005, our net revenue increased $7.0 million or 56.6% from thefirst quarter of 2005. As a result revenue for the nine months ended September 30,2005 was $56.5 million as compared to $48.2 million for the nine monthsended September 30, 2004, an increase of $8.3 million, or 17.2%. Quarterlyfluctuations in net revenue are characteristic of our industry, as carrierspurchase equipment based on expected deployment and OEMs manufactureequipment occasionally at rates higher than equipment is deployed. As a result,periodically and usually without significant notice, carriers will reduce ordersfor new equipment and OEMs will reduce orders for our products, which willadversely impact the quarterly demand for our products, even when deploymentrates may be increasing. For example, our two largest customers in Japansignificantly reduced orders for our chipsets for the quarter ended March 31,2005 and subsequently reinitiated orders for the quarter ended June 30,2005.

 

Grossmargin (which we define as net revenue less cost of revenue divided by netrevenue) has increased as we have introduced new products with lower per portcosts, higher functionality and, at times, higher per port selling prices. Our grossmargin increased from 36.7% for the nine months ended September 30, 2004to 54.2% for the nine months ended September 30, 2005.

 

In September 2005, we completed ourinitial public offering. Aggregate net proceeds from the offering, afterdeducting underwriting discounts and commission and issuance costs, were $67.9million. We also had 15,311,840 shares of redeemable convertible preferred stockoutstanding that automatically converted into 15,311,840 shares of our commonstock upon the closing of the initial public offering in September 2005.

 

*Net loss.*     As of September 30, 2005, we had anaccumulated deficit of $90.6 million and a total stockholders’ equity of$97.6 million. For the nine month period ended September 30, 2005 ascompared to the nine month period ended September 30, 2004, our net lossdecreased as our gross margin increased while our research and development andselling, general and administrative expenses increased as a percentage ofrevenue.

 

*Net revenue.*    Our net revenue is primarily derived from salesof our chipset products. Net revenue from product sales are generallyrecognized upon shipment, net of sales returns, rebates and allowances. As istypical in our industry, the selling prices of our products generally declineover time. Therefore, our ability to increase net revenue is dependent upon ourability to increase unit sales volumes of existing products and to introduceand sell new products in greater quantities. Our ability to increase unit salesvolume is dependent primarily upon our ability to increase and fulfill currentcustomer demand and obtain new customers.

 

Wesell our products to OEMs through a combination of our direct sales forceand third-party sales representatives. Sales are generally made undershort-term non-cancelable purchase orders. We also have volume purchaseagreements with certain customers who provide us with non-binding forecasts.Although our OEM customers may provide us with rolling forecasts, our abilityto predict future sales in any given period is limited and subject to changebased on demand for our OEM customers’ systems and their supply chaindecisions.

 

Historically,a small number of customers have accounted for a substantial portion of our netrevenue, and we expect that significant customer concentration will continuefor the foreseeable future. The following OEMs accounted for more than 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 nine  months  ended September 30,** | ** ** |
|-------------------------------------|------------|--------------------------|------------|-------------------------------------------------------------------------------|------------|
| **OEM  Customer**                   | ** ** | **Sales Representative** | ** ** | **2005**                                                                      | ** ** | **2004** | ** ** |
| NEC Corporation  (Magnus)           |       | NEC Corporation (USA)    |       | 46.0                                                                          | %          | 46.2 | % |
| Sumitomo Electric  Industries, Ltd. |       | Altima                   |       | 26.6                                                                          |       | 20.6 |   |
| Dasan Networks, Inc.           |       | Uniquest Corporation     |       | 17.5                                                                          |       | 14.6 |   |

 

Substantiallyall of our sales are to customers outside the United States. Sales to customersin Asia accounted for  99.4% and 96.8% forthe nine months ended

 

12

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September 30,2005 and 2004, respectively. We anticipate that a majority of our net revenuewill continue to be represented by sales to customers outside the UnitedStates. All of our sales to date have been denominated in U.S. dollars.

 

**Critical Accounting Policies and Estimates**

 

Ourdiscussion and analysis of our financial condition and the results ofoperations are based on our consolidated financial statements that have beenprepared in accordance with accounting principles generally accepted in theUnited States, or GAAP. The preparation of these consolidated financialstatements requires us to make estimates and judgments that affect the reportedamounts of assets, liabilities, revenues and expenses. On an ongoing basis, weevaluate our estimates, including those related to revenue recognition, baddebts, warranty obligations, inventories and income taxes. We base ourestimates on historical experience and on various other assumptions that webelieve to be reasonable under the circumstances, the results of which form thebasis for making judgments about the carrying values of assets and liabilitiesthat are not readily apparent from other sources. Actual results may differfrom these estimates under different assumptions or conditions.

 

For a discussion of our critical accountingpolicies, see “Critical Accounting Policies, Significant Judgments andEstimates” in “Management’s Discussion and Analysis of Financial Condition andResults of Operations” in our prospectus filed with the SEC on September 21,2005.

 

**Results of Operations**

 

Thefollowing table sets forth our financial results, as a percentage of revenue,for the three and nine months ended September 30, 2005 and 2004:

 
| ** **                           | ** ** | **Three months Ended  September 30** | ** ** | **Nine months Ended   September 30** | ** ** |
|--------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                           | ** ** | **2005**                                  | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                           | ** ** | ** **                                | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net revenue                          |       | 100                                       | %          | 100                                       | %          | 100 | % | 100 | % |
| Costs and expenses:                  |       |                                      |       |                                      |       |   |   |   |   |
| Cost  of revenue                     |       | 43.6                                      |       | 52.8                                      |       | 45.8 |   | 63.3 |   |
| Research  and development            |       | 24.3                                      |       | 31.4                                      |       | 31.5 |   | 31.5 |   |
| Selling,  general and administrative |       | 11.8                                      |       | 13.4                                      |       | 14.8 |   | 14.0 |   |
| Stock-based  compensation            |       | 8.3                                       |       | 7.3                                       |       | 10.6 |   | 7.9 |   |
| Operating income(loss)               |       | 12.0                                      |       | (4.9                                      | )          | (2.7 | ) | (16.7 | ) |
| Interest and other income,  net      |       | 0.3                                       |       | 0.2                                       |       | 0.5 |   | 0.1 |   |
| Net income(loss)                     |       | 12.3                                      |       | (4.7                                      | )          | (2.2 | ) | (16.6 | ) |

 

**Comparison of Three Months Ended September 30, 2005 toThree Months ended September 30, 2004**

 

*Net revenue.*    Net revenue was $25.0 million for the threemonths ended September 30, 2005, as compared to $18.0 million for thethree months ended September 30, 2004, an increase of $7.0 million, or38.9%. The increase in our net revenue was the result of increased portshipments offset by slight decreases in average selling prices per port.

 

*Gross Margin.*Gross margin (which we define as net revenueless cost of revenue divided by net revenue) was 56.4% for the three monthsended September 30, 2005, as compared to 47.2% for the three months ended September 30,2004. The increase in gross margin was primarily due to the sales of newproducts during the three months ended September 30, 2005. These newproducts had a lower manufacturing cost per port than products sold in thecorresponding period in 2004.

 

*Research and development expenses.*    Research anddevelopment expenses were $6.1 million for the three months ended September 30,2005, as compared to $5.7 million for the three months ended September 30,2004, an increase of $400,000, or 7.0%. Depreciation expense increased by$215,000 in the three months ended September 30, 2005 as compared to thecorresponding period in 2004 due to $3.4 million in purchases of fixedassets subsequent to September 30, 2005. Personnel expenses increased by$250,000 due to an increase in headcount of 49% in the three months ended September 30,2005 as compared to the corresponding period in 2004.

 

*Selling, general and administrative expenses.*    Selling, general andadministrative expenses were $3.0 million for the three months ended September 30,2005, as compared to $2.4 million for the three months ended September 30,2004, an increase of $600,000, or 25.0%. This increase was primarily due tohigher compensation costs of $635,000 related to a 30% increase in headcount inthe nine months ended September 30, 2005 as compared to the correspondingperiod in 2004.

