##### Table of Contents



SECURITIES AND EXCHANGE COMMISSION
 WASHINGTON, D.C. 20549
 
 FORM 10-Q
 þ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 FOR THE QUARTERLY PERIOD ENDED June 30, 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: 000-24647
 TERAYON COMMUNICATION SYSTEMS, INC.
  DELAWARE
(STATE OR OTHER JURISDICTION OF
INCORPORATION OR ORGANIZATION)
    
    77-0328533
(IRS EMPLOYER
IDENTIFICATION NO.)
 
 
 þ o
 þ o




---



INDEX
 TERAYON COMMUNICATION SYSTEMS, INC.
 Page No.PART I FINANCIAL INFORMATIONItem 1. FINANCIAL STATEMENTS
    
    
    3Item 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
    
    
    16Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
    
    
    46Item 4. CONTROLS AND PROCEDURES
    
    
    47PART II OTHER INFORMATIONItem 1. LEGAL PROCEEDINGS
    
    
    48Item 5. OTHER INFORMATION
    
    
    50Item 6. EXHIBITS
    
    
    50EXHIBIT 10.22EXHIBIT 10.23EXHIBIT 10.24EXHIBIT 10.26EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2




---



##### Table of Contents





SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS








---



##### Table of Contents



PART I. FINANCIAL INFORMATION
 
 ITEM 1. FINANCIAL STATEMENTS
 
 June 30,
    
    December 31,2005
    
    2004(unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    38,605
    
    
    $
    43,218Short-term investments
    
    
    66,383
    
    
    
    54,517Accounts receivable, net
    
    
    17,645
    
    
    
    16,554Accounts receivable from related parties
    
    
    2,312
    
    
    
    3,106Other current receivables
    
    
    1,758
    
    
    
    1,044Inventory
    
    
    12,759
    
    
    
    17,144Other current assets
    
    
    2,100
    
    
    
    2,042Total current assets
    
    
    141,562
    
    
    
    137,625Property and equipment, net
    
    
    4,538
    
    
    
    5,760Restricted cash
    
    
    8,763
    
    
    
    8,827Other assets
    
    
    633
    
    
    
    1,522Total assets
    
    $
    155,496
    
    
    $
    153,734LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    4,572
    
    
    $
    7,845Accrued payroll and related expenses
    
    
    3,147
    
    
    
    3,936Deferred revenues
    
    
    5,427
    
    
    
    2,579Deferred gain on sale of semiconductor assets
    
    
    8,578
    
    
    
    Accrued warranty expenses
    
    
    2,722
    
    
    
    3,870Current portion of accrued restructuring and executive severance
    
    
    1,991
    
    
    
    3,902Accrued vendor cancellation charges
    
    
    374
    
    
    
    521Accrued other liabilities
    
    
    3,609
    
    
    
    4,562Interest payable
    
    
    1,356
    
    
    
    1,356Total current liabilities
    
    
    31,776
    
    
    
    28,571Other long-term obligations
    
    
    1,720
    
    
    
    2,077Long term portion of accrued restructuring and executive
severance
    
    
    1,721
    
    
    
    1,664Convertible subordinated notes
    
    
    65,081
    
    
    
    65,081Commitments and contingenciesStockholders equity:Common stock
    
    
    77
    
    
    
    76Additional paid in capital
    
    
    1,085,820
    
    
    
    1,083,711Accumulated deficit
    
    
    (1,027,203
    )
    
    
    (1,024,091
    )Treasury stock, at cost
    
    
    (773
    )
    
    
    (773
    )Accumulated other comprehensive loss
    
    
    (2,723
    )
    
    
    (2,582
    )Total stockholders equity
    
    
    55,198
    
    
    
    56,341Total liabilities and stockholders equity
    
    $
    155,496
    
    
    $
    153,734
  3




---



##### Table of Contents



Three months ended
    
    Six months endedJune 30,
    
    June 30,2005
    
    2004
    
    2005
    
    2004Revenues
    
    $
    24,692
    
    
    $
    40,138
    
    
    $
    42,228
    
    
    $
    80,560Related party revenues
    
    
    4,841
    
    
    
    2,644
    
    
    
    13,668
    
    
    
    3,389Total revenues
    
    
    29,533
    
    
    
    42,782
    
    
    
    55,896
    
    
    
    83,949Cost of revenues
    
    
    14,024
    
    
    
    27,046
    
    
    
    25,379
    
    
    
    55,605Cost of related party revenues
    
    
    2,677
    
    
    
    614
    
    
    
    4,364
    
    
    
    825Total cost of revenues
    
    
    16,701
    
    
    
    27,660
    
    
    
    29,743
    
    
    
    56,430Gross profit
    
    
    12,832
    
    
    
    15,122
    
    
    
    26,153
    
    
    
    27,519Operating expenses:Research and development
    
    
    4,427
    
    
    
    8,516
    
    
    
    10,371
    
    
    
    17,984Sales and marketing
    
    
    5,611
    
    
    
    5,411
    
    
    
    11,285
    
    
    
    12,632General and administrative
    
    
    2,878
    
    
    
    2,953
    
    
    
    5,673
    
    
    
    5,388Restructuring charges, executive severance and asset
write-offs
    
    
    282
    
    
    
    3,579
    
    
    
    1,564
    
    
    
    6,946Total operating expenses
    
    
    13,198
    
    
    
