##### Table of Contents



SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
 FORM 10-Q x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED September 30, 2004
OR o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE TRANSITION
PERIOD FROM TO .   TERAYON COMMUNICATION SYSTEMS, INC.  DELAWARE
    
    77-0328533(STATE OR OTHER JURISDICTION OF
    
    (IRS EMPLOYERINCORPORATION OR ORGANIZATION)
    
    IDENTIFICATION NO.)
 4988 GREAT AMERICA PARKWAY
SANTA CLARA, CALIFORNIA 95054
(408) 235-5500
(ADDRESS, INCLUDING ZIP CODE, AND TELEPHONE NUMBER, INCLUDING AREA CODE, OF
THE REGISTRANTS PRINCIPAL EXECUTIVE OFFICES)   Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.  Yes x  No o Indication by check mark whether the registrant is an accelerated file (as
defined by Rule 12b-2 of the Exchange Act)  Yes x  No o As of October 31, 2004 registrant had outstanding 76,168,800 shares of
Common Stock.




---



SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS This Report on Form 10-Q contains forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934 which are subject to the safe harbor created
by those sections. These forward-looking statements include, but are not
limited to: statements related to industry trends and future growth in the
markets for cable modem systems; our strategies for reducing the cost of our
products; our product development efforts; the effect of GAAP accounting
pronouncements on our recognition of revenues; our future research and
development; the timing of our introduction of new products; the timing and
extent of deployment of our products by our customers; and future
profitability. We usually use words such as may, will, should, expect,
plan, anticipate, believe, estimate, predict, future, intend, or
certain or the negative of these terms or similar expressions to identify
forward-looking statements. Discussions containing such forward-looking
statements may be found throughout the document. These forward-looking
statements involve certain risks and uncertainties that could cause actual
results to differ materially from those in such forward-looking statements. We
disclaim any obligation to update these forward-looking statements as a result
of subsequent events. The business risks discussed in Part 1, Item 2 of this
Report on Form 10-Q, among other things, should be considered in evaluating our
prospects and future financial performance. ITEM 1. FINANCIAL
STATEMENTSPART I. FINANCIAL INFORMATION TERAYON COMMUNICATION SYSTEMS, INC.
INDEX TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS PageCondensed Consolidated Balance Sheets as of September 30, 2004 (unaudited) and
December 31, 2003
    
    
    3Condensed Consolidated Statements of Operations for the three and nine months
ended September 30, 2004 and 2003
(unaudited)
    
    
    4Condensed Consolidated Statements of Cash Flows for the nine months ended
September 30, 2004 and 2003
(unaudited)
    
    
    5Notes to Condensed Consolidated Financial Statements
(unaudited)
    
    
    6EXHIBIT 10.32EXHIBIT 10.33EXHIBIT 10.34EXHIBIT 10.35EXHIBIT 10.36EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
  2




---



##### Table of Contents



TERAYON COMMUNICATION SYSTEMS, INC. 
 
 September 30,
    
    December 31,2004
    
    2003(unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    64,150
    
    
    $
    30,188Short-term investments
    
    
    47,757
    
    
    
    108,452Accounts receivable, net
    
    
    19,752
    
    
    
    29,199Accounts receivable from related parties
    
    
    723
    
    
    
    600Other current receivables
    
    
    926
    
    
    
    3,662Inventory
    
    
    15,529
    
    
    
    16,364Other current assets
    
    
    2,660
    
    
    
    2,883Total current assets
    
    
    151,497
    
    
    
    191,348Property and equipment, net
    
    
    9,134
    
    
    
    11,871Restricted cash
    
    
    8,727
    
    
    
    9,212Other assets, net
    
    
    2,138
    
    
    
    2,809Total assets
    
    $
    171,496
    
    
    $
    215,240LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    11,128
    
    
    $
    26,049Accrued payroll and related expenses
    
    
    4,368
    
    
    
    6,537Deferred revenues
    
    
    4,345
    
    
    
    3,423Warranty reserves
    
    
    4,043
    
    
    
    5,509Accrued executive severance and restructuring charges
    
    
    7,914
    
    
    
    4,500Accrued vendor cancellation charges
    
    
    2,133
    
    
    
    2,869Other accrued liabilities
    
    
    4,459
    
    
    
    5,036Interest payable and current portion of long-term debt
    
    
    542
    
    
    
    1,358Other current obligations
    
    
    
    
    
    
    124Total current liabilities
    
    
    38,932
    
    
    
    55,405Long-term obligations
    
    
    3,417
    
    
    
    3,366Convertible subordinated notes
    
    
    65,081
    
    
    
    65,081Commitments and contingenciesStockholders equity:Common stock
    
    
    76
    
    
    
    75Additional paid in capital
    
    
    1,083,420
    
    
    
    1,082,036Accumulated deficit
    
    
    (1,016,188
    )
    
    
    (987,560
    )Deferred compensation
    
    
    
    
    
    
    (22
    )Treasury stock, at cost
    
    
    (773
    )
    
    
    (773
    )Accumulated other comprehensive loss
    
    
    (2,469
    )
    
    
    (2,368
    )Total stockholders equity
    
    
    64,066
    
    
    
    91,388Total liabilities and stockholders equity
    
    $
    171,496
    
    
    $
    215,240
 See accompanying notes. 3




---



##### Table of Contents



TERAYON COMMUNICATION SYSTEMS, INC. 
 
 Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Revenues
    
    $
    35,659
    
    
    $
    37,168
    
    
    $
    116,218
    
    
    $
    87,568Related party revenues
    
    
    1,543
    
    
    
    460
    
    
    
    4,933
    
    
    
    2,927Total
revenues
    
    
    37,202
    
    
    
    37,628
    
    
    
    121,151
    
    
    
    90,495Cost of revenues
    
    
    30,393
    
    
    
    27,296
    
    
    
    86,014
    
    
    
    69,500Cost of related party revenues
    
    
    539
    
    
    
    138
    
    
    
    1,348
    
    
    
    1,262Total cost of
revenues
    
    
    30,932
    
    
    
    27,434
    
    
    
    87,362
    
    
    
    70,762Gross profit
    
    
    6,270
    
    
    
    10,194
    
    
    
    33,789
    
    
    
    19,733Operating expenses:Research and development
    
    
    8,696
    
    
    
    9,363
    
    
    
    26,680
    
    
    
    32,797Sales and marketing
    
    
    6,222
    
    
    
    6,452
    
    
    
    18,854
    
    
    
    19,741General and administrative
    
    
    2,993
    
    
    
    2,783
    
    
    
    8,381
    
    
    
    9,510Executive severance, restructuring costs and
asset write-offs
    
    
    1,463
    
    
    
    (244
    )
    
    
    8,409
    
    
    
    2,803Total operating expenses
    
    
    19,374
    
    
    
    18,354
    
    
    
    62,324
    
    
    
    64,851Loss from operations
    
    
    (13,104
    )
    
    
    (8,160
    )
    
    
    (28,535
    )
    
    
    (45,118
    )Interest income
    
    
    525
    
    
    
    583
    
    
    
    1,437
    
    
    
    2,394Interest expense
    
    
    (812
    )
    
    
    (787
    )
    
    
    (2,456
    )
    
    
    (2,438
    )Other income (expense)
    
    
    (46
    )
    
    
    1,238
    
    
    
    1,155
    
    
    
    1,038Loss before income tax expense
    
    
    (13,437
    )
    
    
    (7,126
    )
    
    
    (28,399
    )
    
    
    (44,124
    )Income tax expense
    
    
    (83
    )
    
    
    (84
    )
    
    
    (229
    )
    
    
    (214
    )Net loss
    
    $
    (13,520
    )
    
    $
    (7,210
    )
    
    $
    (28,628
    )
    
    $
    (44,338
    )Net loss per share, basic and diluted
    
    $
    (0.18
    )
    
    $
    (0.10
    )
    
    $
    (0.38
    )
    
    $
    (0.60
    )Shares used in per share calculation, basic and
diluted
    
    
    76,164
    
    
    
    74,551
    
    
    
    75,744
    
    
    
    73,994
 See accompanying notes. 4




---



##### Table of Contents



TERAYON COMMUNICATION SYSTEMS, INC. 
 
 Nine Months EndedSeptember 30,2004
    
    2003Operating activities:Net loss
    
    $
    (28,628
    )
    
    $
    (44,338
    )Adjustments to reconcile net loss to net cash used in operating activities:Depreciation
    
    
    4,788
    
    
    
    7,155Amortization related to stock options
    
    
    17
    
    
    
    17Lower of
cost or market inventory reserve (recovery)
    
    
    6,432
    
    
    
    (8,138
    )Write-off and disposal of fixed assets
    
    
    210
    
    
    
    497Changes in operating assets and liabilities:Accounts
receivable, net
    
    
    9,447
    
    
    
    (13,031
    )Accounts receivable from related parties
    
    
    (123
    )
    
    
    642Inventory
    
    
    (5,597
    )
    
    
    12,826Other current and non-current assets
    
    
    4,116
    
    
    
    5,844Accounts payable
    
    
    (14,921
    )
    
    
    (590
    )Accrued payroll and related expenses
    
    
    (2,169
    )
    
    
    (180
    )Deferred revenues
    
    
    922
    
    
    
    1,675Warranty
reserves
    
    
    (1,466
    )
    
    
    (2,398
    )Accrued
executive severance and restructuring charges
    
    
    3,414
    

    
    
    (1,917
    )Accrued vendor cancellation charges
    
    
    (736
    )
    
    
    (11,274
    )Other accrued liabilities.
    
    
    (1,338
    )
    
    
    (3,911
    )Net cash used in operating activities
    
    
    (25,632
    )
    
    
    (57,121
    )Investing activities:Purchases of short-term investments
    
    
    (77,748
    )
    
    
    (200,239
    )Proceeds from sales and maturities of short-term investments
    
    
    138,160
    
    
    
    182,231Purchases of property and equipment
    
    
    (2,261
    )
    
    
    (2,716
    )Net cash provided by (used in) investing activities
    
    
    58,151
    
    
    
    (20,724
    )Financing activities:Principal payments on capital leases
    
    
    (128
    )
    
    
    (116
    )Proceeds from issuance of common stock
    
    
    1,390
    
    
    
    2,411Net cash provided by financing activities
    
    
    1,262
    
    
    
    2,295Effect of exchange rate changes
    
    
    181
    
    
    
    909Net increase (decrease) in cash and cash equivalents
    
    
    33,962
    
    
    
    (74,641
    )Cash and cash equivalents at beginning of period
    
    
    30,188
    
    
    
    117,079Cash and cash equivalents at end of period
    
    $
    64,150
    
    
    $
    42,438
 See accompanying notes. 5




---



##### Table of Contents



TERAYON COMMUNICATION SYSTEMS, INC. 
 
 1. Organization and Summary of Significant Accounting Policies Description of Business Terayon Communication Systems, Inc., or the Company, was incorporated
under the laws of the State of California on January 20, 1993. In July 1998,
the Company reincorporated in the State of Delaware. The
Company develops, manufactures, markets and sells equipment to broadband service
providers who use the Companys products to deliver broadband voice, video and
data services to residential and business subscribers. Basis of Presentation The accompanying condensed consolidated financial statements have been
prepared in accordance with U.S. generally accepted accounting principles
for interim financial information and in accordance with the
instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they
do not include all of the information and footnotes required by U.S. generally
accepted accounting principles for complete financial
statements. In the opinion of management, all adjustments (consisting of normal
recurring adjustments) necessary for a fair presentation of the financial
statements at September 30, 2004 and for the three and nine months ended
September 30, 2004 and 2003 have been included. Results for the three and nine months ended September 30, 2004 are not
necessarily indicative of results for the entire fiscal year or future periods.
These financial statements should be read in conjunction with the consolidated
financial statements and the accompanying notes included in the Companys Form
10-K dated March 15, 2004, as filed with the U.S. Securities and Exchange
Commission. The accompanying balance sheet at December 31, 2003 is derived
from audited consolidated financial statements at that date. Reclassifications Certain amounts in the 2003 financial statements have been reclassified to
conform to the 2004 presentation. Basis of Consolidation The condensed consolidated financial statements include the accounts of
the Company and its wholly owned subsidiaries. All intercompany balances and
transactions have been eliminated. Use of Estimates The preparation of the condensed consolidated financial statements in
conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts
reported in the financial statements and accompanying notes. Actual results
could differ from those estimates. Estimates are based on historical
experience, input from sources outside of the Company, and other relevant facts
and circumstances. Actual results could differ from those estimates. Areas that
are particularly significant include the Companys valuation of its accounts
receivable and inventory reserves, the assessment of recoverability and the
measurement of impairment of fixed assets, and the recognition of warranty and
restructuring reserves. 6




---



##### Table of Contents



Stock-Based Compensation The Company accounts for stock-based compensation for its employees using
the intrinsic value method presented in Accounting Principles Board (APB)
Opinion No. 25, Accounting for Stock Issued to Employees, (APB No. 25), and
includes the disclosure-only provisions as required under Statement of
Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based
Compensation (SFAS No. 123). The Company provides additional pro forma
disclosures as required under SFAS No. 123 and SFAS No. 148, Accounting for
Stock-Based Compensation, Transition and Disclosure. For purposes of pro forma disclosures, the estimated fair value of the
options granted and employee stock purchase plan shares to be issued is
amortized to expense over their respective vesting periods. Had compensation
cost for the Companys stock-based compensation plans been determined based on
the fair value at the grant dates for awards under those plans consistent with
the method of SFAS No. 123, the Companys net loss applicable to common
stockholders and net loss per share applicable to common stockholders would
have been increased to the pro forma amounts indicated below (in thousands,
except per share data): Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net loss, as reported
    
    $
    (13,520
    )
    
    $
    (7,210
    )
    
    $
    (28,628
    )
    
    $
    (44,338
    )Add:
Stock-based compensation under APB No. 25
    
    
    
    
    
    
    9
    
    
    
    17
    
    
    
    17Deduct: Stock option compensation expense
determined under fair value-based method
    
    
    (3,071
    )
    
    
    (5,602
    )
    
    
    (11,284
    )
    
    
    (17,201
    )Employee stock purchase plan
compensation expense determined under fair value-based method
    
    
    (159
    )
    
    
    (366
    )
    
    
    (872
    )
    
    
    (1,646
    )Pro forma net loss
    
    $
    (16,750
    )
    
    $
    (13,169
    )
    
    $
    (40,767
    )
    
    $
    (63,168
    )Net loss per
share, basic and diluted, as reported
    
    $
    (0.18
    )
    
    $
    (0.10
    )
    
    $
    (0.38
    )
    
    $
    (0,60
    )Pro forma net loss per share, basic and diluted
    
    $
    (0.22
    )
    
    $
    (0.18
    )
    
    $
    (0.54
    )
    
    $
    (0.85
    )Shares used in computing pro forma net loss
per share, basic and diluted
    
    
    76,164
    
    
    
    74,551
    
    
    
    75,744
    
    
    
    73,994
 Inventory Inventory is stated at the lower of cost (first-in, first-out) or market.
The components of inventory are as follows (in thousands): September 30,
    
    December 31,2004
    
    2003Raw materials
    
    $
    683
    
    
    $
    1,440Work-in-process
    
    
    159
    
    
    
    660Finished goods
    
    
    14,687
    
    
    