 

*Stock-based compensation expense.*    Stock-basedcompensation expense was $2.1 million for the three months ended September 30,2005, as compared to $1.3 million for the three months ended September 30,2004, an increase of $800,000, or 61.5%. The increase was primarily due to thestock option exchange program completed in the first quarter of 2005 as well asexpense relating to new options granted subsequent to September 30, 2004.  Asa result of the exchange, the related options are now subject to variableaccounting and are marked-to-market at the end of each period. To the extentour share price increases or decreases in future periods, the related stockcompensation expense will increase or decrease.

 

*Interest and other income, net.*    Net interest incomewas $77,000 in the three months ended September 30, 2005, as compared tonet interest income of $48,000 in the three months ended September 30,2004. The increase was due to higher average balances of cash and cashequivalents.

 

*Net Income (loss).*    Net income was $3.1million in the three months ended September 30, 2005, as compared to a netloss of $844,000 in the three months ended September 30, 2004, an increaseof $3.9 million.

 

**Comparison of Nine Months Ended September 30, 2005 toNine Months ended September  30, 2004**

 

*Net revenue.*    Net revenue was $56.5 million for the ninemonths ended September 30, 2005, as compared to $48.2 million for the ninemonths ended September 30, 2004, an increase of $8.3 million, or 17.2%. Inthe nine months ended September 30, 2005, we experienced significantsequential quarterly volatility as our net revenue

 

13

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inthe first quarter of 2005 decreased 33.4% from the fourth quarter of 2004, andthen increased by 56.6% in the second quarter of 2005 from the first quarter of2005 and 30% in the third quarter of 2005 from the second quarter of 2005. Thisvolatility was primarily due to our two largest customers in Japansignificantly reducing orders for our products for the quarter ended March 31,2005 and subsequently reinitiating orders for the quarters ended June 30and September 30, 2005.

 

*Gross Margin.*Gross margin (which we define as net revenueless cost of revenue divided by net revenue) was 54.2% for the nine monthsended September 30, 2005 as compared to 36.7% for the nine months ended September 30,2004. The increase in gross margin was primarily due to the sales of newproducts during the nine months ended September 30, 2005. These newproducts had a lower manufacturing cost per port than products sold in thecorresponding period in 2004.

 

*Research and development expenses.*    Research anddevelopment expenses were $17.8 million for the nine months ended September 30,2005, as compared to $15.2  million forthe nine months ended September 30, 2004, an increase of $2.6 million, or17.1%. Depreciation expense increased by $731,000 in the nine months ended September 30,2005 as compared to the corresponding period in 2004 due to $3.4 millionin purchases of fixed assets subsequent to September 30, 2005. Personnelexpenses increased by $1.2 million due to an increase in headcount of 49% inthe nine months ended September 30, 2005 as compared to the correspondingperiod in 2004.

 

*Selling, general and administrative expenses.*    Selling, general andadministrative expenses were $8.4 million for the nine months ended September 30,2005, as compared to $6.8 million for the nine months ended September 30,2004, an increase of $1.6 million, or 23.5%. This increase was primarily due tohigher compensation costs of $2.0 million related to a 63% increase inheadcount in the nine months ended September 30, 2005 as compared to thecorresponding period in 2004. This was partially offset by a reduction inexternal commission expenses of $637,000, as we replaced externalrepresentatives with full-time employees.

 

*Stock-based compensation expense.*    Stock-basedcompensation expense was $6.0 million for the nine months ended September 30,2005, as compared to $3.8 million for the nine months ended September 30,2004, an increase of $2.2 million, or 57.9%. The increase was primarily due tothe stock option exchange program completed in the first quarter of 2005 aswell as expense relating to new options granted subsequent to September 30,2004. As a result of the exchange, the related options are now subject tovariable accounting and are marked-to-market at the end of each period. To theextent our share price increases or decreases in future periods, the relatedstock compensation expense will increase or decrease.

 

*Interest and other income, net.*    Net interest incomewas $262,000 in the nine months ended September 30, 2005, as compared tonet interest income of $68,000 in the nine months ended September 30,2004. The increase was due to higher average balances of cash and cashequivalents.

 

*Net loss.*    As a result of the above factors, we had a netloss of $1.2 million in the nine months ended September 30, 2005, ascompared to a net loss of $8.0  million in the nine months ended September 30,2004, a decrease of $6.8 million, or 85.0%.

 

**Liquidity and Capital Resources**

 

Weended the third quarter of 2005 with $98.7 million in cash and cash equivalentsas compared to $25.4 million at December 31, 2004, an increase of $73.3million. This increase was primarily due to the $68.9 million of net proceedsraised in our initial public offering (excluding approximately $960,000 ofissuance costs which have been accrued but not yet paid as of September 30,2005). We expect to finance our operations primarily through operating cashflows and cash balances.

 

Weexpect to grow our operating expenses as we continue to execute our businessstrategy. This increase in operating expenses may not result in an increase inour revenue and our anticipated revenue may not be sufficient to support theseincreased expenditures. We anticipate that operating expenses and workingcapital will constitute a material use of our cash and cash equivalents.

 

Thefollowing table summarizes our statement of cash flows for the nine monthsended September 30, 2005 and 2004:

 
| ** **                                             | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                             | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
| **Statements of Cash Flows Data:**                     |       |                                      |       |   |   |
| Net cash provided by  operating activities             |       | $                                         | 7,959      |   | $ | 446 |   |
| Net cash used in  investing activities                 |       | (2,052                                    | )          | (2,657 | ) |
| Net cash provided by  financing activities             |       | 67,392                                    |       | 16,393 |   |
| Effect of exchange  rates on cash and cash equivalents |       | (16                                       | )          | (8 | ) |
| Net increase in cash  and cash equivalents             |       | 73,283                                    |       | 14,174 |   |
| Cash and cash  equivalents—Beginning of period    |       | 25,428                                    |       | 11,236 |   |
|                                                   |       |                                      |       |   |   |
| Cash and cash  equivalents—End of period          |       | $                                         | 98,711     |   | $ | 25,410 |   |

 

*Operating Activities*

 

Forthe nine months ended September 30, 2005, net cash provided by operatingactivities of $8.0 million resulted from a net loss of $1.2 million that wasoffset by $6.0 million of non-cash charges for amortization of stock basedcompensation and $2.0 million for depreciation of property and equipment.  Inaddition, for the nine months ended September 30, 2005, cash was used inoperating activities to fund increases in accounts receivable of $4.1 milliondue primarily to the timing of our sales and subsequent collections, This wasoffset by an increase in accounts payable and accrued liabilities of $1.7 milliondue to timing of inventory purchases, decrease of inventory by $2.6 million anddecrease in other assets of $1.0 million. We anticipate that accountsreceivable, inventory and accounts payable will increase to the extent ourbusiness expands.

 

*Investing Activities*

 

Ourinvesting activities used net cash of $2.1 million in the nine months ended September 30,2005, as compared to $2.7 million during the nine months ended September 30,2004. Cash used in investing activities in the nine months ended September 30,2005 and 2004 related primarily to the acquisition of property and equipment.We anticipate that our capital expenditures will be approximately $4.0 to $6.0million over the next 12 months.

 

14

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*Financing Activities*

 

Ourfinancing activities provided $67.4 million in the nine months ended September 30,2005, as compared to $16.4 million during the nine months ended September 30,2004. Cash generated by financing activities during the nine months ended September 30,2004 was primarily due to the completion of our initial public offering inwhich we raised $67.9 million of net proceeds. Cash provided by financingactivities during the nine months ended September 30, 2004 was primarilydue to the issuance of convertible preferred stock partially offset byrepayment of capital leases.

 

OnOctober 21, 2004, we entered into a loan and security agreement withSilicon Valley Bank that provides for an up to $5.0 million revolving lineof credit and a $2.0 million equipment financing facility. As of September 30,2005, we had no balance outstanding under the revolving line of credit and $1.6million outstanding under the equipment financing facility.

 

Therevolving line of credit can be used to (1) borrow revolving loans forworking capital requirements, (2) issue letters of credit, (3) enterinto foreign exchange forward contracts and (4) support cash managementservices. Revolving loans will bear interest at a floating rate of interestequal to Silicon Valley Bank’s prime rate plus 0.50% and equipment loans bearinterest at a fixed rate of interest equal to Silicon Valley Bank’s prime rateplus 1.00%. So long as the amount of our unrestricted cash and cash equivalentsless outstanding 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.