    20,459
    
    
    
    28,893
    
    
    
    42,950Loss from operations
    
    
    (366
    )
    
    
    (5,337
    )
    
    
    (2,740
    )
    
    
    (15,431
    )Interest income
    
    
    672
    
    
    
    460
    
    
    
    1,240
    
    
    
    912Interest expense
    
    
    (814
    )
    
    
    (826
    )
    
    
    (1,627
    )
    
    
    (1,643
    )Other income (expense), net
    
    
    (50
    )
    
    
    921
    
    
    
    15
    
    
    
    1,200Loss before income tax benefit (provision)
    
    
    558
    
    
    
    (4,782
    )
    
    
    (3,112
    )
    
    
    (14,962
    )Income tax benefit (provision)
    
    
    50
    
    
    
    (79
    )
    
    
    
    
    
    
    (146
    )Net loss
    
    $
    (508
    )
    
    $
    (4,861
    )
    
    $
    (3,112
    )
    
    $
    (15,108
    )Net loss per share, basic and diluted
    
    $
    (0.01
    )
    
    $
    (0.06
    )
    
    $
    (0.04
    )
    
    $
    (0.20
    )Shares used in per share calculation, basic and diluted
    
    
    77,057
    
    
    
    75,551
    
    
    
    76,898
    
    
    
    75,534
  4




---



##### Table of Contents



Six Months EndedJune 30,2005
    
    2004Operating activities:Net loss
    
    $
    (3,112
    )
    
    $
    (15,108
    )Adjustments to reconcile net loss to net cash used in
operating activities:Depreciation and amortization
    
    
    1,708
    
    
    
    3,319Reduction of accounts receivable allowance
    
    
    (675
    )
    
    
    Amortization of deferred compensation
    
    
    
    
    
    
    17Inventory reserves
    
    
    858
    
    
    
    969Impairment and write-off of fixed assets
    
    
    330
    
    
    
    130Net changes in operating assets and liabilities:Accounts receivable
    
    
    (416
    )
    
    
    2,420Accounts receivable from related parties
    
    
    794
    
    
    
    (505
    )Inventory
    
    
    3,527
    
    
    
    (6,008
    )Other assets
    
    
    181
    
    
    
    2,813Accounts payable
    
    
    (3,273
    )
    
    
    (9,569
    )Accrued payroll and related expenses
    
    
    (789
    )
    
    
    (1,618
    )Deferred revenues
    
    
    2,848
    
    
    
    1,668Accrued warranty expenses
    
    
    (1,148
    )
    
    
    (1,318
    )Accrued restructuring and executive severance
    
    
    (1,853
    )
    
    
    4,570Accrued vendor cancellation charges
    
    
    (147
    )
    
    
    (2,156
    )Other accrued liabilities
    
    
    (1,311
    )
    
    
    (806
    )Net cash used in operating activities
    
    
    (2,478
    )
    
    
    (21,182
    )Investing activities:Purchases of short-term investments
    
    
    (48,938
    )
    
    
    (78,000
    )Proceeds from sales and maturities of short-term investments
    
    
    36,941
    
    
    
    117,429Proceeds from sale of semiconductor assets, net
    
    
    8,578
    
    
    
    Purchases of property and equipment
    
    
    (816
    )
    
    
    (1,623
    )Net cash provided by (used in) investing activities
    
    
    (4,235
    )
    
    
    37,806Financing activities:Principal payments on capital leases
    
    
    
    
    
    
    (178
    )Proceeds from issuance of common stock
    
    
    2,109
    
    
    
    781Net cash provided by financing activities
    
    
    2,109
    
    
    
    603Effect of foreign currency exchange rate changes
    
    
    (9
    )
    
    
    368Net increase (decrease) in cash and cash equivalents
    
    
    (4,613
    )
    
    
    17,595Cash and cash equivalents at beginning of period
    
    
    43,218
    
    
    
    30,188Cash and cash equivalents at end of period
    
    $
    38,605
    
    
    $
    47,783
  5




---



##### Table of Contents



1. Organization
 Description of Business
   2. Summary of Significant Accounting Policies
 Basis of Presentation
   Reclassifications
  Basis of Consolidation
  Use of Estimates
  Net Loss Per Share
  Three months ended
    
    Six months endedJune 30,
    
    June 30,2005
    
    2004
    
    2005
    
    2004Net loss
    
    $
    (508
    )
    
    $
    (4,861
    )
    
    $
    (3,112
    )
    
    $
    (15,108
    )Shares used in
computing basic and
diluted net loss
per share
    
    
    77,057
    
    
    
    75,551
    
    
    
    76,898
    
    
    
    75,534Basic and diluted
net loss per share
    
    $
    (0.01
    )
    
    $
    (0.06
    )
    
    $
    (0.04
    )
    
    $
    (0.20
    )
  6




---



##### Table of Contents



Stock-based Compensation
   Three months ended
    
    Six months endedJune 30,
    
    June 30,2005
    
    2004
    
    2005
    
    2004Net loss, as reported
    
    $
    (508
    )
    
    $
    (4,861
    )
    
    $
    (3,112
    )
    
    $
    (15,108
    )Add:
    
    Stock-based compensation under APB 25
    
    
    
    
    
    
    17
    
    
    
    
    
    
    
    17Deduct:
    
    Stock option compensation expense
determined under fair value-based
method
    
    
    (1,051
    )
    