    14,264Total inventory
    
    $
    15,529
    
    
    $
    16,364
 7




---



##### Table of Contents



During
the three and nine months ended September 30, 2004, the Company reversed
approximately $0.6 million and $1.9 million, respectively, of inventory
reserves, which were previously recorded as cost of goods sold. During the
three and nine months ended September 30, 2003, the Company reversed
approximately $1.0 million and $2.7 million, respectively of inventory
reserves. The Company reversed these reserves as it was able to sell
inventory originally considered to be excess or obsolete. Purchase Obligations The Company has purchase obligations to certain of its suppliers that
support the Companys ability to manufacture its products. The obligations
consist of purchase orders placed with vendors for goods and services and
require the Company to purchase minimum quantities of the suppliers products
at a specified price. As of September 30, 2004, $26.5 million of purchase
obligations were outstanding. The Company accrues for vendor cancellation
charges in amounts, which represent managements estimate of the Companys
exposure to vendors when management curtails or ceases production of certain products or terminates
a vendor or supplier agreement. Estimates of exposure are determined using
vendor inventory data. At September 30, 2004,
accrued vendor cancellation charges were $2.1 million and the remaining $24.4
million was attributable to open purchase orders in the normal course of
business. The remaining obligations are expected to become payable at various
times through the first quarter of 2005. For the three and nine months ended September 30, 2004, the Company
reversed approximately $23,000 and $3.4 million, respectively, of vendor
cancellation charges. For the three and nine months ended September 30, 2003,
the Company reversed $1.0 million and $5.4 million, respectively, of accrued
vendor cancellation charges. The Company reversed these amounts as a result of
favorable negotiations with vendors. Net Loss Per Share A reconciliation of the numerator and denominator of basic and diluted net
loss per share is provided as follows (in thousands, except per share amounts): Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net loss
    
    $
    (13,520
    )
    
    $
    (7,210
    )
    
    $
    (28,628
    )
    
    $
    (44,338
    )Shares used in
computing basic
and diluted net
loss per share
    
    
    76,164
    
    
    
    74,551
    
    
    
    75,744
    
    
    
    73,994Basic and
diluted net
loss per share
    
    $
    (0.18
    )
    
    $
    (0.10
    )
    
    $
    (0.38
    )
    
    $
    (0.60
    )
 Options and warrants to purchase 17,664,919 and 17,634,021 shares of
common stock were outstanding at September 30, 2004 and September 30, 2003,
respectively, but were not included in the computation of diluted net loss per
share, since the effect would have been antidilutive. Accumulated Other Comprehensive Loss Accumulated other comprehensive loss presented in the accompanying
condensed consolidated balance sheets consist of net unrealized gains or losses
on short-term investments and accumulated net foreign currency translation
gains or losses. The following are the components of comprehensive loss (in thousands): 8




---



##### Table of Contents



Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net loss
    
    $
    (13,520
    )
    
    $
    (7,210
    )
    
    $
    (28,628
    )
    
    $
    (44,338
    )Cumulative
translation adjustments
    
    
    (188
    )
    
    
    360
    
    
    
    180
    
    
    
    910Change in unrealized loss on
available- for-sale
investments
    
    
    252
    
    
    
    (67
    )
    
    
    (282
    )
    
    
    (478
    )Total comprehensive net loss
    
    $
    (13,456
    )
    
    $
    (6,917
    )
    
    $
    (28,730
    )
    
    $
    (43,906
    )
 Impact of Recently Issued Accounting Standards In March 2004, the FASB issued a proposed Statement, Share-Based Payment,
an amendment of FASB Statements Nos. 123 and 95, that addresses the accounting
for share-based payment transactions in which a Company receives employee
services in exchange for either equity instruments of the Company or
liabilities that are based on the fair value of the Companys equity
instruments or that may be settled by the issuance of such equity instruments.
The proposed statement would eliminate the ability to account for share-based
compensation transactions using the intrinsic method that the Company currently
uses and generally would require that such transactions be accounted for using
a fair-value-based method and recognized as expense in the consolidated
statement of operations. The effective date of the proposed standard is for
periods beginning after June 15, 2005. It is expected that the final standard
will be issued before December 31, 2004 and should it be finalized in its
current form, it will have a significant impact on the Companys consolidated
statement of operations as the Company will be required to expense the fair value of
stock option grants. 2. Contingencies Beginning in April 2000, several plaintiffs filed class action lawsuits in
federal court against the Company and certain of its officers and directors.
Later that year, the cases were consolidated in the United States District
Court, Northern District of California as In re Terayon Communication Systems,
Inc. Securities Litigation. The Court then appointed lead plaintiffs who filed
an amended complaint. In 2001, the Court granted in part and denied in part
defendants motion to dismiss, and plaintiffs filed a new complaint. In 2002,
the Court denied defendants motion to dismiss that complaint, which, like the
earlier complaints, alleges that the defendants violated the federal securities
laws by issuing materially false and misleading statements and failing to
disclose material information regarding the Companys technology. On February
24, 2003, the Court certified a plaintiff class consisting of those who
purchased or otherwise acquired the Companys securities between November 15,
1999 and April 11, 2000. On September 8, 2003, the Court heard defendants motion to disqualify two
of the lead plaintiffs and to modify the definition of the plaintiff class. On
September 10, 2003, the Court issued an order vacating the hearing date for the
parties summary judgment motions, and, on September 22, 2003, the Court issued
another order staying all discovery until further notice and vacating the trial
date, which had been November 4, 2003. On February 23, 2004, the Court issued an order disqualifying two of the
lead plaintiffs. The order also states that plaintiffs counsel must provide
certain information to the Court about counsels 9




---



##### Table of Contents



relationship with the
disqualified lead plaintiffs, and it provides that defendants may serve certain
additional discovery. On March 24, 2004, plaintiffs submitted certain
documents to the Court in response to its order, and, on April 16, 2004, the
Company responded to this submission. The Company also has initiated discovery
pursuant to the Courts February 23, 2004 order. On October 16, 2000, a lawsuit was filed against the Company and the
individual defendants (Zaki Rakib, Selim Rakib and Raymond Fritz) in the
California Superior Court, San Luis Obispo County. This lawsuit is titled
Bertram v. Terayon Communications Systems, Inc. The factual allegations in the
Bertramcomplaint were similar to those in the federal class action, but the
Bertramcomplaint sought remedies under state law. Defendants removed the
Bertramcase to the United States District Court, Central District of
California, which dismissed the complaint and transferred the case to the
United States District Court, Northern District of California. That Court
eventually issued an order dismissing the case. Plaintiffs have appealed this
order, and their appeal was heard on April 16, 2004. On June 9, 2004, the
United States Court of Appeals for the Ninth Circuit affirmed the order
dismissing the Bertramcase. The Court of Appeals opinion affirming dismissal of the Bertramcase does
not end the class action. The Company believes that the
allegations in the class action are without merit,
and the Company intends to contest this matter vigorously. This matter,
however, could prove costly and time consuming to defend, and there can be no
assurances about the eventual outcome. In 2002, two shareholders filed derivative cases purportedly on behalf of
the Company against certain of the Companys current and former directors,
officers, and investors. (The defendants differed somewhat in the two cases.)
Since the cases were filed, the investor defendants have been dismissed without
prejudice, and the lawsuits have been consolidated as Campbell v. Rakibin the
California Superior Court, Santa Clara County. The Company is a nominal
defendant in these lawsuits, which allege claims relating to essentially the
same purportedly misleading statements that are at issue in the pending
securities class action. In the securities class action, the Company disputes
making any misleading statements. The derivative complaints also allege claims
relating to stock sales by certain of the director and officer defendants. The Company believes that there are many defects in the Campbelland
OBrienderivative complaints. On January 19, 2003, Omniband Group Limited, a Russian company, or
Omniband, filed a request for arbitration with the Zurich Chamber of Commerce,
claiming damages in an amount of $2,094,970 allegedly caused by the Companys
breach of an agreement to sell to Omniband certain equipment pursuant to an
agreement between Omniband and Radwiz, Ltd., one of the Companys wholly-owned
subsidiaries. On December 18, 2003, the panel of arbiters with the Zurich
Chamber of Commerce allowed the arbitration proceeding to continue against
Radwiz. Omniband appealed the Zurich Chamber of Commerces decision, which was
affirmed in its ruling of October 15, 2004. The Company believes that the
allegations are without merit and intends to present a vigorous defense in the
arbitration proceedings. From time to time, the Company receives letters claiming that the
Companys technology and products may infringe on intellectual property rights
of third parties. The Company also has in the past agreed to, and may from
time to time in the future agree to, indemnify a customer of its technology or
products for claims against the customer by a third party based on claims that
the Companys technology or products infringe intellectual property rights of
that third party. These types of claims, meritorious or not, can result in
costly and time-consuming litigation; divert managements attention and other
resources; require the Company to enter into royalty arrangements; subject the
Company to damages or injunctions restricting the sale of its products, require
the Company to indemnify its customers for the use of the allegedly infringing
products; require the Company to refund payment of allegedly infringing
products to its customers or to forgo future payments; require the Company to
redesign certain of its products; or damage the Companys reputation, any one
of which could materially and adversely affect the Companys business, results
of operations and financial condition. The Company is currently a party to various other legal proceedings, in
addition to those noted above, and may become involved from time to time in
other legal proceedings in the future. While the Company currently believes
that the ultimate outcome of these other proceedings, individually and in the
aggregate, will not have a material adverse effect on its financial position or
overall results of operations, litigation is subject to inherent uncertainties.
Were an unfavorable ruling to occur in any of the Companys legal proceedings, there
exists the possibility of a material adverse impact on the Companys results of
operations for the period in which the ruling occurs. The estimate of the
potential impact on the Companys financial position and overall results of
operations for any of the above legal proceedings could change in the future. 10




---



##### Table of Contents



3. Operating Segment Information The Company operates as one business segment. Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,(in thousands)
    
    2004
    
    2003
    
    2004
    
    2003Revenues by product:CMTS products
    
    $
    6,492
    
    
    $
    16,825
    
    
    $
    27,917
    
    
    $
    29,979CPE products
    
    
    18,899
    
    
    
    15,654
    
    
    
    67,658
    
    
    
    46,320Video products
    
    
    10,802
    
    
    
    4,577
    
    
    
    24,381
    
    
    
    11,109Other products
    
    
    1,009
    
    
    
    572
    
    
    
    1,195
    
    
    
    3,087Total revenues
    
    $
    37,202
    
    
    $
    37,628
    
    
    $
    121,151
    
    
    $

    90,495Revenues by geographic areas:United States
    
    $
    25,130
    
    
    $
    16,653
    
    
    $
    68,188
    
    
    $
    47,832Canada
    
    
    401
    
    
    
    370
    
    
    
    2,239
    
    
    
    1,106Europe, Middle East, Africa
Region (EMEA), excluding
Israel
    
    
    3,379
    
    
    
    5,173
    
    
    
    18,344
    
    
    
    15,873Israel
    
    
    1,663
    
    
    
    638
    
    
    
    10,879
    
    
    
    1,449Japan
    
    
    3,876
    
    
    
    11,047
    
    
    
    9,563
    
    
    
    17,859Asia, excluding Japan
    
    
    2,743
    
    
    
    3,246
    
    
    
    11,875
    
    
    
    5,856South America
    
    
    10
    
    
    
    501
    
    
    
    63
    
    
    
    520Total
    
    $
    37,202
    
    
    $
    37,628
    
    
    $
    121,151
    
    
    $
    90,495
 September 30,
    
    December 31,2004
    
    2003Long-lived assets:United States
    
    $
    15,874
    
    
    $
    19,630Canada
    
    
    494
    
    
    
    810Europe
    
    
    157
    
    
    
    175Israel
    
    
    3,344
    
    
    
    3,104Asia
    
    
    130
    
    
    
    173Total long-lived assets
    
    
    19,999
    
    
    
    23,892Total current assets
    
    
    151,497
    
    
    
    191,348Total assets
    
    $
    171,496
    
    
    $
    215,240
 Three customers accounted for 10% or more of total revenues (20%, 15%, and
14%) for the three months ended September 30, 2004. Two customers accounted
for 10% or more of total revenues (21% and 11%) for the nine months ended
September 30, 2004. Three customers accounted for 10% or more of total
revenues (29%, 13%, and 13%) for the three months ended September 30, 2003.
Three customers accounted for 10% or more of total revenues (20%, 17%, and 12%)
for the nine months ended September 30, 2003. 4. Executive Severance,
Restructuring Charges and Asset Write-offs Executive Severance 11




---



##### Table of Contents



In June 2004, the Company entered into an employment agreement with an
executive officer. The executive officer resigned effective as of October 1,
2004. The Company recorded a severance provision of $1.4 million related to
termination costs for this officer in the third quarter of 2004. Most of the
separation costs related to this officer are expected to be paid in the fourth
quarter of 2004 with nominal amounts for employee benefits paid into the fourth
quarter of 2005. In June 2004,
the Company entered into separation agreements with two other executive officers.
Both executive officers resigned from the Company during the third quarter of 2004.
The Company recorded a severance provision of $1.7 million related to termination
costs for these officers in the second quarter of 2004.  Most of the separation
costs were paid in the third quarter of 2004 with nominal amounts for employee
benefits paid through the third quarter of 2005. Restructuring First and Second Quarter 2004 Restructurings During the first quarter of 2004, the Company approved a restructuring
plan. The Company incurred restructuring charges in the amount of $3.3 million
in the first quarter of 2004, of which $1.0 million related to employee termination
costs, $0.9 million related to costs to exit an aircraft lease, and $1.4
million related to costs for excess leased facilities. The Company incurred
restructuring charges in the amount of $1.15 million in the second quarter
 of 2004 related to additional costs for excess leased facilities, which were
contemplated in the first quarter restructuring plan. Net costs accrued under this
restructuring plan, included estimated sublease income from the aircraft and
the excess leased facilities. As of September 30, 2004, the employment of 58
employees had been terminated, and the Company had paid $0.8 million in
termination costs. The amount of net costs accrued under the first quarter
2004 restructuring plan assumed that the Company would successfully sublease
the aircraft and excess leased facilities. The reserve for the aircraft lease
and excess leased facilities was based on information provided by the Companys
brokers that estimated, based on assumptions relevant to the aircraft and real
estate market conditions as of the date of the Companys
restructuring plan, the time it
would likely take to fully sublease the aircraft and excess facilities. In the third quarter of 2004, the Company entered into an
agreement with a third party to sublease the aircraft. Even though it is the
intent of the Company to sublease its interests in the excess facilities at the
earliest possible time, the Company cannot determine with certainty a fixed
date by which this event may occur. In light of this uncertainty, based on
estimates, the Company periodically re-evaluates and adjusts the reserve, as
necessary. The Company currently anticipates the remaining restructuring
accrual related to employee termination costs to be substantially utilized by
the end of 2004. The remaining restructuring accrual related to the aircraft
lease is expected to be substantially utilized for servicing operating lease
payments of operating lease commitments, through January 2007, and the
remaining restructuring accrual related to excess leased facilities, is
expected to be utilized for servicing operating lease payments through October
2009. In the second and third quarters of 2004, the Company re-evaluated the
first and second quarter 2004 restructuring charges for the excess facilities
and the aircraft lease termination. Based on market conditions, new assumptions
provided by the Companys broker, and the terms of the aircraft sublease
agreement, which the Company entered into in the third quarter of
2004, the
Company increased the restructuring charge by a total of  $0.85
million in the nine months ended September 30, 2004. A summary of the first and second quarter 2004 accrued restructuring
charges is as follows (in thousands): Involuntary
    
    Aircraft Lease
    
    Excess LeasedTerminations
    
    Termination
    
    Facilities
    
    TotalTotal charge for
the first quarter
of 2004
    
    $
    952
    
    
    $
    934
    
    
    $
    1,375
    
    
    $
    3,261Additional charges
for the second
quarter of 2004
    
    
    
    
    
    
    
    
    
    
    1,148
    
    
    
    1,148Cash payments
    
    
    (795
    )
    
    
    (947
    )
    
    
    (549
    )
    
    
    (2,291
    )Revaluation
    
    
    
    
    
    
    899
    
    
    
    (54
    )
    
    
    845Balance at
September 30, 2004
    
    $
    157
    
    
    $
    886
    
    
    $
    1,920
    
    
    $
    2,963
 2003 Restructuring 12




---



##### Table of Contents



During the first quarter of 2003, a restructuring plan was approved. The
Company incurred restructuring charges in the amount of $2.7 million related to
employee termination costs. All accrued restructuring costs related to the
2003 restructuring had been paid as of December 31, 2003. 2002 and 2001 Restructurings During 2001, a restructuring plan was approved and the Company incurred
restructuring charges in the amount of $12.7 million of which $2.3 million
remained accrued at September 30, 2004, for excess leased facilities. During
2002, another restructuring plan was approved, which increased the reserve for
excess leased facilities due to the exiting of additional space within the same
facility. The Company incurred restructuring charges in the amount of $3.6
million for the 2002 restructuring of which $1.2 million remained accrued at
September 30, 2004 for excess leased facilities. The Company currently
anticipates the remaining restructuring accrual relating to excess leased
facilities, will be utilized for servicing operating lease payments or
negotiating a buyout of operating lease commitments, through 2005. The following table summarizes the costs and activities during 2004,
related to the 2002 and 2001 restructuring (in thousands): Excess Leased FacilitiesBalance at December 31, 2003
    