 

OnOctober 21, 2006, the revolving line of credit matures and Silicon ValleyBank’s commitment to extend revolving loans terminates.

 

Therevolving and equipment loans under the loan and security agreement arecollateralized by a first priority lien on substantially all of our assets,excluding intellectual property. The loan and security agreement requires us tomaintain a profitability covenant and a minimum quick ratio of not less than1.15 to 1.00. Quick ratio means the ratio of the sum of unrestricted cash andcash equivalents and accounts receivable to current liabilities. In addition,we are required to comply with covenants that limit our ability to, among otherthings, dispose of assets, make acquisitions, be acquired, incur indebtedness,grant liens, make investments, pay dividends or repurchase stock.

 

Theloan and security agreement includes events of default that, include amongother things, non-payment of principal, interest or fees, violation ofcovenants, inaccuracy of representations and warranties, cross-default tocertain other indebtedness, bankruptcy and insolvency events, change of controland material judgments. The occurrence of an event of default could result inthe acceleration of our obligations under the loan and security agreement andforeclosure on the collateral securing our obligations under the loan andsecurity agreement. We were not in compliance with the minimum profitabilityfinancial covenant during the quarter ended March 31, 2005. Silicon ValleyBank agreed to forebear its rights to call the equipment financing facility asa result of the non-compliance. This forbearance pertains to the covenantviolation during the quarter ended March 31, 2005 in perpetuity; however,it does not extend to any future non-compliance with covenants. Based onexpected future operating results, we believe we will continue to be in fullcompliance with the amended covenants for at least 12 months from thebalance sheet date. Accordingly, we have classified the amounts due under thefacility beyond 12 months from the balance sheet date as non-current.

 

Webelieve that our existing cash, cash equivalents and cash flow expected to begenerated from future operations will be sufficient to meet our anticipatedcash needs for at least the next 12 months. Our future capitalrequirements will depend on many factors including our rate of net revenuegrowth, the timing and extent of spending to support development efforts, theexpansion of sales and marketing activities, the timing of introductions of newproducts and enhancements to existing products, the costs to ensure access toadequate manufacturing capacity and the continuing market acceptance of ourproducts. Although we are currently not a party to any agreement or letter ofintent with respect to potential investments in, or acquisitions of,complementary businesses, products or technologies, we may enter into thesetypes of arrangements in the future, which could also require us to seekadditional equity or debt financing. The sale of additional equity securitiesor convertible debt securities would result in additional dilution to ourstockholders. Additional debt would result in increased interest expenses andcould result in covenants that would restrict our operations. We have not madearrangements to obtain additional financing and there is no assurance that suchfinancing, if required, will be available in amounts or on terms acceptable tous, if at all.

 

*Contractual Commitments and off-balance sheet arrangements*

 

Asof September 30, 2005, we have no off-balance sheet arrangements asdefined in Item 303(a)(4) of the SEC’s Regulation S-K.

 

Thefollowing table summarizes our contractual obligations at September 30,2005 and the effect those obligations are expected to have on our liquidity andcash 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      |       | $                         | 758        |   | $ | 494 |   | $ | 264 |   | $ | — |   |
| Operating leases                |       | 986                       |       | 410 |   | 364 |   | 212 |   |
| Notes payable                   |       | 1,593                     |       | 687 |   | 906 |   | — |   |
| Inventory purchase  obligations |       | 6,426                     |       | 6,426 |   | — |   | — |   |
|                            |       |                      |       |   |   |   |   |   |   |
| Total                           |       | $                         | 9,763      |   | $ | 8,017 |   | $ | 1,534 |   | $ | 212 |   |

 

Forthe purpose of this table, purchase obligations for the purchase of goods orservices are defined as agreements that are enforceable and legally binding andthat specify all significant terms, including: fixed or minimum quantities tobe purchased; fixed, minimum or variable price provisions; and the approximatetiming of the transaction. Our purchase orders are based on our currentmanufacturing needs and are fulfilled by our vendors within short timehorizons. In addition, we have purchase orders that represent authorizations topurchase rather than binding agreements. We do not have significant agreementsfor the purchase of raw materials or other goods specifying minimum quantitiesor set prices that exceed our expected requirements.

 

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**Risk Factors**

 

*Investingin our common stock involves a high degree of risk. You should carefullyconsider the following risk factors, as well as the other information in this quarterlyreport, before deciding whether to invest in shares of our common stock.*

 

***Risks Related to Our Business***

 

**We havea limited operating history and our quarterly operating results may fluctuatesignificantly. As a result, we may fail to meet or exceed our forecasts or theexpectations of securities analysts or investors, which could cause our stockprice to decline.**

 

We have a limitedoperating history which makes it difficult to evaluate our prospects. While ourcommercial operations began in 1999, we did not begin commercial shipments ofour products until the fourth quarter of 2002. Since then, our quarterly netrevenue and operating results have varied significantly and are likely tocontinue to vary from quarter to quarter due to a number of factors, many ofwhich are not within our control. For example, in the quarter ended March 31,2005, our net revenue decreased by $6.2 million, or 33.4%, from theprevious 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 our industry, and are likelyto continue in the future. In addition, our expenses are also subject toquarterly fluctuations resulting from factors including the costs related tonew product releases and variable stock-based compensation charges related tothe modification of the exercise price of previously granted options. If ouroperating results do not meet the expectations of securities analysts orinvestors for any quarter or other reporting period, the market price of ourcommon stock may decline. Fluctuations in our operating results may be due to anumber of factors, including, but not limited to, those identified throughoutthis “Risk Factors” section. As a result, you should not rely on quarter toquarter comparisons of our operating results as an indicator of futureperformance.

 

**We haveincurred net losses since our inception and may incur losses in the future. Wemay not be able to generate sufficient net revenue in the future to achieve orsustain profitability.**

 

We have incurredsignificant net losses since our inception and, at September 30, 2005, wehad an accumulated deficit of $90.6 million. To achieve or sustainprofitability, we will need to generate and sustain higher net revenue whilemaintaining reasonable cost and expense levels. We expect to increase expenselevels to support increased research and development efforts related to new andexisting product development and sales and marketing efforts. Because many ofour expenses are fixed in the short term, or are incurred in advance ofanticipated sales, we may not be able to decrease our cost and expenses in atimely manner to offset any shortfall of sales. We may not be able to achieveprofitability at all, and even if we achieve profitability, we may not be ableto sustain or increase profitability on a quarterly or an annual basis.

 

**Ifdemand for our chipsets declines or does not grow, we will be unable toincrease or sustain our net revenue and our operating results will be severelyharmed.**

 

We derive substantiallyall of our net revenue from the sale of chipsets for the fiber-fast broadbandmarket. We currently expect our chipsets to account for substantially all ofour net revenue for the foreseeable future. If we are unable to develop newproducts to meet our customers’ demand in a timely manner or demand for ourchipsets declines or fails to grow as a result of competition or technologicalchanges, it would harm our business. The markets for our products arecharacterized by frequent introduction of new chipsets, short product lifecycles and significant price competition. If we or our OEM customers are unableto manage product transitions in a timely and cost-effective manner, our netrevenue would suffer. In addition, frequent technology changes and introductionof next generation products may result in inventory obsolescence, which wouldincrease our cost of revenue and adversely affect our operating performance.

 

**Theaverage selling prices of our products are subject to rapid declines, which mayharm our net revenue and profitability.**

 

The products we developand sell are used for high volume applications and are subject to rapiddeclines in average selling prices. We have lowered our prices significantly attimes to gain market share, and we expect that we will continue to reduceprices in the future. Offering reduced prices to one customer could impact ouraverage selling prices to all customers. Our financial results will suffer ifwe are unable 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. We expect to increase our research and development expenses todevelop future products and increase spending on our sales and marketingefforts. This continued spending would have an adverse impact on our operatingresults if our net revenue does not continue to grow faster than our cost ofrevenue or expenses.