    
    (3,703
    )
    
    
    (2,367
    )
    
    
    (8,213
    )Employee stock purchase plan
compensation expense determined
under fair value-based method
    
    
    
    
    
    
    (357
    )
    
    
    
    
    
    
    (713
    )Pro forma net loss
    
    $
    (1,559
    )
    
    $
    (8,904
    )
    
    $
    (5,479
    )
    
    $
    (24,017
    )Net loss per share, basic and diluted, as reported
    
    $
    (0.01
    )
    
    $
    (0.06
    )
    
    $
    (0.04
    )
    
    $
    (0.20
    )Pro forma net loss per share, basic and diluted
    
    $
    (0.02
    )
    
    $
    (0.12
    )
    
    $
    (0.07
    )
    
    $
    (0.32
    )Shares used in computing net loss per share , as
reported, and pro forma net loss per share, as
reported, basic and diluted
    
    
    77,057
    
    
    
    75,551
    
    
    
    76,898
    
    
    
    75,534
 Inventory
  June 30,
    
    December 31,2005
    
    2004Raw materials
    
    $
    473
    
    
    $
    1,880Work-in-process
    
    
    23
    
    
    
    1,501Finished goods
    
    
    12,263
    
    
    
    13,763Inventory
    
    $
    12,759
    
    
    $
    17,144
 Purchase Obligations
  7




---



##### Table of Contents



Changes in Accounting Estimates
   Accumulated Other Comprehensive Loss
   Three months ended
    
    Six months endedJune 30,
    
    June 30,2005
    
    2004
    
    2005
    
    2004Net loss
    
    $
    (508
    )
    
    $
    (4,861
    )
    
    $
    (3,112
    )
    
    $
    (15,108
    )Cumulative
translation
adjustments
    
    
    22
    
    
    
    444
    
    
    
    (9
    )
    
    
    368Change in
unrealized gain
(loss) on
available- for-sale
investments
    
    
    174
    
    
    
    (537
    )
    
    
    (131
    )
    
    
    (534
    )Total
comprehensive loss
    
    $
    (312
    )
    
    $
    (4,954
    )
    
    $
    (3,252
    )
    
    $
    (15,274
    )
 8




---



##### Table of Contents



Impact of Recently Issued Accounting Standards
  Stock Based Compensation
  3. Contingencies
   9




---



##### Table of Contents



10




---



##### Table of Contents



4. Operating Segment Information
  Three months ended June 30,
    
    Six months ended June 30,(in thousands)
    
    2005
    
    2004
    
    2005
    
    2004Revenues by product:Digital Video Solutions (DVS)
    
    $
    17,339
    
    
    $
    7,508
    
    
    $
    30,385
    
    
    $
    13,579Home Access Solutions (HAS)
    
    
    10,590
    
    
    
    24,983
    
    
    
    22,160
    
    
    
    48,597Cable Modem Termination
Systems (CMTS)
    
    
    1,506
    
    
    
    10,291
    
    
    
    3,157
    
    
    
    21,588Other
    
    
    98
    
    
    
    
    
    
    
    194
    
    
    
    185Total revenues
    
    $
    29,533
    
    
    $
    42,782
    
    
    $
    55,896
    
    
    $
    83,949Revenues by geographic areas:United States
    
    $
    20,223
    
    
    $
    21,226
    
    
    $
    35,490
    
    
    $
    43,058Americas, excluding United States
    
    
    431
    
    
    
    224
    
    
    
    568
    
    
    
    1,838Europe, Middle East and Africa,
(EMEA), excluding Israel
    
    
    2,288
    
    
    
    7,041
    
    
    
    6,474
    
    
    
    14,965Israel
    
    
    2,797
    
    
    
    5,931
    
    
    
    3,984
    
    
    
    9,215Asia, excluding Japan
    
    
    3,400
    
    
    
    5,037
    
    
    
    8,965
    
    
    
    9,132Japan
    
    
    394
    
    
    
    3,294
    
    
    
    394
    
    
    
    5,688Other
    
    
    
    
    
    
    29
    
    
    
    21
    
    
    
    53Total
    
    $
    29,533
    
    
    $
    42,782
    
    
    $
    55,896
    
    
    $
    83,949
 11




---



##### Table of Contents



June 30,
    
    December 31,2005
    
    2004Long-lived assets:United States
    
    $
    4,079
    
    
    $
    4,423Americas, excluding United States
    
    
    
    
    
    
    402EMEA, excluding Israel
    
    
    96
    
    
    
    131Israel
    
    
    273
    
    
    
    687Asia
    
    
    90
    
    
    
    117Total long-lived assets
    
    
    4,538
    
    
    
    5,760Total current assets
    
    
    141,562
    
    
    
    137,625Other assets
    
    
    9,396
    
    
    
    10,349Total assets
    
    $
    155,496
    
    
    $
    153,734
   5. Restructuring Charges and Asset Write-offs
 Restructuring
 Accounting for Costs Associated with Exit or Disposal Activities, Employers Accounting for Post Employment Benefits
 2004 Restructurings
   12




---



##### Table of Contents



Excess LeasedInvoluntary
    
    
    
    
    
    Facilities andEmployee
    
    Aircraft Lease
    
    CancelledTerminations
    
    Termination
    
    Contracts,
    
    TotalBalance at December 31, 2004
    
    $
    592
    
    
    $
    692
    
    
    $
    1,998
    
    
    $
    3,282Cash payments
    
    
    (1,121
    )
    