    $
    4,500Cash Payments
    
    
    (940
    )Balance at September 30, 2004
    
    $
    3,560
 Asset Write-offs For the nine months ended September 30, 2004, the Company wrote off $0.1
million, of fixed assets, which were determined to have no remaining useful
life. For the nine months ended September 30, 2003, the Company wrote off $0.4
million of fixed assets, which were determined to have no remaining useful
life. For the three months ended September 30, 2003, the Company wrote off
$17,000 of fixed assets, which were determined to have no remaining useful
life. The Company did not write-off any fixed assets during the three months
ended September 30, 2004. 5. Related Party Transactions Lewis Solomon, a member of the Companys Board of Directors and a member
of the Companys Nominating and Governance Committee and Compensation
Committee, is also a member of the Board of Directors of Harmonic, Inc.
(Harmonic). Harmonic is an authorized, non-exclusive reseller of
certain of the Companys video products. For the three and nine months ended
September 30, 2004, related party revenue included $1.5 million and $4.9
million, respectively, of revenue from Harmonic. For the three and nine months
ended September 30, 2003, related party revenue included $0.5 million and $1.5
million, respectively, of revenue from Harmonic. Alek Krstajic, a member of the Companys Board of Directors, was the
Senior Vice President of Interactive Services, Sales and Product Development
for Rogers Communications, Inc. (Rogers) until January 2003. Beginning April
1, 2003, the Company no longer recognized revenues related to Rogers as related
party revenue because Rogers was no longer considered to be a related party.
For the first quarter of 2003, the Company recognized $1.4 million of Rogerss
related party revenue, net of amortization of co-marketing expense. In the nine months ended September 30, 2004, the Company paid Mr. Krstajic
$30,000 for consulting services provided to the Company. In December 2001, the Company entered into a co-marketing arrangement with
Rogers to promote the Companys brand its products. The Company
paid $0.9 million to Rogers, and recorded this amount as other current assets.
In July 2002, the Company began amortizing this prepaid asset and 13




---



##### Table of Contents



charging it
against revenue in accordance with the Emerging Issues Task Force 01-09,
Accounting for Consideration given by a Vendor to a Customer or Reseller in
Connection with the Purchase or Promotion of the Vendors Products. Amounts
charged against revenues in the three and nine months ended
September 30, 2003, totaled approximately $1.4 million and $4.2 million,
respectively. This asset was fully amortized during 2003. Cost of related party revenues in the Companys consolidated statements of
operations consists of direct and indirect costs. Accounts receivable from
Harmonic totaled approximately $0.7 million at September 30, 2004. None of the
related parties is a supplier to the Company. 6. Sale of Assets On April 2, 2004, the Company sold all of its ownership in Radwiz, Ltd.,
Ultracom Communications Holdings Ltd. and Combox Ltd. to a third party for a
cash payment of $0.15 million. In connection with this disposition, the
acquirer received obsolete inventories with no book value, $0.2 million of
selected net assets, and assumed $1.35 million of net liabilities related to
these subsidiaries. The Company recorded a net gain of $1.3 million on this
transaction in the second quarter of 2004, which is included as an element of
other income (expense) in the accompanying condensed consolidated statement of
operations. 7. Product Warranties The Company provides for estimated product warranty expenses when it sells
the related products. Because warranty estimates are forecasts based on the
best available information  mostly historical claims experience  claims costs
may differ from amounts provided. An analysis of changes in the liability for
product warranties for the nine months ended September 30, 2003 and 2004, is as
follows (in thousands): Charges forBalance at
    
    Additions Charged to
    
    Expiration of
    
    Warranty Services
    
    Balance at End ofBeginning of Period
    
    Expenses
    
    Accrued Warranty
    
    Provided
    
    PeriodNine months ended
September 30, 2003Warranty reserve
    
    $
    8,607
    
    
    
    1,350
    
    
    
    
    
    
    
    (3,748
    )
    
    $
    6,209Nine months ended
September 30, 2004Warranty
reserve
    
    $
    5,509
    
    
    
    2,943
    
    
    
    (1,829
    )
    
    
    (2,580
    )
    
    $
    4,043
 7. Subsequent Event In October 2004, the Company announced its intention to cease investment
in future development of its Cable Modem Termination System (CMTS) product
line. In connection with this announcement, the Company initiated a
worldwide reduction in force, which is expected to result in a restructuring
charge of approximately $3.2 million to $3.6 million in the quarter ending
December 31, 2004. 14




---



##### Table of Contents



ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with
our condensed consolidated financial statements and notes thereto. Overview We
develop manufacture, market and sell cable modem termination systems
(CMTS), digital video management systems and customer premise
equipment (CPE), including cable modems to broadband service providers who use the Companys products to deliver
broadband voice, video and data services to residential and business
subscribers. Our revenues have been generated principally from sales of these three major
product groups either directly to broadband service providers through direct
sales forces primarily in North America, Europe and Asia or indirectly through
resellers. In October 2004, after careful evaluation of our overall product portfolio
and strategy,we announced our intention to cease investment in future
development of our CMTS product line and halt development on future hardware
upgrades.  In connection with this action, we
initiated a worldwide reduction in force, which is likely to result in a
restructuring charge of approximately $3.2 million to $3.6 million in the
quarter ending December 31, 2004. Although we currently expect the outcome of this action to generate future
savings, we will incur additional material charges associated with our decision
to cease investment in the CMTS product line and the currently anticipated
employee termination costs may increase, perhaps materially. Our gross margins fluctuate from period to period primarily as a result of
the sales volume and mix of products we sell. Specifically, we derive substantially higher
margins from sales of our CMTS and digital video equipment products than we do
from sales of our CPE products, which are subject to intense price competition.
 Due to disappointing CMTS sales in the third quarter, we undertook an
evaluation of our overall product portfolio and strategy and decided to cease
investing in our current CMTS product line. Moreover,
 to date a majority of our total revenues have been generated from sales of our
CPE products. Historically, erosion of average selling prices (ASPs) of our
CPE products has had a negative impact on our gross margins. However, we
believe that the decline of ASPs will continue to decline moderately in the future. We are working to mitigate
pressures on our gross margins by focusing on increasing sales of our
higher margin digital video equipment and by continuing to focus on product manufacturing
cost reductions for our CPE products. In the first quarter of 2004, we largely
completed our transition to a new original design manufacturer (ODM) in Asia
for our CPE products. To the extent that the containment of our product costs
do not keep pace with ASP declines, our gross margins will be adversely
affected. We have not been profitable since our inception. For the three and nine
months ended September 30, 2004, we had a net loss of $13.5 million and $28.6
million, respectively. We believe our ability to achieve profitability in the
long term will depend primarily on three factors. The first factor is our
ability to achieve improved gross margins through an improved sales mix by
increasing sales of higher margin digital video products relative to the sales
of CPE products. To increase sales of digital video products, we are targeting
new markets such as the broadcast sector and promoting new applications such as
high definition television (HDTV) and digital insertion to cable and satellite
operators. To the extent that sales of CPE products continue to comprise a
greater proportion of our total revenues, our ability to achieve profitability
in the future could be adversely affected. Second, we will continue to
focus on lowering product costs for our CPE products through our ODM
relationships in Asia. Finally, as discussed below, we expect to
benefit from a lower expense base resulting in part from restructuring
activities in the first, second and fourth quarters of 2004 combined with
continued focus on cost containment. Furthermore, as part of our restructuring
efforts, we will continue to divest and cease investment in unprofitable
product lines in an effort to focus on growing our business and redirect our
resources. 15




---



##### Table of Contents



However, despite these efforts, we may not
succeed in attaining profitability in the near future, if at all. At September 30, 2004, we had approximately $111.9 million in cash, cash
equivalents and short-term investments as compared to approximately $138.6
million at December 31, 2003. The decrease in the first nine months of 2004
primarily resulted from the use of cash for operating activities. Although we
believe that our current cash balances will be sufficient to satisfy our cash
requirements for at least the next 12 months, we may need to raise additional
funds in order to support more rapid expansion, develop new or enhanced
services, respond to competitive pressures, acquire complementary businesses or
technologies or respond to unanticipated requirements. There can be no
assurance that additional financing will be available on acceptable terms, if
at all. If adequate funds are not available or are not available on acceptable
terms, we may be unable to continue operations, develop our products, take
advantage of future opportunities or respond to competitive pressures or
unanticipated requirements, which could have a material adverse effect on our
business, financial condition and operating results. Our ability to grow our business and attain profitability is dependent on
our ability to effectively compete in the marketplace with our current products
and services, develop and introduce new products and services, contain
operating expenses and improve our gross margins, as well as the continued
recovery of the communications industry. A more detailed description of the
risks to our business can be found in the section captioned Risk Factors. In the third quarter of 2004, after the resignation of Zaki Rakib, our
former Chief Executive Officer, Jerry Chase was appointed as our Chief
Executive Officer. During the same period, Arthur Taylor, our Chief Financial
Officer, and Douglas Sabella, our Chief Operating Officer, resigned. On
October 1, 2004, Shlomo Rakib, our President and Chief Technology Officer,
resigned. Critical Accounting Policies Inventory Valuation and Purchase Obligations We record losses on commitments to purchase inventory in accordance with
Statement 10 of Chapter 4 of Accounting Research Bulletin No. 43. Our policy for
valuation of inventory and commitments to purchase inventory, including the
determination of obsolete or excess inventory, requires us to perform a
detailed assessment of inventory at each balance sheet date, which
assessment includes a
review of, among other factors, an estimate of future demand for products
within specific time horizons, generally six months as well as product
lifecycle and product development plans. Given the rapid technological change
in the technology and communications equipment industries as well as
significant, unpredictable changes in capital spending by our
customers and therefore demand for our products, we
believe that assessing the value of inventory using generally a six month time
horizon is appropriate. The estimates of future demand that we use in the valuation of inventory
are the basis for our revenue forecast, which is also consistent with our
short-term manufacturing plan. Based on this analysis, we reduce the cost of
inventory that we specifically identify and consider obsolete or excessive to
fulfill future sales estimates. We define obsolete inventory as inventory that
will no longer be used in the manufacturing process. Excess inventory is
generally defined as inventory in excess of projected usage, and is determined
using our best estimate of future demand at the time, based upon information
then available. We purchase components from a variety of suppliers and use several
contract manufacturers to provide manufacturing services for the
manufacture of our products.
During the normal course of business, in order to manage manufacturing lead
times (often ranging from three to six months) and to help ensure adequate
component supply, we enter into agreements with contract manufacturers and
suppliers that either allow them to procure inventory based upon criteria as
defined by us or that establish the parameters defining our component
supply requirements. If
we were to curtail or cease production of certain products or terminate these
agreements, we may be liable for vendor cancellation charges. We accrue for vendor cancellation charges (which increase cost of goods
sold) which represent managements estimate of our financial
exposure to vendors when our
management curtails or ceases production of certain products or
terminates a
vendor or supplier agreement. Estimates of exposure are determined using 16




---



##### Table of Contents



vendor
inventory data. Should we change our short-term manufacturing plans such that
further products or components would no longer be used, additional vendor
cancellation charges may occur. At September 30, 2004, accrued vendor
cancellation charges were $4.3 million which are expected to become payable in
the next three to six months. Historically, we have been able to reverse
portions of our vendor cancellation accrual as we were able to negotiate
downward certain vendor cancellations to more favorable terms. Such reversals
of vendor cancellation charges cause a decrease in cost of goods sold in the
period during which such charges are settled. For the three and nine months
ended September 30, 2004, we reversed approximately $23,000 and $3.4 million,
respectively, of vendor cancellation charges as a result of favorable
negotiations with vendors. There have been no material change to any of our critical accounting
policies and estimates as disclosed in our annual report on Form 10-K for the
year ended December 31, 2003. Results of Operations Three and Nine Months Ended September 30, 2004 and September 30, 2003 Revenues (in thousands)
    
    For the three
    
    For the nine
    
    % Change for the
    
    % Change for themonths ended
    
    months ended
    
    three months ended
    
    nine months endedSeptember 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003
    
    2004/2003
    
    2004/2003Revenues
    
    $
    37,202
    
    
    $
    37,628
    
    
    $
    121,151
    
    
    $
    90,495
    
    
    
    (1
    )%
    
    
    34
    %
 We
sell directly to our customers, principally broadband service providers and broadcasters, and to a
lesser extent, indirectly through resellers. Revenues from sales of
our products are
recognized when: (1) persuasive evidence of a sales arrangement
exists, (2)  product delivery
has occurred or services have been rendered, (3) the selling price is fixed or
determinable, and (4) collectibility of revenue is reasonably assured. A provision is
made for estimated product returns as product warranty shipments are made. Our existing
agreements typically do not grant return rights beyond those provided
by our product warranty. Revenue from product sales to resellers are generally recognized when
product is shipped as we generally do not grant return rights
beyond those provided by the warranty. Our revenues decreased 1% to $37.2 million for the quarter ended September
30, 2004 compared to $37.6 million in the quarter ended September 30, 2003,
primarily due to decreased deployments of our CMTSs by cable
operators across all geographics, which decline in CMTS revenue was offset
by increased sales of our video products and CPE. Our revenues increased 34% to $121.2 million for the nine months ended
September 30, 2004 compared to $90.5 million for the nine months ended
September 30, 2003, primarily due to increased sales of our CPE and video
products, and increased sales of our legacy circuit-switch voice
product, which increased sales were offset by decreased sales of our CMTS products due to decreased
deployments of our CMTSs by cable operators across all geographics. We
expect total revenues to continue to  decline in the fourth quarter of 2004 compared to the
third quarter of 2004 primarily due to a slow-down in the market
for our products as well as our decision to cease investment in
future development of our CMTS product line. Revenues by Groups of Similar Products (in thousands)
    
    For the three
    
    For the nine
    
    % Change for the
    
    % Change for themonths ended
    
    months ended
    
    three months ended
    
    nine months endedSeptember 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003
    
    2004/2003
    
    2004/2003Revenues by
product:CMTS products
    
    $
    6,492
    
    
    $
    16,825
    
    
    $
    27,917
    
    
    $
    29,979
    
    
    
    (61
    )%
    
    
    (7
    )%
 17




---



##### Table of Contents



(in thousands)
    
    For the three
    
    For the nine
    
    % Change for the
    
    % Change for themonths ended
    
    months ended
    
    three months ended
    
    nine months endedSeptember 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003
    
    2004/2003
    
    2004/2003CPE products
    
    
    18,899
    
    
    
    15,654
    
    
    
    67,658
    
    
    
    46,320
    
    
    
    21
    %
    
    
    46
    %Video products
    
    
    10,802
    
    
    
    4,577
    
    
    
    24,381
    
    
    
    11,109
    
    
    
    136
    %
    
    
    119
    %Other products
    
    
    1,009
    
    
    
    572
    
    
    
    1,195
    
    
    
    3,087
    
    
    
    76
    %
    
    
    (61
    %)Total revenues
    
    $
    37,202
    
    
    $
    37,628
    
    
    $
    121,151
    
    
    $
    90,495
    
    
    