 

**Becausewe depend on a few significant customers for a substantial portion of our netrevenue, the loss of any of our key customers, our inability to continue tosell existing and new products to our key customers in significant quantitiesor our failure to attract new significant customers could adversely impact ournet revenue and harm our business.**

 

We derive a substantialportion of our net revenue from sales to a relatively small number ofcustomers. As a result, the loss of any significant customer or a decline inbusiness with any significant customer would materially and adversely affectour financial condition and results of operations. The following OEM customersaccounted for more than 10% of our net revenue for any one of the periods

 

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indicated. Sales made tothese OEMs were made through the indicated third-party salesrepresentatives:

 
| ** **                          | ** ** | ** **               | ** ** | **Percentage of our net  revenue for nine  months  ended September 30,** | ** ** |
|-------------------------------------|------------|--------------------------|------------|-------------------------------------------------------------------------------|------------|
| **OEM  Customer**                   | ** ** | **Sales Representative** | ** ** | **2005**                                                                      | ** ** | **2004** | ** ** |
| NEC Corporation  (Magnus)           |       | NEC Corporation (USA)    |       | 46.0                                                                          | %          | 46.2 | % |
| Sumitomo Electric  Industries, Ltd. |       | Altima                   |       | 26.6                                                                          |       | 20.6 |   |
| Dasan Networks, Inc.           |       | Uniquest Corporation     |       | 17.5                                                                          |       | 14.6 |   |

 

We expect that a smallgroup of OEM customers, the composition of which has varied over time, willcontinue to account for a substantial portion of our net revenue in 2005 and inthe foreseeable future. Accordingly, our future operating results will continueto depend on the success of our largest OEM customers and on our ability tosell existing and new products to these customers in significant quantities.Demand for our chipset products is based on carrier demand for our OEMcustomers’ systems products. Accordingly, a reduction in growth of carrierdeployment of fiber-fast broadband services would adversely affect our productsales and business.

 

In addition, ourlongstanding relationships with some of our larger OEM customers may also deterother potential customers who compete with these customers from buying ourproducts. To attract new customers or retain existing OEM customers, we haveoffered and may continue to offer certain customers favorable prices on ourproducts. If these prices are lower than the prices paid by our existing OEMcustomers, we may have to offer the same lower prices to certain of ourcustomers. In that event, our average selling prices would decline. The loss ofa key customer, a reduction in sales to any major customer or our inability toattract new significant customers could harm our business.

 

**We relyon a limited number of independent subcontractors to manufacture, package andtest our current products, and our failure to secure and maintain sufficientcapacity with these subcontractors could impair our relationships with customersand decrease sales, which would negatively impact our market share andoperating results.**

 

We are a fablesssemiconductor company in that we do not own or operate a fabrication ormanufacturing facility. Five outside factory subcontractors located in Taiwan,Austria, Malaysia and Singapore manufacture, assemble and test all of oursemiconductor devices in current production, two of which are also our waferfoundries. In past periods of high demand in the semiconductor market, we haveexperienced delays in meeting our capacity demand and as a result were unableto deliver products to our customers on a timely basis. In addition, we haveexperienced similar delays due to technical and quality control problems at oursubcontractors’ facilities. In the future, if any of these events occur, or ifthese facilities suffer any damage, power outages, financial difficulties orany other disruption, we may be unable to meet our customer demand on a timelybasis, or at all, and may need to successfully qualify an alternative facilityin a timely manner in order to not disrupt our business. We typically requireseveral months or more to qualify a new facility or process before we can beginshipping products. If we cannot accomplish this qualification in a timely manner,we would experience a significant interruption in supply of the affectedproducts. If we are unable to secure sufficient capacity at our subcontractors’existing facilities, or in the event of a closure or significant delay at anyof these facilities, our relationships with our customers would be harmed andour market share and operating results would suffer as a result. In addition,we do not have formal pricing agreements with our subcontractors regarding thepricing for the products and services that they provide us. If their pricingfor the products and services they provide increases and we are unable to passalong such increases to our OEM customers, our operating results would beadversely affected.

 

**Whendemand for manufacturing capacity is high, we may take various actions to tryto secure sufficient capacity, which may be costly and negatively impact ouroperating results.**

 

The ability of each ofour subcontractors’ manufacturing facilities to provide us with semiconductorsis limited by its available capacity and existing obligations. Although we havepurchase order commitments to supply specified levels of products to our OEMcustomers, we do not have a guaranteed level of production capacity from any ofour subcontractors’ facilities that we depend on to produce our semiconductors.Facility capacity may not be available when we need it or at reasonable prices.We place our orders on the basis of our OEM customers’ purchase orders or ourforecast of customer demand, and our subcontractors may not be able to meet ourrequirements in a timely manner. For example, in 2003 and the first nine monthsof 2004, general market conditions in the semiconductor industry resulted in asignificant increase in demand at these facilities. The demand for our OEM customers’products increased significantly and we were asked to produce significantlyhigher quantities than in the past and to deliver on short notice. In addition,our subcontractors have also allocated capacity to the production of othercompanies’ products and reduced deliveries to us on short notice. It ispossible that our subcontractors’ other customers that are larger and betterfinanced than we are, or that have long-term agreements with oursubcontractors, may have induced our subcontractors to reallocate capacity tothem. If this reallocation occurred again, it could impair our ability todeliver products on a timely basis.

 

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Although we use twoindependent wafer foundries to manufacture all of our semiconductor products,each of our products is designed to be manufactured in a specific process atonly one of these wafer foundries. Accordingly, if one of these wafer foundriesis unable to provide us with semiconductors as needed, we could experience significantdelays in securing sufficient supplies of those semiconductors. We cannotassure you that any of the existing or new wafer foundries that we use will beable to produce semiconductor devices with acceptable manufacturing yields, orthat the wafer foundries will be able to deliver enough devices to us on atimely basis, or at reasonable prices. This could impair our ability to meetour OEM customers’ needs.

 

In order to securesufficient manufacturing facility capacity when demand is high and mitigate therisks described in the foregoing paragraphs, we may enter into variousarrangements with subcontractors that could be costly and harm our operatingresults, including:

 

•                  optionpayments 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;

 

•                  issuanceof our equity securities to a subcontractor; and

 

•                  othercontractual relationships with subcontractors.

 

We may not be able tomake any such arrangements in a timely fashion or at all, and any arrangementsmay be costly, reduce our financial flexibility and not be on terms favorableto us. Moreover, if we are able to secure facility capacity, we may beobligated to use all of that capacity or incur penalties. These penalties andobligations may be expensive and require significant capital and could harm ourbusiness.

 

**If oursubcontractors’ manufacturing facilities do not achieve satisfactory yields orquality, our relationships with our customers and our reputation will be harmedand, if this were to occur, our net revenue and operating income could declineand our cost of revenue as a percentage of net revenue could increase.**

 

The fabrication ofsemiconductors is a complex and technically demanding process. Minor deviationsin the manufacturing process can cause substantial decreases in yields, and insome cases, cause production to be stopped or suspended. Although we workclosely with our subcontractors to minimize the likelihood of reducedmanufacturing yields, their facilities have from time to time experienced lowerthan anticipated manufacturing yields that have resulted in our inability tomeet our customer demand. It is not uncommon for yields in semiconductorfabrication facilities to decrease in times of high demand, in addition toreduced yields that may result from normal wafer lot loss due to workmanship oroperational problems at these facilities. When these events occur, especiallysimultaneously, as happens from time to time, we may be unable to supply ourcustomers’ demand. Many of these problems are difficult to detect at an earlystage of the manufacturing process and may be time consuming and expensive to correct.In addition, because we purchase wafers, our exposure to low wafer yields fromour subcontractors’ 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 by thetesting 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 baseorders for inventory on our forecasts of our OEM customers’ demand and if ourforecasts are inaccurate, our financial condition and liquidity would suffer.**

 

We place orders with oursuppliers based on our forecasts of our OEM customers’ demand. Our forecastsare based on multiple assumptions, each of which may introduce errors into ourestimates. In the past, when the demand for our OEM customers’ productsincreased significantly, we were not able to meet demand on a timely basis, andwe expended a significant amount of time working with our customers to allocatelimited supply and maintain positive customer relations. If we underestimatecustomer demand, we may forego revenue opportunities, lose market share anddamage our customer relationships. Conversely, if we overestimate customerdemand, we may allocate resources to manufacturing products that we may not beable to sell when we expect to or at all. As a result, we would have excess orobsolete inventory, resulting in a decline in the value of our inventory, whichwould increase our cost of revenue. Our failure to accurately manage inventoryagainst demand would adversely affect our financial results.