    
    (125
    )
    
    
    (679
    )
    
    
    (1,925
    )Charges
    
    
    965
    
    
    
    
    
    
    
    
    
    
    
    965Changes in estimate
    
    
    
    
    
    
    
    
    
    
    907
    
    
    
    907Balance at June 30, 2005
    
    $
    436
    
    
    $
    567
    
    
    $
    2,226
    
    
    $
    3,229
 2002 Restructuring
   13




---



##### Table of Contents



Involuntary
    
    Excess LeasedEmployee
    
    Facilities andTerminations
    
    Cancelled Contracts
    
    TotalBalance at December 31, 2004
    
    $
    
    
    
    $
    15
    
    
    $
    15Changes in estimate
    
    
    
    
    
    
    (15
    )
    
    
    (15
    )Balance at June 30, 2005
    
    $
    
    
    
    $
    
    
    
    $
    
 2001 Restructuring
    Involuntary
    
    Excess LeasedEmployee
    
    Facilities andTerminations
    
    Cancelled Contracts
    
    TotalBalance at December 31, 2004
    
    $
    50
    
    
    $
    1,788
    
    
    $
    1,838Cash payments
    
    
    (50
    )
    
    
    (957
    )
    
    
    (1,007
    )Changes in estimate
    
    
    
    
    
    
    (361
    )
    
    
    (361
    )Balance at June 30, 2005
    
    $
    
    
    
    $
    (470
    )
    
    $
    (470
    )
 Executive Severance
  Asset Write-offs
  14




---



##### Table of Contents



6. Related Party Transactions
   7. Product Warranties
   Charges forBalance at
    
    Additions
    
    Expiration
    
    warranty
    
    Balance atbeginning
    
    charged to
    
    of accrued
    
    services
    
    end ofof period
    
    expenses
    
    warranty
    
    provided
    
    periodSix months ended
June 30, 2004
Accrued warranty
expenses
    
    $
    5,509
    
    
    
    1,922
    
    
    
    (1,300
    )
    
    
    (1,940
    )
    
    $
    4,191Six months ended
June 30, 2005
Accrued warranty
expenses
    
    $
    3,870
    
    
    
    830
    
    
    
    (475
    )
    
    
    (1,503
    )
    
    $
    2,722
 8. Sale of Certain Assets
 ATI
  Israel
Subsidiaries
  15




---



##### Table of Contents



RESULTS OF OPERATIONS
  Overview
      Critical Accounting Policies
  16




---



##### Table of Contents



Results of Operations
 Three and Six months ended June 30, 2005 and June 30, 2004
 Revenues
 For the three months
    
    
    
    
    
    
    
    
    
    % Change for the
    
    % Change for theended
    
    For the six months
    
    three months
    
    six months endedJune 30,
    
    ended June 30,
    
    ended June 30,
    
    June 30,(in thousands)
    
    2005
    
    2004
    
    2005
    
    2004
    
    2005/2004
    
    2005/2004Revenues
    
    $
    29,533
    
    
    $
    42,782
    
    
    $
    55,896
    
    
    $
    83,949
    
    
    
    (31
    %)
    
    
    (33
    %)
  Revenues by Groups of Similar Products
 % Change for
    
    % Change forFor the six months
    
    the three
    

    the six monthsFor the three months
    
    ended
    
    months ended
    
    endedended June 30,
    
    June 30,
    
    June 30,
    
    June 30,(in thousands)
    
    2005
    
    2004
    
    2005
    
    2004
    
    2005/2004
    
    2005/2004Revenues by product:DVS
    
    $
    17,339
    
    
    $
    7,508
    
    
    $
    30,385
    
    
    $
    13,579
    
    
    
    131
    %
    
    
    124
    %HAS
    
    
    10,590
    
    
    
    24,983
    
    
    
    22,160
    
    
    
    48,597
    
    
    
    (58
    %)
    
    
    (54
    %)CMTS
    
    
    1,506
    
    
    
    10,291
    
    
    
    3,157
    
    
    
    21,588
    
    
    
    (85
    %)
    
    
    (85
    %)Other
    
    
    98
    
    
    
    
    
    
    
    194
    
    
    
    185
    
    
    
    100
    %
    
    
    5
    %Total revenues
    
    $
    29,533
    
    
    $
    42,782
    
    
    $
    55,896
    
    
    $
    83,949
    
    
    
    (31
    %)
    
    
    (33
    %)
    17




---



##### Table of Contents



Revenues by Geographic Region
 % Change for
    
    % Change forthe three
    
    the sixFor the three months
    
    For the six months
    
    months ended
    
    months endedended June 30,
    
    ended June 30,
    
    June 30,
    
    June 30,(in thousands)
    
    2005
    
    2004
    
    2005
    
    2004
    
    2005/2004
    
    2005/2004Revenues by geographic areas:United States
    
    $
    20,223
    
    
    $
    21,226
    
    
    $
    35,490
    
    
    $
    43,058
    
    
    
    (5
    %)
    
    
    (18
    %)Americas, excluding United
States
    
    
    431
    
    
    
    224
    
    
    
    568
    
    
    
    1,838
    
    
    