    (1
    )%
    
    
    34
    %
 CMTS revenues decreased 61% and 7%, respectively for the three and nine
months ended September 30, 2004 compared to the three and nine months ended
September 30, 2003. This decrease was due to slower CMTS deployments by
existing customers and our ongoing challenge in winning new CMTS accounts. In
October 2004, we announced our intention to cease investment in future
development of our CMTS product line. Consequently, we expect CMTS revenues to
significantly decrease in the fourth quarter of 2004 and future
periods. CPE revenues increased 21% for the quarter ended September 30, 2004
compared to the quarter ended September 30, 2003, due to an increase in modem
sales. The number of modems sold increased from approximately 0.3 million
units in the third quarter of 2003 to approximately 0.5 million units in the
third quarter of 2004. CPE revenues increased 46% for the nine months ended
September 30, 2004 compared to the nine months ended September 30, 2003, due to
an increase in modem sales, as well as an increase in sales of our legacy
circuit-switch voice product especially in the second quarter of 2004. The
number of modems sold increased from approximately 0.9 million units in the
nine months ended September 30, 2003 to approximately 1.5 million units in the
nine months ended September 30, 2004. The intensely competitive nature of the
market for our products has led to significant ASP erosion for our CPE products over time, and we expect this price erosion to
continue, but to a lesser extent. We believe that our full transition to an ODM in Asia, which
was substantially completed in the first quarter of 2004, may allow us to remain competitive in the marketplace and maintain favorable
margins on these products. Additionally, during the second quarter of
2004, we experienced exceptionally strong demand for our legacy Multigate circuit-switch
product line, which is sold primarily to one customer in Europe. Going forward,
we anticipate the level of circuit switch business to continue to remain
relatively low. We expect total CPE revenues to decline in the fourth quarter
of 2004 due to lower expected sales and continued ASP declines. Revenues
from video products increased 136% for the quarter ended September
30, 2004 compared to the quarter ended September 30, 2003, and increased 119%
for the nine months ended September 30, 2004 compared to the nine months ended
September 30, 2003, due to increased sales of our DM 6400
Cherrypicker video product to US multiple system operators MSOs  as
well as revenue recognized in the third quarter of 2004 from
shipments of our BP5100 platform through August 31, 2004.
We currently anticipate that video revenues will likely be flat in the fourth quarter of
2004 when compared to the third quarter of 2004 due to the rapid growth in video revenues in the third quarter of 2004. However, we are encouraged by the
prospects for our video business to grow in the future and currently believe that we will continue to see increased sales of video products as demand for
high definition television (HDTV) and other digital video services, including digital ad insertion, grows in 2005. We
had $1.0 million of sales of our legacy telecom products in the third
quarter of 2004, up 76% from the same period in 2003. Other revenues decreased
61% for the nine months ended September 30, 2004 compared to the nine months
ended September 30, 2003, due to significantly decreased sales of our legacy
telecom products. We expect sales of telecom products to be minimal in the
fourth quarter of 2004. Revenues by Geographic Region (in thousands)
    
    For the three
    
    For the nine
    
    % Change for the
    
    % Change for themonths ended
    
    months ended
    
    three months ended
    
    nine months endedSeptember 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003
    
    2004/2003
    
    2004/2003Revenues by
geographic areas:
 18




---



##### Table of Contents



(in thousands)
    
    For the three
    
    For the nine
    
    % Change for the
    
    % Change for themonths ended
    
    months ended
    
    three months ended
    
    nine months endedSeptember 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003
    
    2004/2003
    
    2004/2003North America
    
    $
    25,531
    
    
    $
    17,023
    
    
    $
    70,427
    
    
    $
    48,938
    
    
    
    50
    %
    
    
    44
    %Europe, Middle
East, Africa
Region (EMEA),
excluding
Israel
    
    
    3,379
    
    
    
    5,173
    
    
    
    18,344
    
    
    
    15,873
    
    
    
    (35
    )%
    
    
    16
    %Israel
    
    
    1,663
    
    
    
    638
    
    
    
    10,879
    
    
    
    1,449
    
    
    
    161
    %
    
    
    651
    %Asia
    
    
    6,619
    
    
    
    14,293
    
    
    
    21,438
    
    
    
    23,715
    
    
    
    (54
    )%
    
    
    (10
    )%South America
    
    
    10
    
    
    
    501
    
    
    
    63
    
    
    
    520
    
    
    
    (98
    )%
    
    
    (88
    )%Total
    
    $
    37,202
    
    
    $
    37,628
    
    
    $
    121,151
    
    
    $
    90,495
    
    
    
    (1
    )%
    
    
    34
    %
 Revenues
in North America increased 50% to $25.5 million in the third
quarter of 2004 compared to the same period in 2003, and increased
44% to $70.4
million in the nine months ended September 30, 2004, compared to the same
period in 2003, primarily due to increased sales of our CPE and video
products to US MSOs and sales of our BP5100 to our broadcast customer,
Fox. Revenues in Israel increased due to
increased sales of our legacy Multigate circuit-switch product.
Revenues in Asia decreased due to decreased sales of DOCSIS 2.0 CMTS
products. During the
nine months ended September 30, 2004, we emphasized sales to our US
customers while placing a lower emphasis on sales internationally
due to our increased success with US opportunities.
We expect revenue in international locations to continue declining in the fourth quarter of
2004, especially since we announced our decision to stop investing in
our CMTS product line. Overall revenues are expected to be significantly lower in the fourth
quarter of 2004, due to decreased deployment of our CPE and video
products and our intention to cease investment in future development
of our CMTS product line. Three customers accounted for 10% or more of total revenues
(20%, 15%, and 14%) for the three months ended September 30, 2004. Two
customers accounted for 10% or more of total revenues (21% and 11%) for the
nine months ended September 30, 2004. Three customers accounted for 10% or
more of total revenues (29%, 13%, and 13%) for the three months ended September
30, 2003. Three customers accounted for 10% or more of total revenues (20%,
17%, and 12%) for the nine months ended September 30, 2003. No other customer
accounted for more than 10% of revenues during these periods. Related Party Revenues (in thousands)
    
    For the three
    
    For the nine
    
    % Change for the
    
    % Change for themonths ended
    
    months ended
    
    three months ended
    
    nine months endedSeptember 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003
    
    2004/2003
    
    2004/2003Related party
revenues:Harmonic revenues
    
    $
    1,543
    
    
    $
    460
    
    
    $
    4,933
    
    
    $
    1,474
    
    
    
    235
    %
    
    
    235
    %Rogers revenues
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,453
    
    
    
    
    
    
    
    Total related
party revenues
    
    $
    1,543
    
    
    $
    460
    
    
    $
    4,933
    
    
    $
    2,927
    
    
    
    235
    %
    
    
    69
    %
 Related party revenues increased 235% in the third quarter of 2004,
compared to the third quarter of 2003. Related party revenues increased 69% in
the nine months ended September 30, 2004, compared to the nine months ended
September 30, 2003. Related party revenues in the first quarter of 2003
included revenues from Rogers Communications, Inc. (Rogers) and Harmonic, Inc.
(Harmonic). Alek Krstajic, a member of our board of directors, was the Senior
Vice President of Interactive Services, Sales and Product Development for
Rogers until January 2003. Effective in April 2003, Rogers was no longer a
related party to us. Consequently, revenues attributable to Rogers
were not
classified as related party revenues after the first quarter of  2003. Lewis Solomon, another
member of our board of directors, is a member of the board of directors of
Harmonic. All revenues attributable to Harmonic were included in related party
revenues in 2004 and 2003. The increase in related party revenues was
primarily due to an increase in sales of our video 19




---



##### Table of Contents



products to Harmonic in 2004 as compared to the same periods in 2003. None of
our related parties is a supplier to us. In December 2001, we entered into a co-marketing arrangement with Rogers.
We paid $0.9 million to Rogers, and recorded this amount as other current
assets. In July 2002, we began amortizing this prepaid asset and charging it
against related party revenues in accordance with Emerging Issues Task Force
(EITF) 01-09, Accounting for Consideration given by a Vendor to a Customer or
Reseller in Connection with the Purchase or Promotion of the Vendors
Products. We charged $0.15 million per quarter of the amortization of this
asset against total revenues through December 31, 2003. Approximately $0.15
million of amortization was charged against total revenues in the first quarter of
2003. No further amounts of this co-marketing arrangement were included in
other current assets after December 31, 2003 and no further amortization has or
will occur in 2004. Cost of Goods Sold and Gross Profit (in thousands)
    
    For the three
    
    For the nine
    
    % Change for the
    
    % Change for themonths ended
    
    months ended
    
    three months ended
    
    nine months endedSeptember 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003
    
    2004/2003
    
    2004/2003Cost of revenues
    
    
    30,393
    
    
    
    27,296
    
    
    
    86,014
    
    
    
    69,500
    
    
    
    13
    %
    
    
    23
    %Cost of related party
revenues
    
    
    539
    
    
    
    138
    
    
    
    1,348
    
    
    
    1,262
    
    
    
    291
    %
    
    
    7
    %Total cost of goods sold
    
    
    30,932
    
    
    
    27,434
    
    
    
    87,362
    
    
    
    70,762
    
    
    
    13
    %
    
    
    23
    %Gross profit
    
    $
    6,270
    
    
    $
    10,194
    
    
    $
    33,789
    
    
    $
    19,733
    
    
    
    (38
    )%
    
    
    71
    %
 Cost of goods sold consists of direct product costs as well as the cost of
our manufacturing operations. The cost of manufacturing includes contract
manufacturing, test and quality assurance for products, warranty costs and
associated costs of personnel and equipment. In the three and nine months ended
September 30, 2004, cost of goods sold was approximately 83% and 72% of
revenues, respectively, compared to 73% and 78% of revenues, respectively, in
the same periods in 2003. For the three and nine months ended September 30,
2004, we reversed approximately $23,000 and $3.4 million, respectively, of
vendor cancellation charges. For the three and nine months ended September 30,
2003, we reversed $1.0 million and $5.4 million, respectively, of vendor cancellation charges. We reversed these charges as we were able to
negotiate downward certain vendor cancellation to more favorable terms.
Additionally, during the three and nine months ended September 30, 2004, we
reversed approximately $0.6 million and $1.9 million, respectively, of
inventory reserves, which were previously recorded as cost of goods sold.
During the three and nine months ended September 30, 2003, we reversed
approximately $1.0 million and $2.7 million, respectively of inventory
reserves. We reversed these reserves as we were able to sell inventory
originally considered to be excess or obsolete. In the three and nine months ended September 30, 2004, related party cost
of revenues increased compared to the same periods in 2003 primarily due to
higher sales of our video products to Harmonic. Our gross profit decreased 38% to $6.3 million or 17% of sales in the
three months ended September 30, 2004 compared to $10.2 million, or 27% of
sales in the same period in 2003. Our gross profit increased 71% to $33.8
million or 28% of sales in the nine months ended September 30, 2004 compared to
$19.7 million, or 22% of sales in the same period in 2003. The decrease in our gross profit for the three months ended September 30, 2004
compared to the same period in 2003, was primarily related to relatively flat
revenues and an unfavorable product line sales mix.
 The increase in our
gross profit for the nine months ended September 30, 2004 was
primarily related to an increase in revenues compared to the same
period in 2003, as well as  a favorable product line sales mix, as we
generated a larger proportion of sales from our higher margin digital video
products, and the continued effective cost management of our CPE products due
largely to the benefits gained from moving manufacturing operations
to on ODM in Asia. For the three and nine months ended September 30, 2004, we accrued $2.0 million
and $3.3 million, respectively, of vendor cancellation charges. For the three
months ended September 30, 2003, we did not accrue any vendor cancellation
charges. For the nine months ended September 30, 2003, we accrued $2.2 million
of vendor cancellation charges. We accrued these charges, which represent
managements estimate of our exposure to vendors should we curtail or cease
production of certain products or terminate a vendor or supplier agreement.
Additionally, during the three and nine months ended September 30, 2004, we
accrued $5.5 million and $7.7 million, respectively, of inventory reserves to
cost of goods sold. During the three and nine months ended September 30, 2003,
we accrued $1.0 million and $3.6 million, respectively of inventory reserves to
cost of goods sold. Based on a detailed analysis of our inventory, we accrued
these reserves to reduce the cost of our inventory by the amounts we
specifically identified and considered obsolete or excessive to fulfill future
sales estimates. 20




---



##### Table of Contents



We will continue to focus on improving sales of higher margin products and
reducing product-manufacturing costs. We are now partnering with contract
manufacturers in Asia primarily for our CPE products, which may provide us with
more competitive component pricing, economies of scale, and improved
manufacturing capabilities. However, there are no assurances that we will
succeed in selling a greater percentage of higher margin products or reducing
our product manufacturing costs. Primarily due to our intention to cease investment in future development of
our CMTS product line and halt development on future hardware upgrades, we
believe our lower margin CPE products will comprise a larger percentage of our
revenue and cost of good sold. Consequently, we expect margins to decline
beginning in the fourth quarter of 2004. Operating Expenses (in thousands)
    
    For the three
    
    For the nine
    
    % Change for the
    
    % Change for themonths ended
    
    months ended
    
    three months ended
    
    nine months endedSeptember 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003
    
    2004/2003
    
    2004/2003Research and
development
    
    $
    8,696
    
    
    $
    9,363
    
    
    $
    26,680
    
    
    $
    32,797
    
    
    
    (7
    )%
    
    
    (19
    %)Sales and marketing
    
    $
    6,222
    
    
    $
    6,452
    
    
    $
    18,854
    
    
    $
    19,741
    
    
    
    (4
    )%
    
    
    (4
    )%General and
administrative
    
    $
    2,993
    
    
    $
    2,783
    
    
    $
    8,381
    
    
    $
    9,510
    
    
    
    8
    %
    
    
    (12
    )%
 Research and Development.Research and development expenses consist
primarily of personnel costs, internally designed prototype material
expenditures, and expenditures for outside engineering consultants,
and equipment
and supplies required to develop and enhance our products. Research and
development expenses decreased 7% to $8.7 million or 23% of sales in the three
months ended September 30, 2004 from $9.4 million or 25% of sales in the same
period in 2003. The $0.7 million decrease in research and development expenses
was attributable to $0.5 million of reductions in employee related expenses.
The decrease in research and development expenses also included reductions of
$0.5 million in purchases of materials, costs incurred to develop prototypes,
and other research and development expenses, and a decrease of $0.1 million of
outside engineering consultants, partially offset by an increase of $0.4
million related to the implementation of an incentive compensation
plan for research and development personnel in the
third quarter of 2004. Research and development expenses decreased 19% to $26.7 million or 22% of
sales in the nine months ended September 30, 2004 from $32.8 million or 36% of
sales in the same period in 2003. The $6.1 million decrease in research and
development expenses was attributable to $2.6 million of reductions in employee
related expenses due to restructuring actions in 2004. The decrease in research and development expenses also
included reductions of $0.3 million of outside engineering consultants and $3.6
million of reductions in purchases of materials, costs incurred to develop
prototypes, and other research and development expenses partially offset by an
increase of $0.4 million related to the implementation of an incentive
compensation plan for research and development personnel in the third quarter of 2004.
In connection with our intention to cease investment in future development of
our CMTS product line and halt development on future CMTS hardware upgrades, we
currently expect research and development expenses to continue to decrease in
the fourth quarter of 2004. However, we
 believe it is critical for
us to continue to make significant investments in research and development to
create innovative technologies and products that meet the current and future
requirements of our customers. Accordingly, we intend to continue our
investment in research and development specifically related to our video
and CPE product lines. Sales and Marketing. Sales and marketing expenses consist primarily of
salaries and commissions for sales personnel, and marketing and support
personnel, and costs related to trade shows, consulting and travel. Sales and
marketing expenses decreased 4% to $6.2 million or 17% of sales in the three
months ended September 30, 2004 from $6.5 million or 17% of sales in the same
period in 2003. The $0.3 million decrease in sales and marketing expenses was
primarily due to $0.2 million of decreased travel costs, $0.7 million of
reductions related to leased aircraft costs now included in restructuring charges, and
$0.2 million of overall sales and marketing cost reductions. These reductions
were partially offset by $0.2 million in increased employee expenses in sales
and marketing and $0.5 million of increased spending for outside consultants,
and $0.1 million related to the implementation of an incentive compensation
plan for sales and marketing personnel in the third quarter of 2004. 21