 

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**Toremain competitive, we need to continue to transition our semiconductor chipsto increasingly smaller sizes, and our failure to do so may harm our business.**

 

We periodically evaluatethe benefits, on a product-by-product basis, of migrating to smaller chips,which are measured in microns and referred to as geometry processes. We havedesigned our products to be manufactured in 0.8 micron, 0.25 micron, 0.18micron and 0.13 micron geometry processes. We are currently migrating some ofour products to even smaller 90-nanometer geometry process technology, and overtime, we are likely to migrate to even smaller geometries. The smaller chipsize reduces our production and packaging costs, which enables us to becompetitive in our pricing. The transition to smaller geometries requires us towork with our subcontractors to modify the manufacturing processes for ourproducts and to redesign some products. In the past, we have experienced somedifficulties in shifting to smaller geometry process technologies or newmanufacturing processes, which resulted in reduced manufacturing yields, delaysin product deliveries and increased expenses. We may face similar difficulties,delays and expenses as we continue to transition our products to smallergeometry processes, all of which could harm our relationships with ourcustomers, and our failure to do so would impact our ability to providecompetitive prices to our customers, which would have a negative impact on oursales.

 

**We faceintense competition in the semiconductor industry and the broadbandcommunications markets, which could reduce our market share and negativelyimpact our net revenue.**

 

The semiconductorindustry and the broadband communications markets are intensely competitive. Wecurrently compete or expect to compete with Broadcom Corporation, CentilliumCommunications, Inc., Conexant Systems, Inc., Infineon TechnologiesA.G., Metalink Ltd., STMicroelectronics N.V. and Texas InstrumentsIncorporated, which companies, we believe, have experience in VDSL, orVDSL-like, technology. We expect competition to continue to increase.Competition has resulted and may continue to result in declining averageselling prices for our products and reduced volume.

 

We consider othercompanies that have access to discrete multi-tone, or DMT, technology aspotential competitors in the future, and we also may face competition fromnewly established competitors, suppliers of products based on new or emergingtechnologies and customers may choose to develop their own chipsets. To remaincompetitive, we need to provide products that are designed to meet ourcustomers’ needs. Our fiber-fast broadband products must:

 

•                  achieveoptimal product performance;

 

•                  complywith industry standards;

 

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

 

•                  meetfunctional specifications;

 

•                  beintroduced timely to the market; and

 

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

 

Many of our competitorsoperate their own fabrication facilities or have stronger manufacturing partnerrelationships than we have. In addition, many of our competitors have extensivetechnology libraries that could enable them to incorporate fiber-fast broadbandtechnologies into a more attractive product line than ours. Many of them alsohave longer operating histories, greater name recognition, larger customerbases, and significantly greater financial, sales and marketing, manufacturing,distribution, technical and other resources than we do. These competitors maybe able to adapt more quickly to new or emerging technologies and changes incustomer requirements. In addition, current and potential competitors haveestablished or may establish financial or strategic relationships amongthemselves or with existing or potential customers, resellers or other thirdparties. Accordingly, new competitors or alliances among competitors couldemerge and rapidly acquire significant market share. Existing or newcompetitors may also develop technologies that more effectively address ourmarkets with products that offer enhanced features and functionality, lowerpower requirements, greater levels of semiconductor integration or lower cost.We cannot assure you that we will be able to compete successfully againstcurrent or new competitors, in which case we may lose market share in ourexisting markets and our net revenue may fail to increase or may decline.

 

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**Otherdata transmission technologies may compete effectively with the carrierservices addressed by our products, which could adversely affect our productsales and business.**

 

Our net revenue isdependent on the increase in demand for carrier services that use fiber-fastbroadband. These services 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 maybe unable to attract, retain and motivate key senior management and technicalpersonnel, which could harm our development of technology and ability to becompetitive.**

 

Our future successdepends to a significant extent upon the continued service of our keypersonnel, including our President and Chief Executive Officer, Rajesh Vashist,and our other senior executives and key technical personnel. We do not haveemployment agreements with any of these executives, except for Mr. Vashist,or any other key employees, that govern the length of their service. The lossof the services of Mr. Vashist or other senior management or technicalpersonnel could harm our business. Furthermore, our future success depends onour ability to continue to attract, retain and motivate other senior managementand qualified technical personnel, particularly software engineers, digitalcircuit designers, mixed-signal circuit designers and systems and algorithmsengineers. Competition for these employees is intense. Stock options generallycomprise a significant portion of our compensation packages for all employees,and the expected volatility in the price of our common stock may make it moredifficult for us to attract and retain key employees, which could harm ourability to provide technologically competitive products.

 

**If weare unable to develop, introduce or to achieve market acceptance of our newchipset products, our operating results would be adversely affected.**

 

Our future successdepends on our ability to develop new chipset products and transition to newproducts, introduce these products in a cost-effective and timely manner andconvince OEMs to select our products for design into their new systems.Our historical quarterly results have been, and we expect that our futureresults will continue to be, dependent on the introduction of a relativelysmall number of new products and the timely completion and delivery of thoseproducts to customers. The development of new chipset products is complex, andfrom time to time we have experienced delays in completing the development andintroduction of new products. We have in the past invested substantialresources in emerging technologies that did not achieve the market acceptancethat we had expected. Our ability to develop and deliver new chipset productssuccessfully will depend on various factors, including our ability to:

 

•                  accuratelypredict market requirements and evolving industry standards;

 

•                  accuratelydefine new chipset products;

 

•                  timelycomplete and introduce new product designs;

 

•                  timelyqualify and obtain industry interoperability certification of our products andthe equipment into which our products will be incorporated;

 

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

 

•                  shiftour products to smaller geometry process technologies to achieve lower cost andhigher levels of design integration; and

 

•                  gainmarket acceptance of our products and our OEM customers’ products.

 

If we are unable todevelop and introduce new chipset products successfully and in a cost-effectiveand timely manner, we will not be able to attract new customers or retain ourexisting customers, which would harm our business.

 

**Oursuccess is dependent on achieving design wins into commercially successful OEMsystems.**

 

Our products aregenerally incorporated into our OEMs customers’ systems at the designstage. As a result, we rely on OEMs to

 

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select our products to bedesigned into their systems, which we refer to as a design win. We often incursignificant expenditures on the development of a new product without anyassurance that an OEM will select our product for design into its own system.Additionally, in some instances, we are dependent on third parties to obtain orprovide information that we need to achieve a design win. Some of these thirdparties may not supply this information to us on a timely basis, if at all.Furthermore, even if an OEM designs one of our products into its systemoffering, we cannot be assured that its equipment will be commerciallysuccessful or that we will receive any net revenue as a result of that designwin. Our OEM customers are typically not obligated to purchase our products andcan choose at any time to stop using our products if their own systems are notcommercially successful, if they decide to pursue other systems strategies, orfor any other reason. If we are unable to achieve design wins or if our OEMcustomers’ systems incorporating our products are not commercially successful,our net revenue would suffer.

 

**Acquisitions,strategic partnerships, joint ventures or investments may impair our capitaland equity resources, divert our management’s attention or otherwise negativelyimpact our operating results.**

 

We intend to activelypursue acquisitions, strategic partnerships and joint ventures that we believemay allow us to complement our growth strategy, increase market share in ourcurrent markets and expand into adjacent markets, broaden our technology andintellectual property and strengthen our relationships with carriers and OEMs. Whilewe currently have no such agreements, any future acquisition, partnership jointventure or investment may require that we pay significant cash, issue stock orincur substantial 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 may require significant managerial attention,which may be diverted from our other operations. These capital, equity andmanagerial commitments may impair the operation of our business. Furthermore,acquired businesses may not be effectively integrated, may be unable tomaintain key pre-acquisition business relationships, may contribute toincreased fixed costs and may expose us to unanticipated liabilities andotherwise harm our operating results.

 

**We relyon third-party sales representatives to assist in selling our products, and thefailure of these representatives to perform as expected could reduce our futuresales.**

 

We sell our products tosome of 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 salesrepresentatives also market and sell competing products. Our third-party salesrepresentatives may terminate their relationships with us at any time. Ourfuture performance will also depend, in part, on our ability to attractadditional third-party sales representatives that will be able to market andsupport our products effectively, especially in markets in which we have notpreviously distributed our products. If we cannot retain our currentthird-party sales representatives or recruit additional or replacementthird-party sales representatives, our sales and operating results could beharmed.