    92
    %
    
    
    (69
    %)Europe, Middle East and Africa,
(EMEA), excluding Israel
    
    
    2,288
    
    
    
    7,041
    
    
    
    6,474
    
    
    
    14,965
    
    
    
    (68
    %)
    
    
    (57
    %)Israel
    
    
    2,797
    
    
    
    5,931
    
    
    
    3,984
    
    
    
    9,215
    
    
    
    (53
    %)
    
    
    (57
    %)Asia excluding Japan
    
    
    3,400
    
    
    
    5,037
    
    
    
    8,965
    
    
    
    9,132
    
    
    
    (32
    %)
    
    
    (2
    %)Japan
    
    
    394
    
    
    
    3,294
    
    
    
    394
    
    
    
    5,688
    
    
    
    (88
    %)
    
    
    (93
    %)Other
    
    
    
    
    
    
    29
    
    
    
    21
    
    
    
    53
    
    
    
    (100
    %)
    
    
    (60
    %)Total
    
    $
    29,533
    
    
    $
    42,782
    
    
    $
    55,896
    
    
    $
    83,949
    
    
    
    (31
    %)
    
    
    (33
    %)
  Related Party Revenues
 % Change for% Change for
    
    the sixFor the three months
    
    For the six months
    
    the three months
    
    months endedended June 30,
    
    ended June 30,
    
    ended June 30,
    
    June 30,(in thousands)
    
    2005
    
    2004
    
    2005
    
    2004
    
    2005/2004
    
    2005/2004Related party revenues
    
    $
    4,841
    
    
    $
    2,644
    
    
    $
    13,668
    
    
    $
    3,389
    
    
    
    83
    %
    
    
    303
    %
  Cost of Goods Sold and Gross Profit
 % Change for
    
    % Change for theFor the three months
    
    For the six months
    
    the three months
    
    six months endedended June 30,
    
    ended June 30,
    
    ended June 30,
    
    June 30,(in thousands)
    
    2005
    
    2004
    
    2005
    
    2004
    
    2005/2004
    
    2005/2004Cost of revenues
    
    $
    14,024
    
    
    $
    27,046
    
    
    $
    25,379
    
    
    $
    55,605
    
    
    
    (48
    %)
    
    
    (54
    %)Cost of related party
revenues
    
    
    2,677
    
    
    
    614
    
    
    
    4,364
    
    
    
    825
    
    
    
    336
    %
    
    
    429
    %Total cost of goods sold
    
    $
    16,701
    
    
    $
    27,660
    
    
    $
    29,743
    
    
    $
    56,430
    
    
    
    (40
    %)
    
    
    (47
    %)Gross profit
    
    $
    12,832
    
    
    $
    15,122
    
    
    $
    26,153
    
    
    $
    27,519
    
    
    
    (15
    %)
    
    
    (5
    %)
 18




---



##### Table of Contents



Operating Expenses
 % Change for
    
    % Change forthe three
    
    the six monthsFor the three months
    
    For the six months
    
    months ended
    
    endedended June 30,
    
    ended June 30,
    
    June 30,
    
    June 30,(in thousands)
    
    2005
    
    2004
    
    2005
    
    2004
    
    2005/2004
    
    2005/2004Research and
development
    
    $
    4,427
    
    
    $
    8,516
    
    
    $
    10,371
    
    
    $
    17,984
    
    
    
    (48
    %)
    
    
    (42
    %)Sales and marketing
    
    $
    5,611
    
    
    $
    5,411
    
    
    $
    11,285
    
    
    $
    12,632
    
    
    
    4
    %
    
    
    (11
    %)General and
administrative
    
    $
    2,878
    
    
    $
    2,953
    
    
    $
    5,673
    
    
    $
    5,388
    
    
    
    (3
    %)
    
    
    5
    %
 Research and Development.
 19




---



##### Table of Contents



Sales and Marketing
 General and Administrative
 Restructuring
Charges and Asset Write-offs
 For the three months
    
    For the six months endedended June 30,
    
    June 30,(in thousands)
    
    2005
    
    2004
    
    2005
    
    2004Executive severance charges
    
    $
    
    
    
    $
    1,682
    
    
    $
    
    
    
    $
    1,682Restructuring charges, net
    
    
    282
    
    
    
    1,897
    
    
    
    1,479
    
    
    
    5,158Long-lived assets written-off
    
    
    
    
    
    
    
    
    
    
    85
    
    
    

    106Restructuring costs and
asset write-offs
    
    $
    282
    
    
    $
    3,579
    
    
    $
    1,564
    
    
    $
    6,946
 Restructuring Costs
 20




---



##### Table of Contents



Executive Severance
 Asset Write-offs
 Non-operating Expenses
 % Change forFor the six months
    
    the three
    
    % Change forFor the three months
    
    ended
    
    months ended
    
    the six monthsended June 30,
    
    June 30,
    
    June 30,
    
    ended June 30,(in thousands)
    
    2005
    
    2004
    
    2005
    
    2004
    
    2005/2004
    
    2005/2004Interest income
    
    $
    672
    
    
    $
    460
    
    
    $
    1,240
    
    
    $
    912
    
    
    
    46
    %
    
    
    36
    %Interest expense
    
    $
    (814
    )
    
    $
    (826
    )
    
    $
    (1,627
    )
    
    $
    (1,643
    )
    
    
    (1
    %)
    
    
    (1
    %)Other income expense
    
    $
    (50
    )
    