---



##### Table of Contents



Sales and marketing expenses decreased 4% to $18.9 million or 16% of sales
in the nine months ended September 30, 2004 from $19.7 million or 22% of sales
in the same period in 2003. The $0.9 million decrease in sales and marketing
expenses was primarily due to $1.6 million of reductions related
to leased aircraft
costs now included in restructuring charges, $0.2 million of decreased travel
costs, a decrease in accrued bonuses in 2004 of $0.1 million due to the
discontinuation of the executive bonus plan in 2004, and $1.0 million of
overall sales and marketing cost reductions. These reductions were partially
offset by $0.8 million in increased employee expenses in sales and marketing,
and $1.2 million of increased spending for outside consultants. We currently
expect sales and marketing expenses to be slightly higher for the fourth quarter
of 2004 compared to the third quarter of 2004. General and Administrative. General and administrative expenses consist
primarily of salary and benefits for administrative and support
personnel, travel expenses and legal, accounting and consulting fees. Overall
general and administrative expenses increased 8% to $3.0 million or 8% of
sales for the three months ended September 30, 2004 from $2.8 million or 7% of
sales in the same period in 2003. Prior to the second quarter of 2004, we
included severance expense related to the termination of an executive officer
in general and administrative expenses. In the first quarter of 2003, $0.3
million of general and administrative expense included severance expense
related to the termination of the executive officer. Beginning the second
quarter of 2004, we now record all severance expenses associated with the
termination of executive officers in the statements of operations
under the caption, Executive Severance, Restructuring Costs
and Asset Write-offs. The $0.2 million increase in general
and administrative expenses for the three months ended September 30,
2004, compared to the same period in 2003 was primarily due to $0.7
million of increased spending for outside consultants, $0.1 million of
increased severance expense, $0.1 million increase of travel and other
expenses, partially offset by a $0.2 million decrease related to the
discontinuation of the executive bonus plan in 2004, and $0.5 million in
decreased employee expenses. General and administrative expenses decreased by $1.1 million to $8.4
million or 7% of sales for the nine months ended September 30, 2004 from $9.5
million or 11% of sales in the same period in 2003. The $1.1 million decrease
was primarily due to $1.6 million in reduced employee expenses including a
decrease of $0.5 million of accrued bonuses in 2004 due to the discontinuation of
the executive bonus plan in 2004, $0.2 million of decreased severance cost, and
$0.8 million of overall general and administrative cost decreases, partially
offset by $1.3 million of increased spending for outside consultants and $0.2
million increase of travel expenses. We currently expect general and
administrative expenses to be slightly lower for the fourth quarter of 2004
compared to the third quarter of 2004. Executive Severance, Restructuring Costs and Asset Write-offs (in thousands)
    
    For the three months
    
    For the nine monthsended
    
    endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Executive severance charges
    
    $
    1,366
    
    
    $
    
    
    
    $
    3,048
    
    
    $
    Restructuring charges (recovery)
    
    
    
    
    
    
    (261
    )
    
    
    4,409
    
    
    
    2,398Long-lived assets written-off
    
    
    
    
    
    
    17
    
    
    
    106
    
    
    
    405Revaluation of restructuring charges
    
    
    97
    
    
    
    
    
    
    
    846
    
    
    
    Executive severance, restructuring
costs and asset write-offs
    
    $
    1,463
    
    
    $
    (244
    )
    
    $
    8,409
    
    
    $
    2,803
 Executive Severance ChargesIn June 2004, we entered into an employment agreement with an executive
officer. Although this executive officer resigned effective as of October 1,
2004, we recorded a severance provision of $1.4 million related to termination
cost for this officer in the third quarter of 2004. Most of the separation
costs related to this officer are expected to be paid in the fourth quarter of
2004 with nominal amounts for employee benefits paid into the fourth quarter of
2005. In June 2004, we entered into separation agreements with two executive
officers. Both executive officers resigned in the third quarter of 2004. We
recorded a severance provision of $1.7 million related to termination costs for
these officers in the second quarter of 2004. Most of the separation costs
were paid in the third quarter of 2004 with nominal amounts for employee
benefits paid through the third quarter of 2005. 22




---



##### Table of Contents



Restructuring CostsDuring the first quarter of 2004, we initiated a
restructuring plan to bring operating expenses in line with revenue levels. We incurred
restructuring charges in the amount of $3.3 million of which $1.0 million
related to employee termination costs, $0.9 million related to exit costs for
an aircraft lease, and $1.4 million related to costs for excess leased
facilities. We incurred restructuring charges in the amount of $1.15 million
in the second quarter of 2004 related to additional costs for excess leased
facilities, which were contemplated in the first quarter restructuring  plan. As of September
30, 2004, the employment of 58 employees had been terminated, and we paid $0.8
million in termination costs, $0.9 million of costs related to the aircraft
lease, and $0.6 million of costs related to excess leased facilities. We
anticipate the remaining restructuring accrual related to the aircraft lease to
be substantially utilized for servicing operating lease payments, through
January 2007, and the remaining restructuring accrual related to excess leased
facilities to be utilized for servicing operating lease payments or negotiating
a buyout of operating lease commitments through October 2009. In the second and third quarters of 2004, we re-evaluated the first and second
quarter 2004 restructuring charges for the excess facilities and the aircraft
lease termination. Based on market conditions, new assumptions provided by our
broker, and the terms of aircraft sublease agreement, which we entered into in
the third quarter of 2004, we increased the restructuring charge by a total of
$0.8 million in the nine months ended September 30, 2004. The amount of net costs accrued under the 2004 restructuring plan assumes
that we will successfully sublease the aircraft and excess leased facilities.
The reserve for the aircraft lease and excess leased facilities approximates
the difference between our current costs for the aircraft and excess leased
facilities and the estimated income derived from subleasing, which is based on
information derived by our brokers that estimated, based on assumptions
relevant to the aircraft lease and real estate market conditions as of the date
of our implementation of the restructuring plan, the time it would likely take
to fully sub-lease the aircraft and excess leased facilities. In the third
quarter of 2004, we entered into an agreement with a third party to sublease
the aircraft. Even though it is our intent to sublease our interests in the
excess facility at the earliest possible time, we cannot determine with
certainty a fixed date by which such events will occur, if at all. In light of
this uncertainty, we will continue to periodically re-evaluate and adjust the
reserve, as necessary. During the first quarter of 2003, we initiated a restructuring program. We
incurred restructuring charges in the amount of $2.7 million related to
employee termination costs and paid $2.7 million in termination costs. At
September 30, 2004, no restructuring charges remain accrued. In the third quarter of 2002, we initiated a restructuring program. As
part of this program, we restructured our worldwide operations including a
worldwide reduction in workforce and the consolidation of excess facilities. We
incurred additional restructuring charges of $3.6 million in 2002. Of the
total restructuring charge, $2.3 million was related to employee termination
costs. The remaining $1.3 million related primarily to costs for excess leased
facilities. At September 30, 2004, restructuring charges of $1.2 million
remained accrued. As of September 30, 2004, the employment of 153 employees had
been terminated, and we paid $2.2 million in termination costs and $0.2 million
in excess facility costs. We currently anticipate the remaining restructuring
accrual, primarily relating to excess leased facilities, will be utilized for
servicing operating lease payments or negotiating a buyout of operating lease
commitments, through 2005. In 2001 we incurred restructuring charges of $12.7 million. Of the total
restructuring charges recorded, $3.2 million related to employee termination
costs covering 293 technical, production, and administrative employees. The
remaining $9.5 million of restructuring charges related primarily to costs for
excess leased facilities. As of September 30, 2004, restructuring charges of
$2.4 million remained accrued. We anticipate utilizing the remaining
restructuring accrual, which relates to servicing operating lease payments or
negotiating a buyout of operating lease commitments, through 2005. In October 2004, we announced our intention to cease investment in future
development of our CMTS product line. In connection with this announcement,
we initiated a worldwide reduction in force, which is expected to result in a
restructuring charge of approximately $3.2 million to $3.6 million related to
employee termination costs in the quarter ending December 31, 2004. We may
incur additional material charges associated, and may further reduce our
workforce in connection, with this determination. Asset Write-offsFor the nine months ended September 30, 2004 and
September 30, 2003, we wrote off $0.1 million and $0.4 million, respectively,
of fixed assets, which were determined to have no remaining useful life. We did
not write-off any fixed assets during the three months ended September 30,
2004. For the nine months ended September 30, 2003, we wrote off $17,000 of
fixed assets, which were 23




---



##### Table of Contents



determined to have no remaining useful life. We did not write-off any
fixed assets during the three months ended September 30, 2003. Non-Operating Expenses (in thousands)
    
    For the three
    
    For the nine
    
    % Change for the
    
    % Change for themonths ended
    
    months ended
    
    three months ended
    
    nine months endedSeptember 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003
    
    2004/2003
    
    2004/2003Interest income
    
    $
    525
    
    
    $
    583
    
    
    $
    1,437
    
    
    $
    2,394
    
    
    
    (10
    %)
    
    
    (40
    %)Interest expense
    
    $
    (812
    )
    
    $
    (787
    )
    
    $
    (2,456
    )
    
    $
    (2,438
    )
    
    
    3
    %
    
    
    1
    %Other income (expense)
    
    $
    (46
    )
    
    $
    1,238
    
    
    $
    1,155
    
    
    $
    1,038
    
    
    
    
    
    
    
    11
    %
 Interest Income. Interest income decreased 10% to $0.5 million in the
third quarter of 2004 compared to $0.6 million in the same period in 2003.
Interest income decreased 40% to $1.4 million in the nine months ended
September 30, 2004 compared to $2.4 million in the same period in 2003. The
decrease in interest income in both periods was primarily due to lower invested
average cash balances, slightly off-set by higher interest rates. Interest Expense. Interest expense, which related primarily to interest
on our Convertible Subordinated Notes (Notes) due in 2007, remained relatively
flat in the third quarter of 2004 and the nine months ended September 30, 2004,
compared to the same periods in 2003 as no Notes were repurchased in 2003 or
2004. Other Income (Expense).Other income (expense) is generally comprised of
the impact of foreign currency transaction gains and losses and realized gains
or losses on investments. In the second quarter of 2004, we sold all of our
ownership in Radwiz, Ltd., Ultracom Communications Holdings Ltd. and Combox
Ltd. to a third party for a cash payment of $150,000. In connection with this
disposition, the acquirer received obsolete inventories with no book value,
$0.2 million of selected net assets, and $1.35 million of net liabilities
related to these subsidiaries. We recorded other income of $1.3 million on
this transaction in the second quarter of 2004. Income Taxes (in thousands)
    
    For the three months ended
    
    For the nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Income tax expense
    
    $
    (83
    )
    
    $
    (84
    )
    
    $
    (229
    )
    
    $
    (214
    )
 We have generated losses since our inception. In the three and nine
months ended September 30, 2004 and 2003, we recorded an income tax expense
related primarily to foreign taxes. Litigation Beginning in April 2000, several plaintiffs filed class action lawsuits in
federal court against us and certain of our officers and directors. Later that
year, the cases were consolidated in the United States District Court, Northern
District of California as In re Terayon Communication Systems, Inc. Securities
Litigation. The Court then appointed lead plaintiffs who filed an amended
complaint. In 2001, the Court granted in part and denied in part defendants
motion to dismiss, and plaintiffs filed a new complaint. In 2002, the Court
denied defendants motion to dismiss that complaint, which, like the earlier
complaints, alleges that the defendants violated the federal securities laws by
issuing materially false and misleading statements and failing to disclose
material information regarding our technology. On February 24, 2003, 24




---



##### Table of Contents



the Court certified a plaintiff class consisting of those who purchased or
otherwise acquired our securities between November 15, 1999 and April 11, 2000. On September 8, 2003, the Court heard defendants motion to disqualify two
of the lead plaintiffs and to modify the definition of the plaintiff class. On
September 10, 2003, the Court issued an order vacating the hearing date for the
parties summary judgment motions, and, on September 22, 2003, the Court issued
another order staying all discovery until further notice and vacating the trial
date, which had been November 4, 2003. On February 23, 2004, the Court issued an order disqualifying two of the
lead plaintiffs. The order also states that plaintiffs counsel must provide
certain information to the Court about counsels relationship with the
disqualified lead plaintiffs, and it provides that defendants may serve certain
additional discovery. On March 24, 2004, plaintiffs submitted certain
documents to the Court in response to its order, and, on April 16, 2004, we
responded to this submission. We also have initiated discovery pursuant to the
Courts February 23, 2004 order. On October 16, 2000, a lawsuit was filed against us and the individual
defendants (Zaki Rakib, Selim Rakib and Raymond Fritz) in the California
Superior Court, San Luis Obispo County. This lawsuit is titled Bertram v.
Terayon Communications Systems, Inc. The factual allegations in the Bertram
complaint were similar to those in the federal class action, but the Bertram
complaint sought remedies under state law. Defendants removed the Bertramcase
to the United States District Court, Central District of California, which
dismissed the complaint and transferred the case to the United States District
Court, Northern District of California. That Court eventually issued an order
dismissing the case. Plaintiffs have appealed this order, and their appeal was
heard on April 16, 2004. On June 9, 2004, the United States Court of Appeals
for the Ninth Circuit affirmed the order dismissing the Bertramcase. The Court of Appeals opinion affirming dismissal of the Bertramcase does
not end the class action. We believe that the allegations in
 the class action are without merit, and we intend to
contest this matter vigorously. This  matter, however, could prove costly
and time consuming to defend, and there can be no assurances about the eventual
outcome. In 2002, two shareholders filed derivative cases purportedly on behalf of
us against certain of our current and former directors, officers, and
investors. (The defendants differed somewhat in the two cases.) Since the
cases were filed, the investor defendants have been dismissed without
prejudice, and the lawsuits have been consolidated as Campbell v. Rakibin the
California Superior Court, Santa Clara County. We are a nominal defendant in
these lawsuits, which allege claims relating to essentially the same
purportedly misleading statements that are at issue in the pending securities
class action. In the securities class action, we dispute making any misleading
statements. The derivative complaints also allege claims relating to stock
sales by certain of the director and officer defendants. We believe that there are many defects in the Campbelland OBrien
derivative complaints. On January 19, 2003, Omniband Group Limited, a Russian company, or
Omniband, filed a request for arbitration with the Zurich Chamber of Commerce,
claiming damages in an amount of $2,094,970 allegedly caused by our breach of
an agreement to sell to Omniband certain equipment pursuant to an agreement
between Omniband and Radwiz, Ltd., one of our wholly-owned subsidiaries. On
December 18, 2003, the panel of arbiters with the Zurich Chamber of Commerce
allowed the arbitration proceeding to continue against Radwiz. Omniband
appealed the Zurich Chamber of Commerces decision, which was affirmed in its
ruling of October 15, 2004. We believe that the allegations are without merit
and intend to present a vigorous defense in the arbitration proceedings. From time to time, we receive letters claiming that our technology and
products may infringe on intellectual property rights of third parties. We
also have in the past agreed to, and may from time to time in the future agree
to, indemnify a customer of our technology or products for claims against the
customer by a third party based on claims that our technology or products
infringe intellectual property rights of that third party. These types of
claims, meritorious or not, can result in costly and time-consuming litigation;
divert managements attention and other resources; require us to enter into
royalty arrangements; subject us to damages or injunctions restricting the sale
of its products, require us to indemnify its customers for the use of the
allegedly infringing products; require us to refund payment of allegedly
infringing products to our customers or to forgo future payments; require us to
redesign certain of our products; or damage our reputation, any one of which
could materially and adversely affect our business, results of operations and
financial condition. 25