 

**We relyon third-party technologies for the development of our products and ourinability to use such technologies in the future would harm our ability toremain competitive.**

 

We rely on third partiesfor technology that is integrated into some of our products, including memorycells, input/output cells and core processor logic. If we are unable tocontinue to use or license these technologies on reasonable terms, or if thesetechnologies fail to operate properly, we may not be able to securealternatives in a timely manner and our ability to remain competitive would beharmed. In addition, if we are unable to successfully license technology fromthird parties to develop future products, we may not be able to develop suchproducts in a timely manner or at all.

 

**Rapidlychanging standards and regulations could make our products obsolete, whichwould cause our sales and operating results to suffer.**

 

We design our products toconform to regulations established by governments and to standards set byindustry standards bodies such as The American National Standards Institute(ANSI) and The Committee T1E1.4 in North America, European TelecommunicationsStandards Institute (ETSI) in Europe and ITU-T and the Institute of Electricaland Electronics 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 make significantexpenditures to develop new products. If our customers adopt new or competingindustry standards with which our products are not compatible, or the industrygroups adopt standards or governments issue regulations with which our productsare not compatible, our existing products would become less desirable to ourcustomers and our sales and operating results would suffer.

 

**If wefail to secure or protect our intellectual property rights, competitors may beable to use our technologies, which could weaken our competitive position,reduce our net revenue or increase our costs.**

 

Our success will depend,in part, on our ability to protect our intellectual property. We rely on acombination of patent, copyright, trademark and trade secret laws, confidentialityprocedures and licensing arrangements to establish and protect our proprietaryrights in the United States. We do not currently have any applications on filein any foreign jurisdictions with respect to our intellectual propertynotwithstanding the fact that a significant portion of our net revenue isgenerated abroad. Our pending patent applications may not result in issuedpatents, and our existing and future patents may not be sufficiently broad toprotect our proprietary technologies or may be held

 

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invalid or unenforceablein 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 may obtain in thefuture, may not be adequate to protect our proprietary rights. Our competitorsmay independently develop or may have already developed technology similar toours, duplicate our products or design around any patents issued to us or ourother intellectual property. In addition, we may be required to license ourpatents as a result of our participation in various standards organizations. Ifcompetitors appropriate our technology and we are not adequately protected, ourcompetitive position would be harmed, our legal costs would increase and ournet revenue would be harmed.

 

**Third-partyclaims of infringement or other claims against us could adversely affect ourability to market our products, require us to redesign our products or seeklicenses from third parties, and harm our business. In addition, any litigationrequired to defend such claims could result in significant costs and diversionof our resources.**

 

Companies in thesemiconductor industry often aggressively protect and pursue their intellectualproperty rights. From time to time, we receive, and may continue to receive inthe future, notices that claim we have infringed upon, misappropriated ormisused other parties’ proprietary rights. While we are not aware that we arecurrently infringing on the proprietary rights of third parties, we may in thefuture be engaged in litigation with parties who claim that we have infringedtheir patents or misappropriated or misused their trade secrets or who may seekto invalidate 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 past infringementand royalties for future use of the technology and we may be liable for trebledamages if infringement is found to have been willful. Even if claims againstus are not valid or successfully asserted, these claims could result insignificant costs and a diversion of management and personnel resources todefend.

 

**Anypotential dispute involving our patents or other intellectual property couldalso include our manufacturing subcontractors and OEM customers, which couldtrigger our indemnification obligations to them and result in substantial expenseto 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.

 

**Ourproducts typically have lengthy sales cycles, which may cause our operatingresults to fluctuate and result in volatility in the price of our common stock.An OEM customer or a carrier may decide to cancel or change its product plans,which could cause 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 our productand an additional three to more than nine months to begin volume production ofequipment that incorporates our product. Due to this lengthy sales cycle, wemay experience significant delays from the time we increase our operatingexpenses and make investments in inventory until the time that we generate netrevenue from these products. It is possible that we may never generate any netrevenue from these products after incurring these expenditures and investments.Even if an OEM customer selects our product to incorporate into its equipment,we have no assurances that the customer will ultimately market and sell itsequipment or that such efforts by our customer will be successful. The delaysinherent in our lengthy sales cycle increase the risk that an OEM customer orcarrier will decide to cancel or change its product plans. From time to time,we have experienced changes and cancellations in the purchase plans of our OEMcustomers. A cancellation or change in plans by an OEM customer or carriercould cause us to not achieve anticipated net revenue and result in volatilityof the price of our common stock. In addition, our anticipated sales could belost or substantially reduced if a significant OEM customer or carrier reducesor delays orders during our sales cycle or chooses not to release equipmentthat contains our products.

 

**As ourinternational manufacturing, sales and research and development operationsexpand, we will be increasingly exposed to various legal, business, politicaland economic risks associated with our international operations.**

 

We currently obtainsubstantially all of our manufacturing, assembly and testing services fromsuppliers and subcontractors located outside the United States, and have asignificant portion of our research and development team located in India. Inaddition, 99.8% of our net revenue in 2004 and 99.4% of our net revenue in the ninemonths ended September 30, 2005 was derived from sales to customersoutside the United States. We may expand our international business activitiesand open other design and operational centers abroad. International operationsare subject to many other inherent risks, including but not limited to:

 

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

 

•                  exposureto different legal standards, particularly with respect to intellectualproperty;

 

•                  naturaldisasters and public health emergencies;

 

•                  tradeand travel restrictions;

 

•                  theimposition of governmental controls and restrictions or unexpected changes inregulatory requirements;

 

•                  burdensof complying with a variety of foreign laws;

 

•                  importand export license requirements and restrictions of the United States and eachother country in which we operate;

 

•                  foreigntechnical standards;

 

•                  changesin tariffs;

 

•                  difficultiesin staffing and managing international operations;

 

•                  fluctuationsin currency exchange rates;

 

•                  difficultiesin collecting receivables from foreign entities or delayed revenue recognition;and

 

•                  potentiallyadverse tax consequences.

 

Because we are currentlysubstantially dependent on our foreign sales, research and development andoperations, any of the factors described above could significantly harm ourability to produce quality products in a timely and cost effective manner, andincrease or maintain our foreign sales.

 

**Significantfluctuations or a slowdown in deployment of fiber extension over copper andbroadband over copper in Asia would adversely affect our operating results.**

 

Sales to customerslocated in Asia accounted for 97.2% of our net revenue in 2004 and 99.4% forthe nine months ended September 30, 2005. Our sales have been dependent onthe continuous growth of new fiber extension over copper and broadband overcopper subscribers in Asia. Fluctuations in or a plateau of new subscribers inAsia could impact our net revenue and a sustained slow down in growth of fiberextension over copper and broadband over copper subscribers in Asia may causeour net revenue to decline. In addition, our sales have been historicallydenominated in U.S. dollars and an increase in the U.S. dollar relative to thecurrencies of the countries that our customers operate in could materiallyaffect our Asian customers’ demand for our products, thereby forcing them toreduce their orders, which would adversely affect our business.

 

**Wederive a substantial amount of our net revenue from Asia, and our failure todiversify the geographic sources of our net revenue could harm our operatingresults.**

 

Because a substantialportion of our net revenue has been derived from sales into Japan and Korea,our net revenue has been heavily dependent on developments in these markets. Asa result, our sales are subject to economic downturns, decrease in demand andoverall negative market conditions in Asia. While part of our strategy is todiversify the geographic sources of our net revenue, failure to furtherpenetrate markets outside of Japan and Korea could harm our business andoperating results.

 

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**Thecomplexity of our products could result in unforeseen delays or expenses and inundetected defects or bugs, which could damage our reputation with current orprospective customers and adversely affect the market acceptance of newproducts.**

 

Highly complex productssuch as those that we offer frequently contain defects and bugs, particularlywhen they are first introduced or as new versions are released. In the past wehave experienced, and may in the future experience, defects and bugs in ourproducts. If any of our products contains defects or bugs, or has reliability,quality or compatibility problems, our reputation may be damaged and our OEMcustomers may be reluctant to buy our products, which could harm our ability toretain existing customers and attract new customers. In addition, these defectsor bugs could interrupt or delay sales or shipment of our products to ourcustomers.