    $
    921
    
    
    $
    15
    
    
    $
    1,200
    
    
    
    (106
    %)
    
    
    (99
    %)
 Interest Income
 21




---



##### Table of Contents



Interest Expense
 Other Income.
 Income Taxes
 For the three months ended
    
    For the six months endedJune 30,
    
    June 30,(in thousands)
    
    2005
    
    2004
    
    2005
    
    2004Income tax expense
    
    $
    50
    
    
    $
    (79
    )
    
    
    
    
    
    $
    (146
    )
  Litigation
  Off-Balance Sheet Financings and Liabilities
  Liquidity and Capital Resources
   22




---



##### Table of Contents



23




---



##### Table of Contents



Contractual Obligations
  Payments Due by PeriodLess than
    
    1-3
    
    4-5
    
    After 5Total
    
    1 year
    
    years
    
    years
    
    yearsUnconditional Purchase Obligations
    
    $
    21.8
    
    
    $
    21.8
    
    
    $
    
    
    
    $
    
    
    
    $
    Long Term Debt
    
    
    65.1
    
    
    
    
    
    
    
    65.1
    
    
    
    
    
    
    
    Operating Lease Obligations
    
    
    14.3
    
    
    
    3.8
    
    
    
    6.3
    
    
    
    4.1
    
    
    
    0.1Aircraft Lease Obligations
    
    
    2.3
    
    
    
    1.5
    
    
    
    0.8
    
    
    
    
    
    
    
    Total Contractual Commitments
    
    $
    103.5
    
    
    $
    27.1
    
    
    $
    72.2
    
    
    $
    4.1
    
    
    $
    0.1
   Amount of Commitment Expiration Per PeriodTotalAmounts
    
    Less than
    
    1-3
    
    4-5
    
    Over 5Committed
    
    1 year
    
    years
    
    years
    
    yearsDeposits
    
    $
    7.5
    
    
    $
    
    
    
    $
    7.5
    
    
    $
    
    
    
    $
    Standby Letters of Credit
    
    
    1.2
    
    
    
    0.9
    
    
    
    
    
    
    
    0.3
    
    
    
    Total Commercial Commitments
    
    $
    8.7
    
    
    $
    0.9
    
    
    $
    7.5
    
    
    $
    0.3
    
    
    $
    
  Impact of Recently Issued Accounting Standards
  24




---



##### Table of Contents



Stock Based Compensation
  RISK FACTORS
 You should carefully consider the risks described below before making an investment decision. The
risks and uncertainties described below are not the only ones facing us. Additional risks and
uncertainties not presently known to us or that we currently deem immaterial also may impair our
business operations. If any of the following risks actually occur, our business could be harmed.
In such case, the trading price of our common stock could decline, and you may lose all or part of
your investment.
 Risks Related to Our Business
 We have a history of losses and may continue to incur losses in the future
  25




---



##### Table of Contents



We may continue to experience fluctuations in our operating results and face unpredictability in
our future revenues
  
    
    variations in the timing of orders and shipments of our products;
    
    variations in the size of the orders by our customers and pricing concessions on volume sales;
    
    competitive market conditions;
    
    unpredictable sales cycles;
    
    new product introductions by competitors or by us;
    
    delays in our introduction of new products;
    
    delays in our introduction of added features to our products;
    
    delays in the commercialization of products that are competitive in the marketplace;
    
    delays in our receipt of and cancellation of orders forecasted by customers;
    
    variations in capital spending budgets of cable operators and other broadband service providers;
    
    international conflicts, including the continuing conflict in Iraq, and acts of
terrorism and the impact of adverse economic, market and political conditions worldwide;
and
    
    ability of our products to be qualified or certified as meeting industry standards.
  
    
    the sales mix of our products;
    
    the volume of products manufactured;
    
    the type of distribution channel through which we sell our products;
    
    the ASPs of our products;
    
    our ability to manage excess and obsolete inventory;
    
    delays in reducing the cost of our products;
    
    the costs of manufacturing our products; and
    
    the effectiveness of our cost reduction measures.
 26




---



##### Table of Contents



27




---



##### Table of Contents



We are dependent on a small number of customers and resellers and our business could be harmed
by the loss of any of these customers or reductions in their purchasing volumes
     Recent changes in senior management and the reductions in workforce associated with our
restructuring efforts could disrupt the operation of our business, distract our management from
focusing on revenue- generating efforts, result in the erosion of employee morale, and impair our
ability to respond rapidly to growth opportunities in the future
  28




---



##### Table of Contents



We are dependent on key personnel
   There are many risks associated with our participation in industry standards
  29




---



##### Table of Contents



We need to certify and qualify our new and existing products to meet industry specifications in
order to remain competitive
   30




---



##### Table of Contents



Our video products and applications must achieve widespread market acceptance to advance the growth
of our digital video solutions business
  The emerging market trend to standardize the digital video technology may challenge our ability to
continue to grow our digital video business
  31




---



##### Table of Contents



We depend on broadband providers capital spending for a substantial portion of our revenue and any
decrease or delay in capital spending would negatively impact our operating results and financial
condition
  
    
    the availability of financing;
    
    annual budget cycles, as well as the typical reduction in upgrade projects during the
winter months;
    
    the status of federal, local and foreign government regulation and deregulation of the
telecommunications industry;
    
    overall demand for broadband services and the acceptance of new data, video and voice services;
    
    evolving industry standards and network architectures;
    
    competitive pressures (including the availability of alternative data transmission and
access technologies);
    
    discretionary consumer spending patterns; and
    
    general economic conditions.
 32




---



##### Table of Contents



Average selling prices of broadband equipment may continue to decline, decreasing our gross margins
   We must achieve cost reductions or increase revenues to attain profitability
    33