---



##### Table of Contents



We are currently a party to various other legal proceedings, in addition
to those noted above, and may become involved from time to time in other legal
proceedings in the future. While we currently believe that the ultimate outcome
of these other proceedings, individually and in the aggregate, will not have a
material adverse effect on our financial position or overall results of
operations, litigation is subject to inherent uncertainties. Were an
unfavorable ruling to occur in any of our legal proceedings, there exists the
possibility of a material adverse impact on our results of operations for the
period in which the ruling occurs. The estimate of the potential impact on our
financial position and overall results of operations for any of the above legal
proceedings could change in the future. Off-Balance Sheet Financings and Liabilities Other than lease commitments and unconditional purchase obligations
incurred in the normal course of business, we do not have any off-balance sheet
financing arrangements or liabilities, guarantee contracts, retained or
contingent interests in transferred assets or any obligation arising out of a
material variable interest in an unconsolidated entity. We do not have any
majority-owned subsidiaries that are not included in the consolidated financial
statements. Liquidity and Capital Resources At September 30, 2004, we had approximately $64.1 million in cash and cash
equivalents and $47.8 million in short-term investments. Cash used in operating activities for the nine months ended September 30,
2004 was $25.6 million compared to $57.1 million used in the same period in
2003. In the nine months ended September 30, 2004, significant uses of cash
from operating activities included $28.6 million loss from operations, $14.9
million decrease in accounts payable, and $5.6 million of increase in gross
inventory, offset by a $6.4 million write-off of CMTS and modem inventories in
2004. In the nine months ended September 30, 2003, significant uses of cash
from operating activities included a $44.3 million loss from operations, and a
$11.3 million decrease in vendor cancellation reserves as we paid down these
obligations, $13.0 million decrease in accounts receivable, partially offset by
a $5.8 million increase in other assets, and $4.7 million net increase in
inventory. Cash provided by investing activities for the nine months ended September
30, 2004, was $58.2 million compared to cash used in investing activities of
$20.7 million in the same period in 2003. Investing activities consisted
primarily of net purchases and sales of short-term investments in 2004 and
2003. The increase in cash provided by investing activities in the nine months
ended September 30, 2004, was primarily due to the maturity of short-term
investments during the period. The decrease in cash used in investing
activities in the nine months ended September 30, 2003 was primarily due to
movement of short-term investments to cash and cash equivalents to fund
operations. Cash provided by financing activities was $1.3 million in the nine months
ended September 30, 2004 compared to $2.3 million in the same period in 2003
primarily due to proceeds from the exercise of stock options and the sale of
shares of common stock through our Employee Stock Purchase Plan. In July 2000, we issued $500.0 million of Notes, resulting in net proceeds
to us of approximately $484.4 million. The Notes are a general unsecured
obligation and are subordinated in right of payment to all of our existing and
future senior indebtedness and to all of the liabilities of our subsidiaries.
The Notes are convertible into shares of our common stock at a conversion price
of $84.01 per share at any time on or after October 24, 2000 through maturity,
unless previously redeemed or repurchased. Interest is payable semi-annually.
Debt issuance costs related to the Notes were approximately $15.5 million. Through September 30, 2004, we had repurchased approximately $434.9
million of the Notes for $171.0 million in cash and $17.9 million in stock,
resulting in a gain on early retirement of debt of approximately $234.4 million
net of related unamortized issuance costs of $11.6 million. We did not
repurchase any Notes in 2003 or 2004. 26




---



##### Table of Contents



We believe that our current cash balances will be sufficient to
satisfy our cash requirements for at least the next 12 months. In order to
obtain profitability in the future, we will need to increase revenues
from the sale of our  more profitable products while decreasing
costs.  We also may need to raise additional funds in order to support more rapid
expansion, develop new or enhanced products and services, respond to competitive pressures,
acquire complementary businesses or technologies or respond to unanticipated
requirements. We may seek to raise additional funds through private or public
sales of securities, strategic relationships, bank debt, and financing under
leasing arrangements or otherwise. If additional funds are raised through the
issuance of equity securities, the percentage ownership of our current
stockholders will be reduced, stockholders may experience additional dilution
or such equity securities may have rights, preferences or privileges senior to
those of the holders of our common stock. We cannot assure you that additional
financing will be available on acceptable terms, if at all. If adequate funds
are not available or are not available on acceptable terms, we may be unable to
continue operations, develop our products, or services take advantage of future
opportunities or respond to competitive pressures or unanticipated
requirements, which could have a material adverse effect on our business,
financial condition and operating results. Contractual Obligations The following summarizes our contractual obligations at September 30,
2004, and the effect such obligations are expected to have on our liquidity and
cash flows in future periods (in millions): Payments Due by PeriodLess than
    
    1-3
    
    4-5
    
    After 5Total
    
    1 year
    
    years
    
    years
    
    yearsUnconditional Purchase Obligations
    
    $
    26.5
    
    
    $
    26.5
    
    
    $
    
    
    
    $
    
    
    
    $
    Long Term Debt
    
    
    68.5
    
    
    
    
    
    
    
    1.6
    
    
    
    65.1
    
    
    
    1.8Operating Lease Obligations
    
    
    19.7
    
    
    
    6.6
    
    
    
    6.5
    
    
    
    6.2
    
    
    
    0.4Aircraft Lease
    
    
    3.4
    
    
    
    1.5
    
    
    
    1.9
    
    
    
    
    
    
    
    Total Contractual Commitments
    
    $
    118.1
    
    
    $
    34.6
    
    
    $
    10.0
    
    
    $
    71.3
    
    
    $
    2.2
 We have unconditional purchase obligations to certain of our suppliers
that support our ability to manufacture our products. The obligations require
us to purchase minimum quantities of the suppliers products at a specified
price. As of September 30, 2004, we had approximately $26.5 million of purchase
obligations, of which $2.1 million is included in the consolidated balance
sheets as accrued vendor cancellation charges, and the remaining $24.4 million
is attributable to open purchase orders in the ordinary course of
business. The remaining obligations are
expected to become payable at various times through the first quarter of 2005. In the third quarter of 2004, the Company entered into an agreement with a
third party to sublease the aircraft. The aircraft lease commitment above does
not include an estimated reduction of $100,000 per month related to this
sublease income. We had restricted cash of $8.7 million at September 30, 2004. Restricted
cash related to commitments primarily required to support operating leases, are
as follows (in millions): Amount of Commitment Expiration Per PeriodTotalAmounts
    
    Less than
    
    1-3
    
    4-5
    
    Over 5Committed
    
    1 year
    
    years
    
    years
    
    yearsDeposits
    
    $
    1.0
    
    
    $
    0.3
    
    
    $
    0.7
    
    
    $
    
    
    
    $
    Standby Letters of Credit
    
    
    7.7
    
    
    
    
    
    
    
    
    
    
    
    7.5
    
    
    
    0.2Total Commercial Commitments
    
    $
    8.7
    
    
    $
    0.3
    
    
    $
    0.7
    
    
    $
    7.5
    
    
    $
    0.2
 27




---



##### Table of Contents



In 2002, we entered into an operating lease arrangement to lease a
corporate aircraft. This lease arrangement was secured by a $9.0 million
letter of credit. The letter of credit was reduced to $7.5 million in February
2003. This lease commitment is included in the table above. As
discussed above, in the third quarter of 2004, we entered into an
agreement with a third party to sublease the aircraft. Impact of Recently Issued Accounting Standards In March 2004, the FASB issued a proposed Statement, Share-Based Payment,
an amendment of FASB Statements Nos. 123 and 95, that addresses the accounting
for share-based payment transactions in which a Company receives employee
services in exchange for either equity instruments of the Company or
liabilities that are based on the fair value of the Companys equity
instruments or that may be settled by the issuance of such equity instruments.
The proposed statement would eliminate the ability to account for share-based
compensation transactions using the intrinsic method that the Company currently
uses and generally would require that such transactions be accounted for using
a fair-value-based method and recognized as expense in the consolidated
statement of operations. The effective date of the proposed standard is for
periods beginning after June 15, 2005. It is expected that the final standard
will be issued before December 31, 2004 and should it be finalized in its
current form, it will have a significant impact on our consolidated statement
of operations as we will be required to expense the fair value of stock option
grants. 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. It is difficult to predict our future operating results. We began
shipping products commercially in June 1997, and we have been shipping products
in volume since the first quarter of 1998. As of September 30, 2004, we had an
accumulated deficit of $1.0 billion. We believe that we will continue to
experience challenges in selling our products at a profit and may continue to
operate with net losses for the foreseeable future. In the past few years, we
experienced a decrease in revenues, which was, in large part, due to the
erosion of average selling prices (ASPs) of our products and a drop in CMTS
sales volume due to our transition from a proprietary platform to the DOCSIS
standards platform. Although our revenues increased in the first half of 2004
as compared to 2003, we still incurred losses of $13.5 million and
$28.6 million, respectively, in the three and nine months ended September
30, 2004. As a result of the operating deficiencies, we have had to use
available cash and cash equivalents to supplement the operation of our
business. Cash used in operating activities for the nine months ended
September 30, 2004 was $25.6 million compared to $57.1 million used in the same
period in 2003. Additionally, we generally have been 28




---



##### Table of Contents



unable to significantly reduce our short-term expenses in order to
compensate for unexpected decreases in anticipated revenues or delays in
generating anticipated revenues. For example, we have fixed commitments with
some of our suppliers that require us to purchase minimum quantities of their
products at a specified price irrespective of whether we can subsequently use
such quantities in our products. Further, we have experienced and will likely
continue to experience declining ASPs of our products. We record an inventory
charge to reduce our inventory to the lower of cost or market if ASPs fall
below the cost of these products. In addition, we have significant operating
lease commitments for facilities and equipment that generally cannot be
cancelled in the short-term without substantial penalties. Our business may be adversely affected by delays in, or our failure to,
commercialize new products, or reduce the cost of manufacturing our current
products. Moreover, given the conditions in the broadband equipment market,
the profit potential of our business remains unproven. We may experience fluctuations in our operating results and face
unpredictability in our future revenues. Our quarterly revenues have fluctuated and are likely to continue to
fluctuate significantly in the future due to a number of factors, many of which
are outside our control. Factors that affect our revenues include, among
others, the following:  
    
    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. Our quarterly results are affected by the gross margin we achieve for the
quarter relative to our gross revenues. A variety of factors influence our
gross margin for a particular quarter, including, among others, the following:  
    
    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;  
    
    the 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. We often recognize a substantial portion of our revenues in the last month
of the quarter. We establish our expenditure levels for product development
and other operating expenses based on projected sales levels, and expenses are
relatively fixed, particularly in the short term. For example, a significant
percentage of these operating expenses are fixed due to operating leases for
our facilities and equipment. Also, we have fixed commitments with some of our
suppliers that require us to purchase minimum quantities of their products at a
specified price. Because in the past, we have been unable to use all of the
products that we purchased from our suppliers, we have taken vendor
cancellation charges as a result of 29




---



##### Table of Contents



these fixed commitments, and we may have to take additional charges in the
future if we are unable to use all of the products that we purchase from our
suppliers. As of September 30, 2004, $26.5 million of purchase obligations
were outstanding. Accordingly, variations in timing of sales can cause
significant fluctuations in operating results. In addition, because a
significant portion of our business is derived from orders placed by a limited
number of large customers, the timing of such orders can also cause significant
fluctuations in our operating results. Our expenses for any given quarter are
typically based on expected sales and if sales are below expectations, our
operating results may be adversely impacted by our inability to adjust spending
to compensate for the shortfall. Moreover, our research and development
expenses fluctuate in response to new product development, and changing
industry requirements and customer demands. Additionally, the unit ASPs of our products declined considerably in 2002,
2003, and 2004, and we anticipate that unit ASPs of our products will continue
to decline in the future. This has caused and will continue to cause a
decrease in our gross margins if we are unable to off-set the decline in ASPs
with cost reduction measures. In addition, the gross margins we realize from
the sale of our products are affected by the mix of product sales between
higher margin, lower volume head-end equipment, such as digital video management systems, and lower margin, higher
volume Customer Premise Equipment (CPE) products, such as
modems. We are attempting to increase our gross margin by shifting our product mix from CPE revenues to higher margin digital video
product revenues, and cease investment in our CMTS product line.
However there are no assurances that we will succeed. For the
reminder of 2004 and 2005, we expect that sales of our low-margin CPE products will continue to
make up a significant portion of our revenues. Revenues for our video products will remain flat for the remainder of 2004.
Moreover, we are in the early stages of development with respect to our video
product line. Historically, video product revenues represented less than 30%
of our total revenues. If our video product line does not receive broader
market acceptance and we do not generate a greater percentage of total revenues
from video product revenues, we will not succeed in greatly improving our gross
margin. We are dependent on a small number of customers and our business could be
harmed by the loss of any of these customers or reductions in their purchasing
volumes. Our customers have undergone and continue to undergo significant
consolidation in both North America and internationally, as a limited number of
cable operators control an increasing number of systems. For example, the top
nine cable operators in the United States operate systems that service
approximately 90% of homes that receive cable services in the United States.
As a result of the consolidation among cable operators, our revenue has been
and will continue to be dependent on sales to the few leading cable operators
worldwide. Three customers accounted for 10% or more of total revenues (20%,
15%, and 14%) for the three months ended September 30, 2004. Two customers
accounted for 10% or more of total revenues (21% and 11%) for the nine months
ended September 30, 2004. Three customers accounted for 10% or more of total
revenues (29%, 13%, and 13%) for the three months ended September 30, 2003.
Three customers accounted for 10% or more of total revenues (20%, 17%, and 12%)
for the nine months ended September 30, 2003. As is common in our industry, we typically do not enter into contracts
with our customers in which they commit to purchase products from us.
Typically, our sales are made on a purchase order or system contract basis, and
none of our customers has entered into a long-term agreement requiring it to
purchase our products. Moreover, we do not typically require our customers to
purchase a minimum quantity of our products, and our customers can generally
cancel or significantly reduce their orders on short notice without significant
penalties. The loss of any of our customers can have a material adverse effect
on our results of operations. Further, any reduction in orders from a given
customer can likewise have a material adverse affect on our results of
operations. Also, we may not succeed in attracting new customers as many of our
potential customers have pre-existing relationships with our current or
potential competitors and the continued consolidation of the cable industry
reduces the number of potential customers. To attract new customers, we may be
faced with intense price competition, which may affect our gross margins. We
may also face losing existing customers or business from our existing customers
because of our decision to cease investment in our CMTS product line. 30