 

**Recentchanges to environmental laws and regulations applicable to manufacturers ofelectrical and electronic equipment are causing us to redesign our products,and may increase our costs and expose us to liability.**

 

The implementation of newenvironmental regulatory legal requirements, such as lead free initiatives,could impact our product designs and manufacturing processes. The impact ofsuch regulations on our product designs and manufacturing processes couldaffect the timing of compliant product introductions as well as theircommercial success. For example, a recent directive in the European Union bansthe use of lead and other heavy metals in electrical and electronic equipmentafter July 1, 2006. As a result, in advance of this deadline, some of ourcustomers selling products in Europe have begun demanding product fromcomponent manufacturers that do not contain these banned substances. Becausemost of our existing assembly processes (as well as those of most othermanufacturers) utilize a tin-lead alloy as a soldering material in themanufacturing process, we must redesign many of our products if we are to meetcustomer demand. This redesign may result in increased research and developmentand manufacturing and quality control costs. In addition, the products that wemanufacture that comply with the new regulatory standards may not perform aswell as our current products. Moreover, if we are unable to successfully andtimely redesign existing products and introduce new products that meet thestandards set by environmental regulation and our customers, sales of ourproducts could decline, which could materially adversely affect our business,financial condition and results of operations.

 

**We planto implement a new ERP system, an enhancement which could disrupt ouroperations and negatively impact our sales volume and net revenue.**

 

We intend to implement acomprehensive enterprise resource planning, or ERP, information system tomanage our business operations, and our migration to this new system coulddisrupt our operations. We have experienced difficulties in the past inimplementing new information systems. The process of implementing newinformation systems could also adversely impact our ability to do the followingin a timely manner:

 

•                  acceptand process customer orders;

 

•                  receiveinventory and ship products;

 

•                  invoiceand collect receivables;

 

•                  placepurchase orders and pay invoices; and

 

•                  allother business transactions related to the finance, order entry, purchasing,supply chain and human resource processes within the new ERP informationsystem.

 

**Due tothe cyclical nature of the semiconductor and telecommunications industries, ouroperating results may fluctuate significantly, which could adversely affect themarket price of our common stock.**

 

The semiconductor industryis highly cyclical and subject to rapid change and evolving industry standardsand, from time to time, has experienced significant downturns. These downturnsare characterized by decreases in product demand, excess customer inventoriesand accelerated erosion of prices. These factors could cause substantialfluctuations in our net revenue and in our operating results. Any downturns inthe semiconductor or broadband communications industry may be severe andprolonged, and any failure of this industry or the broadband communicationsmarkets to fully recover from downturns could harm our business. Thesemiconductor industry also periodically experiences increased demand andproduction capacity constraints, which may affect our ability to ship products.Accordingly, our operating results may vary significantly as a result of thegeneral conditions in the semiconductor or broadband communications industry,which could cause our stock price to decline.

 

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In addition, thetelecommunications industry from time to time has experienced and may againexperience a pronounced downturn. To respond to a downturn, many carriers maybe required to slow their capital expenditures, cancel or delay newdevelopments, reduce their workforces and inventories and take a cautiousapproach to acquiring new equipment and technologies from OEMs, which wouldhave a negative impact on our business. In the future, a downturn in thetelecommunications industry may cause our operating results to fluctuate fromyear to year, which also may tend to increase the volatility of the price ofour common stock and harm our business.

 

**Severalof the facilities that manufacture our products, most of our OEM customers andthe carriers they serve, and our California facility are located in regionsthat are subject to earthquakes and other natural disasters.**

 

Several of oursubcontractors’ facilities that manufacture, assemble and test our products,and one of our subcontractor’s wafer foundries, are located in Taiwan. Ourcustomers are currently primarily located in Japan and Korea. The Asia-Pacificregion has experienced significant earthquakes in the past and could be subjectto additional seismic activities. Any earthquake or other natural disaster inthese areas could significantly disrupt these manufacturing facilities’production capabilities and could result in our experiencing a significantdelay in delivery, or substantial shortage, of wafers in particular, andpossibly in higher wafer prices, and our products in general. Our headquartersin California are also located near major earthquake fault lines. If there is amajor earthquake or any other natural disaster in a region where one of ourfacilities is located, it could significantly disrupt our operations.

 

***Risks Related to our Common Stock***

 

**Ourstock price may be volatile, and you may not be able to resell shares of ourcommon stock at or above the price you paid, or at all.**

 

Prior to our initialpublic offering, our common stock had not been sold in a public market. Wecannot predict the extent to which a trading market will develop or how liquidthat market might become. The initial public offering price for the shares wasdetermined by negotiations between us and the representatives of theunderwriters and may not be indicative of prices that will prevail in thetrading market. The trading price of our common stock could be subject to widefluctuations due to the factors discussed in this “Risk Factors” section andelsewhere in this Form 10Q. In addition, the stock market in general, andthe Nasdaq National Market and technology companies in particular, haveexperienced extreme price and volume fluctuations. Our initial trading priceand valuation may not be sustainable, and broad market and industry factors maydecrease the market price of our common stock, regardless of our actualoperating performance.

 

**Class actionlitigation due to stock price volatility or other factors could cause us toincur substantial costs and divert our management’s attention and resources.**

 

In the past, securitiesclass action litigation often has been brought against a company followingperiods of volatility in the market price of its securities. Companies such asours in the semiconductor industry and other technology industries areparticularly vulnerable to this kind of litigation due to the high volatilityof their stock prices. While we are not aware of any such contemplated classaction litigation 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.

 

**Ifsecurities or industry analysts do not publish research or reports about ourbusiness, or if they issue an adverse opinion regarding our stock, our stockprice and trading volume could decline.**

 

The trading market forour common stock will be influenced by the research and reports that industryor securities 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.

 

**Substantialfuture sales of our common stock in the public market could cause our stockprice to fall.**

 

As of September 30,2005 we had 23,792,253 shares of common stock outstanding. Of these shares,6,400,000 were recently sold in our initial public offering and are freelytradable under federal and state securities laws without further registrationunder the Securities Act of 1933, as amended, or the Securities Act, exceptthat any shares held by our “affiliates” (as that term is defined under Rule 144of the Securities Act) may be sold only in compliance with the limitationsunder Rule 144. The remaining outstanding shares after completion of ourinitial public offering are “restricted securities” and generally will beavailable for sale in the public market as follows:

 

•                  shares,which are subject to lock-up agreements with the underwriters, will be eligiblefor sale at various times beginning 180 days (subject to an extension ofup to 18 days) after September 21, 2005, the date of our initialpublic offering,  pursuant to Rules 144,144(k) and 701 of the Securities Act.

 

The underwriters may,however, release all or a portion of the shares subject to lock-up agreementsat any time without notice. To the extent shares are released before theexpiration of the lock-up period and these shares are sold into the market, themarket price of our common stock could decline.

 

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In addition, after the initialpublic offering, the holders of 15,311,840 shares of common stock are now entitledto rights to cause us to register the sale of those shares under the SecuritiesAct. Registration of these shares under the Securities Act would result inthese shares, other than shares purchased by our affiliates, becoming freelytradable without restriction under the Securities Act immediately upon theeffectiveness of the registration statement.

 

In the future, we mayalso issue 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 anytime. These sales could reduce the market price of our common stock.

 

**Ourcorporate actions are substantially controlled by our directors, executiveofficers and their affiliated entities who could exert control over our companyin a manner that may be contrary to the interests of other investors.**

 

Our directors, executiveofficers and their affiliated entities beneficially own over 35% 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 also discourage,delay or prevent a change in control of our company, which could deprive ourstockholders of an opportunity to receive a premium for their stock as part ofa sale of our company and might reduce our stock price. These actions may betaken even if they are opposed by our other stockholders, including those whopurchase shares in this offering.