---



##### Table of Contents



We may not be able to raise additional funds to continue operating our business
   We may dispose of or discontinue existing product lines, which may adversely impact our future
results
   We may be unable to provide adequate customer support
  34




---



##### Table of Contents



We may have financial exposure to litigation
    The sales cycle for certain of our products is lengthy, which makes forecasting of our customer
orders and revenues difficult
  We need to develop additional distribution channels to market and sell our products
  We may fail to accurately forecast customer demand for our products
  35




---



##### Table of Contents



We may not be able to manage expenses and inventory risks associated with meeting the demand of our
customers
  We are dependent on key third-party suppliers and any failure by them to deliver components could
limit our ability to satisfy customer demand
   We may be unable to migrate to new semiconductor process technologies successfully or on a timely
basis
  36




---



##### Table of Contents



Our ability to directly control product delivery schedules and product quality is dependent on
third-party contract manufacturers
  We are dependent upon international sales and there are many risks associated with international
operations
  
    
    changes in foreign government regulations and communications standards;
    
    import and export license requirements, tariffs and taxes;
    
    trade barriers and trade disputes;
    
    difficulty in protecting intellectual property;
    
    difficulty in collecting accounts receivable;
    
    currency fluctuations;
    
    the burden of complying with a wide variety of foreign laws, treaties and technical standards;
    
    difficulty in staffing and managing foreign operations; and
    
    political and economic instability.
     37




---



##### Table of Contents



The deployment process for our equipment may be lengthy and may delay the receipt of new orders and
cause fluctuations in our revenues
  Our industry is highly competitive with many larger and more established competitors
  
    
    product performance, features and reliability;
    
    price;
    
    size and stability of operations;
    
    breadth of product line;
    
    sales and distribution capabilities;
    
    technical support and service;
    
    relationships with providers of service providers; and
    
    compliance with industry standards.
   38




---



##### Table of Contents



Our business is subject to the risks of warranty returns, product liability and product defects
  We may be unable to adequately protect or enforce our intellectual property rights
    39




---



##### Table of Contents



Third party claims of infringement or other claims against us could adversely affect our ability to
market our products, require us to redesign our products or seek licenses from third parties, and
seriously harm our operating results and disrupt our business
  Our indebtedness could adversely affect our financial condition and we may incur substantially more
debt
  
    
    making it more difficult for us to satisfy our obligations with respect to our indebtedness;
    
    increasing our vulnerability to general adverse economic and industry conditions;
    
    limiting our ability to obtain additional financing;
    
    requiring the dedication of a substantial portion of our cash flow from operations to
the payment of principal of, and interest on, our indebtedness, thereby reducing the
availability of our cash flow to fund our growth strategy, working capital, capital
expenditures and other general corporate purposes;
    
    limiting our flexibility in planning for, or reacting to, changes in our business and
the industry; and
    
    placing us at a competitive disadvantage relative to our competitors with less debt.
  40




---



##### Table of Contents



We need to develop and introduce new and enhanced products in a timely manner to remain competitive
   
    
    cost effective;
    
    brought to market in a timely manner;
    
    in accordance with evolving industry standards and architecture; or
    
    fail to achieve market acceptance.
  We are exposed to the credit risk of our customers and to credit exposures in weakened markets,
which could result in material losses
   41




---



##### Table of Contents



We have and we may seek to expand our business through acquisitions which could disrupt our
business operations and harm our operating results
  
    
    difficulties in integrating the operations, technologies, products and personnel of an
acquired company;
    
    diversion of managements attention from normal daily operations of the business;
    
    potential difficulties in completing projects associated with in-process research and development;
    
    difficulties in entering markets in which we have no or limited direct prior experience
and where competitors in such markets have stronger market positions;
    
    initial dependence on unfamiliar supply chains or relatively small supply partners;
    
    insufficient revenues to offset increased expenses associated with acquisitions; and
    
    the potential loss of key employees of the acquired companies.
  
    
    issue common stock that would dilute our current stockholders percentage ownership;
    
    assume liabilities;
    
    record goodwill and non-amortizable intangible assets that will be subject to
impairment testing and potential periodic impairment charges;
    
    incur amortization expenses related to certain intangible assets;
    
    incur large and immediate write-offs; or
    
    become subject to litigation.
   42




---



##### Table of Contents



Our products are subject to safety approvals and certifications
  Compliance with current and future environmental regulations may be costly which could impact our
future earnings.
  Various export licensing requirements could materially and adversely affect our business or require
us to significantly modify our current business practices
  Compliance with changing laws and regulations relating to corporate governance and public
disclosure has resulted, and will continue to result, in the incurrence of additional expenses
associated with being a public company
  43




---



##### Table of Contents



Newly adopted accounting regulations that require companies to expense stock options will result in
a decrease in our earnings and our stock price may decline.
  Exchange rate fluctuations could cause a decline in our financial condition and results of
operations
  44