---



##### Table of Contents



The sales cycle for certain of our products is lengthy, which makes forecasting
of our customer orders and revenue difficult. The sales cycle for certain of our products is lengthy, often lasting nine
months to more than a year. Our customers generally conduct significant
technical evaluations, including customer trials, of our products as well as
competing products prior to making a purchasing decision. In addition,
purchasing decisions may also be delayed because of a customers internal
budget approval processes. Because of the lengthy sales cycle and the size of
customer orders, if orders forecasted for a specific customer for a particular
period do not occur in that period, our revenues and operating results for that
particular quarter could suffer. Moreover, a portion of our expenses related
to an anticipated order is fixed and difficult to reduce or change, which may
further impact our revenues and operating results for a particular period. We are dependent on key personnel. Due to the specialized nature of our business, we are highly dependent on
the continued service of, and on our ability to attract and retain, qualified
senior management, engineering, sales, and marketing personnel. The
competition for some of these personnel is intense. The loss of any of these
individuals may significantly disrupt and be harmful to our business. In
addition, if we are unable to hire qualified personnel as needed in a timely
manner, we may be unable to adequately manage and grow our business. Highly skilled employees with the education and training that we require,
especially employees with significant experience and expertise in video, data
networking and radio frequency design, are in high demand. We may incur
additional expenses to attract and retain key personnel. We cannot assure you
that the additional expenses we may incur will enable us to attract and retain
qualified personnel necessary for the development of our business. We do not
have key person insurance coverage for the loss of any of our employees. Any
officer or employee can terminate his or her relationship with us at any time.
Although a few of our executive officers have limited non-competition
agreements with us, our employees generally are not bound by non-competition
agreements. Additionally, we have recently experienced and may continue to experience
significant changes in key personnel, including the resignation of our Chief
Executive Officer and his appointment as Chairman of the Board of Directors,
the resignation of our Chairman, President and Chief Technology Officer
although he remains a member of the Board, and the resignation of our Chief
Operating Officer and Chief Financial Officer, as well as the appointment of a
new Chief Executive Officer and the appointment of our General Counsel and Head
of Human Resources as the Acting Chief Financial Officer. Turnover in
personnel, and the recruitment and retention of a new senior management staff,
has created and could continue to create a number of transitional challenges
for us. For instance, we are currently actively engaged in the search for a
new Chief Financial Officer. Although we have an Acting Chief Financial
Officer, we may experience transitional difficulties in financial management
and administration during the period until a new Chief Financial Officer is
appointed. These transitional issues have caused, and may cause, disruptions
to our business. We cannot assure you that the steps we have taken will
succeed in establishing a smooth transition of our senior management staff, or
result in the orderly continuation of our operations during the interim
period. As a result of these and other changes, including the search for
a new Chief Financial Officer, we also may experience additional turnover in
management. Further, we cannot assure you that the integration of our new
senior management staff will occur in a timely manner, or that such integration
will not present additional transitional challenges for us. There are many risks associated with our participation in industry standards. In connection with the development of the DOCSIS 2.0 specification by
Cable Television Laboratories, Inc., a cable industry consortium that
establishes cable technology standards and administers compliance testing
(CableLabs), we entered into an agreement with CableLabs whereby we licensed to
CableLabs on a royalty-free basis any of our intellectual property rights,
including rights to our proprietary S-CDMA technology, to the extent that such
rights may be asserted against a party desiring to design, manufacture or sell
DOCSIS based products, including DOCSIS 2.0 based products. This license
agreement grants to CableLabs the right to sublicense our intellectual
property, including our intellectual property rights in our S-CDMA patents, to
manufacturers that compete with us in the marketplace for DOCSIS based
products. As a result of this license to CableLabs, our competitors that
produce DOCSIS-based products have access to our technology without having to
pay us any royalties or other compensation for the use of our technology. As a
result of our contribution of technology to the DOCSIS intellectual property
pool, we may have foregone significant revenue from the potential licensing of
our proprietary technology, and we may be unable to recoup the investment in
the research and development of intellectual property contributed to the DOCSIS
technology pool. Additionally, the agreement that we signed with CableLabs to participate
in the DOCSIS intellectual property pool may make it difficult for us to
enforce our intellectual property rights against other companies. Certain
cable equipment vendors manufacture and sell DOCSIS based and DOCSIS certified
and qualified products without sublicensing from CableLabs the technology in
the CableLabs intellectual property pool. Due to the interests of cable
operators in having as many equipment vendors as possible, we may feel
constrained by competitive pressures from pursuing the enforcement of our
intellectual property rights against our competitors that have not entered into
sublicenses with CableLabs. Moreover, if we seek to enforce our intellectual
property rights against other equipment manufacturers that access technology
from the CableLabs intellectual property pool, our license to the technology in
the pool may be jeopardized. Certain contributors of technology to the
CableLabs intellectual property pool are our competitors and may elect to
revoke our license to their technology if we attempt to enforce our
intellectual property rights against them. We may have lost any competitive advantage that our proprietary S-CDMA
technology may have provided us in the marketplace by licensing it to
CableLabs, and we may face increased competition because our competitors have
the ability to incorporate our technology into their products. We believe that
this increased competition could come from existing competitors or from new
competitors who enter the market and that such competition is likely to result
in lower product ASPs, which could harm our revenues and gross margins.
Additionally, because our competitors will be able to incorporate our
technology into their products, our current customers may choose alternate
suppliers or choose to purchase DOCSIS-compliant products from multiple
suppliers. We may be unable to effectively compete with the other vendors if
we cannot produce DOCSIS compliant cable products more quickly or at lower cost
than our competitors. DOCSIS specifications have not yet been accepted in Asia, although an
increasing number of Asian cable operators are requiring product to be DOCSIS
qualified or certified. An alternate specification for cable products, called
the Euro-DOCSIS specification, has been formalized by TComLabs, a cable 31




---



##### Table of Contents



technology consortium of European cable operators, and European and some
Asian cable operators have embraced it. We have contributed certain of our
technologies, including our proprietary S-CDMA technology, to the Euro-DOCSIS
specification. We may develop and sell products that comply with the
Euro-DOCSIS specification, and we may be unsuccessful in these efforts. Even
if we are successful in our efforts, we may face some of the same risks
associated with our contribution of intellectual property to the CableLabs
DOCSIS intellectual property pool. We need to certify and qualify our new and existing products to meet industry
specifications in order to remain competitive. Major cable operators worldwide have endorsed the DOCSIS, Euro-DOCSIS and
PacketCable specifications and rarely purchase equipment that is not certified
or qualified as compliant with these specifications. Cable operators have
chosen to purchase only products meeting industry specifications because the
specifications enable interoperability among products from multiple vendors,
which leads to increased competition among equipment manufacturers and
consequently lowers product ASPs. Consequently, our future success depends on
our ability to compete effectively in this marketplace by developing, marketing
and selling products that are certified and qualified to industry standards in
a timely fashion and in a cost effective manner. The DOCSIS and PacketCable specifications are promulgated by CableLabs.
Currently these specifications have been widely adopted by cable operators in
North America and by some cable operators in Asia, Latin America and Europe.
The Euro-DOCSIS specifications have been developed by TComLabs specifically to
meet the requirements of European operators, and have found some acceptance in
China as well. There is no guarantee that our products will be DOCSIS,
EuroDOCSIS or PacketCable certified or qualified. If we are unable to certify
or qualify our products as DOCSIS, EuroDOCSIS or PacketCable compliant in a
timely manner, we may be unable to sell our products and may lose some or all
of any advantage we might otherwise have had, and our future operating results
may be adversely affected. Although we sell certified and qualified products, there have been and may
continue to be instances where our existing customers and potential new
customers elect to purchase products from one or more of our competitors rather
than from us. In response to this situation, we have reduced our prices and
continue to experience customer demand to further reduce our prices in order to
promote sales of our current products. This has had and may continue to have
an adverse impact on our revenues, operating results and gross margin. Developing products to meet these various industry specifications has
several risks. The first is the cost and effort to engineer standards-based
products and to then prepare them for compliance testing. Not only do we have
to certify or qualify new products, but any of our currently certified or
qualified products must be re-certified or re-qualified should they be changed
in any way. Second, there is no guarantee that these products will be
certified or qualified as meeting these specifications in a timely fashion, if
ever. Because most cable operators purchase only those products that have been
certified or qualified as meeting these specifications, it is highly unlikely
that we will be able to sell our products until they achieve certification or
qualification, which can be a lengthy process. As a result, we may incur
significant research and development expenses to develop new products that may
not receive certification or qualification and we cannot recoup the costs of
these research and development expenses by marketing uncertified or unqualified
products. Moreover, a consequence of cable operators only purchasing products
certified or qualified as meeting industry specifications is the increased
competition between equipment vendors, which has resulted in a steady and
ongoing decline in equipment prices as vendors compete for cable operators
business. Third, there is no guarantee that we will be able to support all
future cable industry specifications, which will likely have an adverse impact
on our future revenues. Average selling prices of broadband equipment continue to decline, which is
decreasing our gross margins. The broadband equipment market has been characterized by erosion of
product ASPs, particularly for CPE devices. This erosion may continue. The
ASPs for our products are likely to continue to decline 32




---



##### Table of Contents



due to competitive pricing pressures, promotional programs and customers
possessing strong negotiating positions who require price reductions as a
condition of purchase. In addition, we believe that the widespread adoption of
industry specifications, such as the DOCSIS and EuroDOCSIS specifications, is
further eroding ASPs as cable modems and other similar CPE products become
commodity products. Decreasing ASPs could result in decreased revenues even if
the number of units sold increases. Decreasing ASPs may also require us to
sell our products at much lower gross margin than in the past, and in fact, we
may sell products at a loss. The primary reason that our gross profits have
declined year-over year is the decline in product ASPs. As a result, we may
experience substantial period-to-period fluctuations in future revenue, gross
margin and operating results due to ASP erosion. Therefore, we must continue
to develop and introduce on a timely basis and a cost-effective manner new
products or next-generation products with enhanced functionalities that can be
sold at higher gross margins. Our failure to do this could cause our revenues
and gross margin to decline further. We must achieve cost reductions or increase revenues to attain profitability. In prior years, we have experienced a decrease in revenue, which was, in
large part, due to declining product ASPs and a drop in CMTS sales volume due
to our transition from a proprietary platform to the DOCSIS standards platform.
Most recently, we have experienced a decrease in revenue derived from our
DOCSIS CMTS sales. This has resulted in increased losses and made it difficult
for us to attain profitability. In order to achieve profitability, we must
significantly increase our revenues, reduce the cost of our products, and
maintain or reduce our operating expenses. Although we have implemented expense reduction and restructuring plans in
the past, including the latest restructurings in the first and second quarters
of 2004, that have focused on cost reductions and operating efficiencies, our
operating expenses are still higher than our gross margins. A large portion of
our expenses, including rent, and operating lease expenditures, is fixed and
difficult to reduce or change. Accordingly, if our revenue does not meet our
expectations, we may not be able to adjust our expenses quickly enough to
compensate for the shortfall in revenue. In that event, our business,
financial condition and results of operations could be materially and adversely
affected. As product ASPs decline, we need to reduce the cost of our products
through design and engineering changes. We may not be successful in
redesigning our products, and, even if we are successful, our efforts may be
delayed or our redesigned products may contain significant errors and product
defects. In addition, any redesign may not result in sufficient cost
reductions to allow us to reduce significantly the prices of our products or
improve our gross margin. Reductions in our product costs may require us to
use lower-priced components that are highly integrated in future products and
may require us to enter into high volume or long-term purchase or manufacturing
agreements. Volume purchase or manufacturing agreements may not be available
on acceptable terms, if at all, and we could incur significant expenses without
related revenues if we cannot use the products or services offered by such
agreements. We have incurred significant vendor cancellation charges related to
volume purchase and manufacturing agreements in the past and may incur such
charges in the future. Broadband services delivered by cable operators have not achieved widespread
market acceptance, and other competing service providers exist. Our success will depend upon the widespread acceptance of broadband
services delivered by cable television operators. The markets for these
services are growing, but are not fully developed nor exploited. Additionally,
these markets may not grow as cable operators may elect not to increase
available bandwidth over which they can offer new services, such as high-speed
Internet access, High Definition Television (HDTV), Video on Demand, and
internet telephony. Cable operators may elect not to provide any or all of
these new services to their customers or may not aggressively market these
services to their customers. If cable operators elect not to deploy such new
services or if customers elect not to subscribe to such services, it may affect
our ability to sell products to cable operators as their existing equipment may
meet their current infrastructure demands. We depend on cable operators to
provide new services and maintain their infrastructure in such a manner that
allows us to continue to sell products to them. 33




---



##### Table of Contents



Cable operators must also compete with other service providers in the
delivery of services to their customers. Regional Bell Operating Companies
(RBOCs), Competitive Local Exchange Carriers (CLECs), Incumbant Local Exchange
Carriers (ILECs), satellite TV and other broadband service providers are
aggressively competing with the cable industry to deliver broadband services
via Digital Subscriber Lines or satellite broadcast technologies. We cannot
accurately predict the future growth rate or the ultimate size of the market
for broadband services delivered via cable. The success of RBOCs, CLECs,
ILECs, satellite TV and other broadband service providers may slow or hamper
the continued acceptance of cable operators in delivering broadband services,
which in turn may impact demand for our products by cable operators. We need to develop additional distribution channels to market and sell our
products. The vast majority of our sales are to large cable operators. However, we
currently have limited access to smaller or geographically diverse cable
operators. Although we intend to establish strategic relationships with
leading distributors worldwide to access these customers, we may not succeed in
establishing these relationships. Even if we do establish these relationships,
the distributors may not succeed in marketing our products to their customers.
Some of our competitors have established, long-standing relationships with
these cable operators that may limit our and our distributors ability to sell
our products to those customers. Even if we were to sell our products to those
customers, it would likely not be based on long-term commitments, and those
customers would be able to terminate their relationships with us at any time
without significant penalties. We depend on cable industry capital spending for a substantial portion of our
revenue and any decrease or delay in capital spending by cable operators would
negatively impact our operating results and financial condition. Historically, almost all of our sales had been derived from sales to cable
operators, and we expect these sales to constitute a significant portion of net
sales for the foreseeable future. Demand for our products will depend on the
magnitude and timing of capital spending by cable television operators. These
capital spending patterns are dependent on a variety of factors including:  
    
    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. In recent years, the cable market has been characterized by consolidation.
 Furthermore, cable
operators may undertake additional business combinations to expand their
business. We cannot predict the effect, if any, this will have on overall
capital spending patterns by cable operators. The effect on our business of
further industry consolidations and combinations also is uncertain. We may fail to accurately forecast customer demand for our products. The nature of the cable industry makes it difficult for us to accurately
forecast demand for our products. Our inability to forecast accurately the
actual demand for our products may result in too much or too little supply of
products or an over/under capacity of manufacturing or testing resources at any
given point in time. The existence of any one or more of these situations
could have a negative impact on our business, operating results or financial
condition. We had purchase obligations of approximately $26.5 34




---



##### Table of Contents



million as of September 30, 2004, primarily to purchase minimum quantities
of materials and components used to manufacture our products. We may be
obligated to fulfill these purchase obligations even if demand for our products
is lower than we anticipate. We may not be able to manage expenses and inventory risks associated with
meeting the demand of our customers. From time to time, we receive indications from our customers as to their
future plans and requirements to ensure that we will be prepared to meet their
demand for our products. If actual orders differ materially from these
indications, our ability to manage inventory and expenses may be affected. In
addition, if we fail to meet customers supply expectations, we may lose
business from such customers. If we enter into purchase commitments to acquire
materials, or expend resources to manufacture products and such products are
not purchased by our customers, our business and operating results could
suffer. We may have financial exposure to litigation. We and/or our directors and officers are defendants in a number of
lawsuits, including securities litigation lawsuits. As a result, we may have
financial exposure to litigation as a defendant and because we are obligated to
indemnify our officers and members of our board of directors for certain
actions taken by our officers and directors on our behalf. In order to limit financial exposure arising from litigation and/or our
obligation to indemnify our officers and directors, we have historically
purchased directors and officers insurance (D&O Insurance). However, the
availability of D&O Insurance is becoming more difficult for companies to
attain as a number of insurance underwriters no longer offer D&O Insurance and
the remaining insurance underwriters offering D&O Insurance have significantly
increased the premiums of such coverage. In recent years, we have experienced
a significant increase in the cost of our D&O Insurance. Although the cost of
our D&O insurance decreased in fiscal year 2003, our coverage amount did as
well. There can be no assurance that D&O Insurance will be available to us in
the future or, if D&O Insurance is available, it may be prohibitively
expensive. Additionally, some insurance underwriters who offered D&O Insurance
in the past have been placed into liquidation or may be, at some future point,
placed into liquidation. In October 2001, one of the insurance underwriters
from which we purchased D&O Insurance, Reliance Insurance Co. (Reliance), was
placed into liquidation by the state of Pennsylvania. Reliance was the
underwriter for one excess layer of our D&O Insurance for the period covering
the claims made against us and our officers in the pending securities
litigation. Because Reliance is in liquidation, in 2003 we paid for the amount
insured under the Reliance policy, which was $2.5 million. 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 manufacture all of our products using components or subassemblies
procured from third-party suppliers, including semiconductors. Some of these
components are available from a sole source and others are available from
limited sources. A majority of our sales are from products containing one or
more components that are available only from sole source suppliers.
Additionally, some of our components are custom parts that are produced to our
specifications, and it may be difficult to move the manufacturing of such
components from one vendor to another vendor. Any interruption in the operations of our vendors of sole source or custom
product parts could adversely affect our ability to meet our scheduled product
deliveries to customers. If we are unable to obtain a sufficient supply of
components, including semiconductors, from our current sources, we could
experience difficulties in obtaining alternative sources or in altering product
designs to use alternative components. Resulting delays or reductions in
product shipments could damage customer relationships and expose us to
potential damages that may arise from our inability to supply our customers
with products. Further, a significant increase in the price of one or more of
these components, such as our semiconductor components, could harm our gross
margin or operating results. Additionally, we attempt to limit this risk by
maintaining safety stocks of these components, subassemblies and modules. As a
result of this 35