 

**Delawarelaw and our corporate charter and bylaws contain anti-takeover provisions thatcould delay or discourage takeover attempts that stockholders may considerfavorable.**

 

Provisions in ourcertificate of incorporation may have the effect of delaying or preventing achange of control or changes in our management. These provisions include thefollowing:

 

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

 

•                  theestablishment of a classified board of directors requiring that not all membersof the board be elected at one time;

 

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

 

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

 

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

 

•                  theability of the board of directors to issue, without stockholder approval, up to5,000,000 shares of preferred stock with terms set by the board of directors,which rights could be senior to those of common stock;

 

•                  therequired approval of holders of at least two-thirds of the shares entitled tovote at an election of directors to adopt, amend or repeal our bylaws or amendor repeal the provisions of our certificate of incorporation regarding theelection and removal of directors and the ability of stockholders to takeaction;

 

•                  therequired approval of holders of a majority of the shares entitled to vote at anelection of directors to remove directors for cause; and

 

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

 

We are also subject toprovisions of the Delaware General Corporation Law that, in general, prohibitany business combination with a beneficial owner of 15% or more of our commonstock for three years after the point in time that such stockholder acquiredshares

 

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constituting 15% or moreof our shares, unless the holder’s acquisition of our stock was approved inadvance by our board of directors.

 

**We willincur increased costs as a result of being a public company.**

 

As a public company, wewill incur significant legal, accounting and other expenses that we did notincur as a private company. In addition, the Sarbanes-Oxley Act of 2002, aswell as new rules subsequently implemented by the SEC, and the NasdaqNational Market, have required changes in corporate governance practices ofpublic companies. We expect these new rules and regulations to significantlyincrease our legal and financial compliance costs and to make some activitiesmore time-consuming and costly. For example, we have created additional boardcommittees and adopted policies regarding internal controls and disclosurecontrols and procedures. In addition, we will incur additional costs associatedwith our public company reporting requirements. We also expect these new rules andregulations to make it more difficult and more expensive for us to obtaindirector and officer liability insurance and we may be required to acceptreduced policy limits and coverage or incur substantially higher costs toobtain the same or similar coverage. As a result, it may be more difficult forus to attract and retain qualified persons to serve on our board of directorsor as executive officers. We are currently evaluating and monitoringdevelopments with respect to these new rules, and we cannot predict or estimatethe amount of additional costs we may incur or the timing of such costs.

 

**Item 3.Quantitative and Qualitative Disclosures About Market Risk**

 

*ForeignCurrency Exchange Risk*

 

Our net revenue and ourcosts and expenses, including subcontractor manufacturing expenses, aredenominated in U.S. dollars. An increase of the U.S. dollar relative to the currenciesof the countries that our customers operate in would make our products moreexpensive to them and increase pricing pressure or reduce demand for ourproducts. We do not currently enter into forward exchange contracts to hedgeexposure denominated in foreign currencies or any other derivative financialinstruments for trading or speculative purposes. In the future, if we feel ourforeign currency 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 and cashequivalents totaling $98.7 million at September 30, 2005. Theseamounts were invested primarily in money market funds. The unrestricted cashand cash equivalents are held for working capital purposes. We do not enterinto investments for trading or speculative purposes. Due to the short-termnature of these investments, we do not believe that a 10% change in interestrates would have a material impact on our financial position and results ofoperations. However, declines in interest rates will reduce future investmentincome. During October 2004 we entered into a loan agreement with SiliconValley Bank. Interest is calculated at Silicon Valley Bank’s prime rate plus0.5 percentage points. The balance outstanding on this working capitalline facility at September 30, 2005 was $1.6 million at 4.5%. A 10%change in interest rates (0.45%) would not have a material impact on ourfinancial position and results of operations.

 

**Item 4. Controls and Procedures**

 

*Evaluation of disclosure controls and procedures.*

 

Based on their evaluation as of September 30,2005, 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.

 

*Changes in internal controls.*

 

There were no changes in our internal controls overfinancial reporting during the quarter ended September 30, 2005 that havematerially affected, or are reasonably likely to materially affect, ourinternal controls over financial reporting.

 

*Limitations on the effectiveness of controls.*

 

Our management, including our Chief Executive Officerand Chief Financial Officer, does not expect that our disclosure controls andprocedures or our internal controls will prevent all error and all fraud. Acontrol system, no matter how well conceived and operated, can provide onlyreasonable, not absolute, assurance that the objectives of the control systemare met. Further, the design of a control system must reflect the fact thatthere are resource constraints, and the benefits of controls must be consideredrelative to their costs. Because of the inherent limitations in all controlsystems, no evaluation of controls can provide absolute assurance that allcontrol issues and instances of fraud, if any, within Ikanos Communications, Inc.have been detected. These inherent limitations include the realities thatjudgments in decision-making can be faulty, and that breakdowns can occurbecause of simple error or mistake. Additionally, controls can be circumventedby the individual acts of some persons, by collusion of two or more people, orby management override of the control. The design of any system of controlsalso is based in part upon certain assumptions about the likelihood of futureevents, and there can be no assurance that any design will succeed in achievingits stated goals under all potential future conditions; over time, control maybecome inadequate because of changes in conditions, or the degree of compliancewith the policies or procedures may deteriorate. Because of the inherentlimitations in a cost-effective control system, misstatements due to error orfraud may occur and not be detected.

 

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**PART II. OTHER INFORMATION**

 

**Item 2. Unregistered Sales of Equity Securities and Use ofProceeds**

 

During the three months ended September 30, 2005,we issued 9,318 shares of our common stock that were not registered under theSecurities Act of 1933 to our employees upon the exercise of options for cashconsideration with an aggregate exercise price of $21,759. These transactionswere undertaken in reliance upon the exemption from the registrationrequirements of the Securities Act afforded by Rule 701 promulgated underthe Securities Act and Section 4(2) of the Securities Act.

 

The Securities and Exchange Commission declared ourfirst registration statement, which we filed on Form S-1 (File No. 333-113880),under the Securities Act of 1933 as amended,  in connection with the initial public offeringof our common stock, par value $0.001, effective on September 21, 2005.Citigroup and Lehman Brothers acted as the lead underwriters of the offering.Our common stock commenced trading on the Nasdaq National Market on September 22,2005 under the trading symbol “IKAN.” A total of 6,400,000 shares of commonstock were sold in the offering at $12.00 per share. All of the shares ofcommon stock were sold by us. 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 $67.9 million from the offering. None of the expenses were paid,directly or indirectly, to directors, officers or persons owning 10% or more ofour common stock, or to our affiliates. To date, we have not used any part ofthe net proceeds of the offering. To date, all of the net proceeds of theoffering have been applied to temporary investments.

 

Following the completion of the offering, all sharesof our issued and outstanding preferred stock, par value $0.001, convertedautomatically into 15,311,840 shares of common stock.

 

**Item 4. Submission of Matters to a Vote of Stockholders**

 

Pursuant to a writtenconsent dated August 26, 2005, our stockholders approvedthe following actions by a written consent of thestockholders in connection with our initial public offering:  anamendment to our restated certificate of incorporation to effect a 1-for-12reverse stock split; the approval and adoption of our amended and restatedcertificate of incorporation effective upon the closing of the initial publicoffering; the establishment of a staggered board; the amendment of the 1999Stock Plan to increase the number of shares of common stock reserved forissuance; and the approval of amendments to the 2004 Equity IncentivePlan and the 2004 Employee Stock Purchase Plan.  Based on pre-splitnumbers, of the 24,713,487 shares of Common Stock outstanding, 13,266,757shares were voted in favor of the consent with 11,446,730 shares notvoted; of the 183,743,668 shares of Preferred Stock thenoutstanding, 160,403,196 shares were voted in favor of the consentwith 23,340,472 shares not voted.

 

**Item 5.Other Information**

 

None

 

**Item 6.Exhibits**

 

AnExhibit Index hasbeen attached as part of this quarterly report and is incorporated herein byreference.

 

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**SIGNATURE**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|                            | **IKANOS COMMUNICATIONS, INC.** |
|---------------------------------|---------------------------------|
|                            |                            |   |
| Dated:  November 15, 2005  | By:                             | /s/  RAJESH VASHIST |
|                            |                            | Rajesh  Vashist |
|                            |                            | President,  Chief Executive Officer and Chairman of the Board |
|                            | ** **                      | **(Principal Executive Officer)** |
|                            |                            |   |
| Dated:  November 15 , 2005 | By:                             | /s/  DANIEL K. ATLER |
|                            |                            | Daniel  K. Atler |
|                            |                            | Chief  Financial Officer |
|                            | ** **                      | **(Principal Financial and Accounting Officer)** |

 

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**EXHIBIT INDEX**

 
| 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     |   | 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.    |

 

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