---



##### Table of Contents



Our stock price has been and is likely to continue to be highly volatile
  
    
    actual or anticipated variations in quarterly operating results;
    
    announcements of technological innovations;
    
    new products or services offered by us or our competitors;
    
    changes in financial estimates by securities analysts;
    
    conditions or trends in the broadband services industry;
    
    changes in the economic performance and/or market valuations of Internet, online
service or broadband service industries;
    
    our announcement of significant acquisitions, strategic partnerships, joint ventures or
capital commitments;
    
    adoption of industry standards and the inclusion or compatibility of our technology
with such standards;
    
    adverse or unfavorable publicity regarding us or our products;
    
    additions or departures of key personnel;
    
    sales of common stock; and
    
    other events or factors that may be beyond our control.
  We have adopted a stockholder rights plan, which, together with provisions in our charter documents
and Delaware law, may delay or prevent an acquisition of us, which could decrease the value of our
stock
  45




---



##### Table of Contents



We rely on complex information technology systems and networks to operate our business. Any
significant system or network disruption could have a material adverse impact on our operations,
sales and operating results
  We are vulnerable to earthquakes, disruptions to our power supply, labor issues and other
unexpected events
  Our independent auditors recently notified us of their intention to resign, and our business will
be harmed if we are unable to retain a replacement auditing firm in a timely manner.
  
 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 Interest Rate Risk.
  Foreign Currency Risk.
   46




---



##### Table of Contents



ITEM 4. CONTROLS AND PROCEDURES
 Evaluation of Disclosure Controls and Procedures.
     Remediation Steps
  (i)
    
    Established procedures to document the review of press releases to
account for transactions in a complete and timely manner;(ii)
    
    Engaged the former Assistant Controller, who has significant SEC
reporting experience, to serve as our Controller, in part to
supervise our financial reporting to ensure compliance with SEC
requirements;(iii)
    
    Promoted our Consolidations Reporting Manager to Director of
Accounting to provide greater individual management of all
accounting functions; and(iv)
    
    Improved our internal process of drafting and reviewing periodic
reports by implementing additional management and external legal
counsel review prior to their submission to our independent
registered public accounting firm.
 47




---



##### Table of Contents



(i)
    
    Continue to monitor the communication channels between our senior
management and our finance department and take prompt action, as
necessary, to further strengthen these communication channels;(ii)
    
    Increase staffing in the finance department;(iii)
    
    Re-allocate duties to persons within the finance organization to
maximize their skills and experience;(iv)
    
    Implement training procedures for new employees and/or consultants
in the finance department on our disclosure procedures and controls,
our Company and our actions in previous reporting periods; and(v)
    
    Take steps to ensure that our senior management has timely access to
all material financial and non-financial information concerning our
business.
 Changes in internal control over financial reporting.
 
 PART II. OTHER INFORMATION
 
 ITEM 1. LEGAL PROCEEDINGS
    48




---



##### Table of Contents



49




---



##### Table of Contents



ITEM 5. OTHER INFORMATION
   
 ITEM 6. EXHIBITS
 ExhibitNumber
    
    Exhibit Description10.22
    
    Employment Agreement dated July 22, 2005 between Terayon
Communication Systems, Inc. and Jerry D. Chase10.23
    
    Employment Agreement dated July 22, 2005 between Terayon
Communication Systems, Inc. and Mark A. Richman10.24
    
    Employment Agreement dated July 27, 2005 between Terayon
Communication Systems, Inc. and Matthew J. Aden.10.26
    
    Proprietary Information and Inventions Agreement dated July 27,
2005 between Terayon Communication Systems, Inc. and Matthew J.
Aden.31.1
    
    Certification of the Chief Executive Officer Pursuant to Section
302 of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification of the Chief Financial Officer Pursuant to Section
302 of the Sarbanes-Oxley Act of 2002.32.1
    
    Certification of the Chief Executive Officer Pursuant to Section
906 of the Sarbanes-Oxley Act of 2002.32.2
    
    Certification of the Chief Financial Officer Pursuant to Section
906 of the Sarbanes-Oxley Act of 2002.
 50




---



##### Table of Contents



Date: August 9, 2005
    
    TERAYON COMMUNICATION SYSTEMS, INC.By /s/ Mark A. Richman

Mark A. RichmanChief Financial Officer
 51




---



##### Table of Contents



Exhibit Index
 10.22
    
    Employment Agreement dated July 22, 2005 between Terayon
Communication Systems, Inc. and Jerry D. Chase10.23
    
    Employment Agreement dated July 22, 2005 between Terayon
Communication Systems, Inc. and Mark A. Richman10.24
    
    Employment Agreement dated July 27, 2005 between Terayon
Communication Systems, Inc. and Matthew J. Aden.10.26
    
    Proprietary Information and Inventions Agreement dated July 27,
2005 between Terayon Communication Systems, Inc. and Matthew J.
Aden.31.1
    
    Certification of the Chief Executive Officer Pursuant to Section
302 of the Sarbanes-Oxley Act of 2002.31.2
    
    Certification of the Chief Financial Officer Pursuant to Section
302 of the Sarbanes-Oxley Act of 2002.32.1
    
    Certification of the Chief Executive Officer Pursuant to Section
906 of the Sarbanes-Oxley Act of 2002.32.2
    
    Certification of the Chief Financial Officer Pursuant to Section
906 of the Sarbanes-Oxley Act of 2002.