---



##### Table of Contents



investment in inventories, we have in the past and in the future may be
subject to risk of excess and obsolete inventories, which could harm our
business. In this regard, our gross margins and operating results could be
adversely affected by excess and obsolete inventory. We may be unable to migrate to new semiconductor process technologies
successfully or on a timely basis. Our future success will depend in part upon our ability to develop
products that utilize new semiconductor process technologies. These
technologies change rapidly and require us to spend significant amounts on
research and development. We continuously evaluate the benefits of redesigning
our integrated circuits using smaller geometry process technologies to improve
performance and reduce costs. The transition of our products to integrated
circuits with increasingly smaller geometries will be important to our
competitive position. Other companies have experienced difficulty in migrating
to new semiconductor processes and, consequently, have suffered reduced yields,
delays in product deliveries and increased expense levels. Moreover, we depend
on our relationship with our third-party manufacturers to migrate to smaller
geometry processes successfully. Our ability to directly control product delivery schedules and product quality
is dependent on third-party contract manufacturers. Most of our products are assembled and tested by contract manufacturers
using testing equipment that we provide. As a result of our dependence on
these contract manufacturers for the assembly and testing of our products, we
do not directly control product delivery schedules or product quality. Any
product shortages or quality assurance problems could increase the costs of
manufacturing, assembling or testing our products. In addition, as
manufacturing volume increases, we will need to procure and assemble additional
testing equipment and provide it to our contract manufacturers. The production
and assembly of testing equipment typically requires significant lead times.
We could experience significant delays in the shipment of our products if we
are unable to provide this testing equipment to our contract manufacturers in a
timely manner. We are dependent upon international sales and there are many risks associated
with international operations. We expect sales to customers outside of the United States to continue to
represent a significant percentage of our revenues for the foreseeable future.
For the three months ended September 30, 2004 and September 30, 2003,
approximately 32% and 56%, respectively, of our net revenues were from
customers outside of the U.S. For the nine months ended September 30, 2004 and
September 30, 2003, approximately 44% and 47%, respectively, of our net
revenues were from customers outside of the U.S. International sales are
subject to a number of risks, including the following:  
    
    changes in foreign government regulations and communications standards;  
    
    import and export license requirements, tariffs and taxes;  
    
    trade barriers;  
    
    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. If our customers are affected by currency devaluations or general economic
downturns their ability to purchase our products could be reduced
significantly. Payment cycles for international customers typically are longer
than those for customers in North America. While we generally invoice our foreign sales in U.S. dollars, we invoice
some of our sales in Europe in Euros and other sales in the United
Kingdom, Belgium, Canada, Japan, Hong Kong, Korea, China and 36




---



##### Table of Contents



Brazil in local currencies. Since we have also elected to take payment
 from our customers in local currencies and may elect to take payment in
other foreign currencies in the future, we are exposed to losses as the result
of foreign currency fluctuations. Additionally, we have an Israel based
operation whose expenses are denominated in Israeli NIS. We currently do not
engage in foreign currency hedging transactions. We may in the future choose
to limit our exposure by the purchase of forward foreign exchange contracts or
through similar hedging strategies. No currency hedging strategy can fully
protect against exchange-related losses. In addition, if the relative value of
the U.S. dollar in comparison to the currency of our foreign customers should
increase, the resulting effective price increase of our products to those
foreign customers could result in decreased sales. Furthermore, foreign countries may decide to prohibit, terminate or delay
the construction of new cable infrastructures for a variety of reasons. These
reasons include environmental issues, economic downturns and availability of
favorable pricing for other communications services or the availability and
cost of related equipment. Any such action by foreign countries would reduce
the market for our products. Our business may be affected by conditions in Israel. We have significant operations in Israel. Our operations in Israel
consist primarily of research and development, and to a lesser extent sales and
manufacturing. Revenues generated by our business in Israel were $1.0 million
and $3.5 million for the three months ended September 30, 2004 and September
30, 2003, respectively. Revenues generated by our business in Israel were $9.7
million and $9.0 million for the nine months ended September 30, 2004 and
September 30, 2003, respectively. Our research and development operations may
be significantly affected by conditions in Israel. Since the establishment of
the State of Israel in 1948, a number of armed conflicts have taken place
between Israel and its Arab neighbors and a state of hostility, varying in
degree and intensity, has led to security and economic problems for Israel.
Hostilities within Israel have continued over the past year, which could
disrupt some of our operations. We could be adversely affected by any major
hostilities involving Israel. As a result of the hostilities and unrest
presently occurring within Israel, the future of the peace efforts between
Israel and its Arab neighbors is uncertain. A number of our employees based in
Israel are currently obligated to perform annual military reserve duty and are
subject to being called to active duty at any time under emergency
circumstances. We cannot assess the full impact of these requirements and the
hostilities on our workforce, business or operations if conditions should
change, and we cannot predict the effect of any expansion or reduction of these
obligations or the hostilities. We may be unable to provide adequate customer support. Our ability to achieve our planned sales growth and retain current and
future customers will depend in part upon the quality of our customer support
operations. Our customers generally require significant support and training
with respect to our products, particularly in the initial deployment and
implementation stages. Spikes in demand of our support services may cause us
to be unable to serve our customers. We may not have adequate personnel to
provide the levels of support that our customers may require during initial
product deployment or on an ongoing basis especially during peak periods. Our
inability to provide sufficient support to our customers could delay or prevent
the successful deployment of our products. In addition, our failure to provide
adequate support could harm our reputation and relationships with our customers
and could prevent us from selling product to existing customers or gaining new
customers. The deployment process for our equipment may be lengthy and may delay the
receipt of new orders and cause fluctuations in our revenues. The timing of deployment of our equipment can be subject to a number of
other risks, including the availability of skilled engineering and technical
personnel, the availability of other equipment such as fiber optic cable, and
the need for local zoning and licensing approvals. We believe that changes in
our customers deployment plans have delayed, and may in the future delay, the
receipt of new orders. Since the majority of our sales have been to relatively
few customers, a delay in equipment deployment with any 37




---



##### Table of Contents



one customer has in the past had, and could in the future, have a material
adverse effect on our sales for a particular quarter. Our industry is highly competitive with many larger and more established
competitors. The market for our products is extremely competitive and is characterized
by rapid technological change. Our direct competitors include Ambit
Microsystems Corporation, Cisco Systems, ADC, Arris, BigBand Networks,
Motorola, Scientific-Atlanta and Toshiba. Additionally, we face competition
from early stage companies with access to significant financial backing that
improve existing technologies or develop new technologies. The principal
competitive factors in our market include the following:  
    
    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. Some of these factors are outside of our control. Conditions in the
market could change rapidly and significantly as a result of technological
advancements. The development and market acceptance of alternative
technologies could decrease the demand for our products or render them
obsolete. Our competitors may introduce products that are less costly, provide
superior performance or achieve greater market acceptance than our products. Many of our current and potential competitors have greater financial,
technical, marketing, distribution, customer support and other resources, as
well as better name recognition and access to customers than we do. The
widespread adoption of DOCSIS and other industry standards has and is likely to
continue to cause increased price competition. We believe that the adoption of
these standards have resulted in and are likely to continue to result in lower
ASPs for our products. Any increased price competition or reduction in sales
of our products, particularly our higher margin head-end products, has resulted
and will continue to result in decreased revenue and downward pressure on our
gross margin. These competitive pressures have and are likely to continue to
have an adverse impact on our business. 38




---



##### Table of Contents



Our business is subject to the risks of product returns, product liability and
product defects. Products like ours are very complex and can frequently contain undetected
errors or failures, especially when first introduced or when new versions are
released. Despite testing, errors may occur. Product errors could affect the
performance or interoperability of our products, delay the development or
release of new products or new versions of products, adversely affect our
reputation and our customers willingness to buy products from us and adversely
affect market acceptance or perception of our products. Any such errors or
delays in releasing new products or new versions of products or allegations of
unsatisfactory performance could cause us to lose revenue or market share,
increase our service costs, cause us to incur substantial costs in redesigning
the products, subject us to liability for damages and divert our resources from
other tasks, any one of which could materially and adversely affect our
business, results of operations and financial condition. Although we have
limitation of liability provisions in our standard terms and conditions of
sale, they may not be effective as a result of federal, state or local laws or
ordinances or unfavorable judicial decisions in the United States or other
countries. The sale and support of our products also entails the risk of
product liability claims. We maintain insurance to protect against certain
claims associated with the use of our products, but our insurance coverage may
not adequately cover any claim asserted against us. In addition, even claims
that ultimately are unsuccessful could result in our expenditure of funds in
litigation and divert managements time and other resources. We may be unable to adequately protect or enforce our intellectual property
rights. We rely on a combination of patent, trade secret, copyright and trademark
laws and contractual restrictions to establish and protect proprietary rights
in our products. Even though we seek to establish and protect proprietary
rights in our products, there are risks. We cannot be assured that any patent,
trademark, copyright or other intellectual property rights owned by us will not
be invalidated, circumvented or challenged, that such intellectual property
rights will provide competitive advantages to us or that any of our pending or
future patent applications will be issued with the scope of the claims sought
by us, if at all. We cannot be assured that others will not develop
technologies that are similar or superior to our technology, duplicate our
technology or design around the patents that we own. In addition, effective
patent, copyright and trade secret protection may be unavailable or limited in
certain foreign countries in which we do business or may do business in the
future. Our pending patent applications may not be granted. Even if they are
granted, the claims covered by any patent may be reduced from those included in
our applications. Any patent might be subject to challenge in court and,
whether or not challenged, might not be broad enough to prevent third parties
from developing equivalent technologies or products without a license from us. We believe that the future success of our business will depend on our
ability to translate the technological expertise and innovation of our
employees into new and enhanced products. We have entered into confidentiality
and invention assignment agreements with our employees, and we enter into
non-disclosure agreements with many of our suppliers, distributors and
appropriate customers so as to limit access to and disclosure of our
proprietary information. These contractual arrangements, as well as statutory
protections, may not prove sufficient to prevent misappropriation of our trade
secrets or technology or deter independent third-party development of similar
technologies. In addition, the laws of 39




---



##### Table of Contents



some foreign countries may not protect our intellectual property rights to
the same extent as do the laws of the United States. We may, in the future,
take legal action to enforce our patents and other intellectual property
rights, to protect our trade secrets, to determine the validity and scope of
the proprietary rights of others, or to defend against claims of infringement
or invalidity. Such litigation could result in substantial costs and diversion
of resources and could negatively affect our business, operating results,
financial position and liquidity. CableLabs DOCSIS 2.0 specification includes two modulation techniques,
S-CDMA and A-TDMA. In connection with the development of the DOCSIS 2.0
specification by CableLabs, we entered into an agreement with CableLabs, on a
royalty-free basis, whereby we licensed to CableLabs many of our intellectual
property rights to the extent that such rights may be asserted against a party
desiring to design, manufacture or sell DOCSIS-based products, including DOCSIS
2.0-based products. This license agreement grants to CableLabs the right to
sublicense our intellectual property, including our intellectual property
rights in our S-CDMA patents, to manufacturers that compete with us in the
marketplace for DOCSIS based products. We pursue the registration of our trademarks in the United States and have
applications pending to register several of our trademarks throughout the
world. However, the laws of certain foreign countries might not protect our
products or intellectual property rights to the same extent as the laws of the
United States. Effective trademark, copyright, trade secret and patent
protection may not be available in every country in which our products may be
manufactured, marketed or sold. 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. As is typical in the industry in which we operate, we have been and may
from time to time be notified of claims that we may be infringing intellectual
property rights owned by third parties. We also have in the past agreed to,
and may from time to time in the future agree to, indemnify a customer of our
technology or products for claims against the customer by a third party based
on claims that our technology or products infringe patents of that third party.
We further believe that companies may be increasingly subject to infringement
claims as distressed companies and individuals attempt to generate cash by
enforcing their patent portfolio against a wide range of products. These types
of claims, meritorious or not, can result in costly and time-consuming
litigation; divert managements attention and other resources; require us to
enter into royalty arrangements; subject us to damages or injunctions
restricting the sale of our products, require us to indemnify our customers for
the use of the allegedly infringing products; require us to refund payment of
allegedly infringing products to our customers or to forgo future payments;
require us to redesign certain of our products; or damage our reputation. Our
failure to obtain a license for key intellectual property rights from a third
party for technology used by us could cause us to incur substantial liabilities
and to suspend the manufacturing of products utilizing the technology.
Alternatively, we could be required to expend significant resources to develop
non-infringing technology with no assurances that we would be successful in
such endeavors. The occurrence of any of the above events could materially and
adversely affect our business, results of operations and financial condition. Our indebtedness could adversely affect our financial condition; we may incur
substantially more debt. As of September 30, 2004, we had approximately $68.5 million of long-term
obligations of which $65.1 million is long-term debt associated with our Notes.
This level of indebtedness may adversely affect our stockholders by:  
    
    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 40




---



##### Table of Contents



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. We may incur substantial additional debt in the future. The terms of our
outstanding debt do not fully prohibit us from doing so. If new debt is added
to our current levels, the related risks described above could intensify. We may not be able to raise additional funds to continue operating our
business. Our main source of liquidity continues to be our unrestricted cash on
hand. As a result of our history of operating losses, we
expect to continue to use our unrestricted cash to fund operating losses in the
future. Our cash, cash equivalents, and short-term investments decreased to
$111.9 million at September 30, 2004, from $138.6 million at December 31, 2003.
If our operating losses are more severe than expected or continue longer than
expected, we may find it necessary to seek other sources of financing to
support our capital needs and provide available funds for working capital.
Given the current condition of the capital markets, there are few sources of
financing available to us. Commercial bank financing may not be available to
us on acceptable terms. Accordingly, any plan to raise additional capital, if
available to us, would likely involve an equity-based or equity-linked
financing, such as the issuance of convertible debt, common stock or preferred
stock, which would be dilutive to our stockholders. If we are unable to
procure additional working capital, as necessary, we may be unable to continue
operations. On October 7, 2003, we filed a registration statement on Form S-3 with the
Securities and Exchange Commission. This shelf registration statement, which
was declared effective by the SEC on November 4, 2003, will allow us to issue
various types of securities, including common stock, preferred stock, debt
securities and warrants to purchase common stock, from time to time up to an
aggregate of $125.0 million, subject to market conditions and our capital
needs. On November 7, 2003, we filed a prospectus supplement with reference to
our intention to offer 10,800,000 shares of common stock, which would have
result in gross proceeds of $75.0 million. On November 14, 2003, we withdrew
our previously announced public offering of 10,800,000 shares of common stock
under the shelf registration statement. Our restructuring efforts and recent changes in senior management could result
in the erosion of employee morale, legal actions against us and management
distractions, and could impair our ability to respond rapidly to growth
opportunities in the future. As a result of the significant economic downturn and the related
uncertainties in the technology sector, we have implemented a number of
restructuring plans, including the most recent in the first and second quarters
of 2004, which has resulted in personnel reduction. We also have experienced a
number of recent changes in senior management and other key personnel. These
employee reductions and changes, as well as future changes in senior management
and key personnel, could result in an erosion of morale, and affect the focus
and productivity of our remaining employees, including those directly
responsible for revenue generation and the management and
administration of our finances which in turn may affect our revenue in the
future or cause other administrative deficiencies. Additionally, employees directly affected by the reductions may seek
future employment with our business partners, customers or competitors.
Although all employees are required to sign a proprietary information agreement
with us at the time of hire, there can be no assurances that the confidential
nature of our proprietary information will be maintained in the course of such
future employment. Additionally, we may face wrongful termination,
discrimination, or other claims from employees affected by the reduction
related to their employment and termination. We could incur substantial costs
in defending ourselves or our employees against such claims, regardless of the
merits of such actions. Furthermore, such matters could divert the attention
of our employees, including management, away from our operations, harm
productivity, harm our reputation and increase our expenses. We cannot assure
you that our restructuring efforts will be successful, and we may need to take
additional restructuring efforts, including additional personnel reduction, in
the future. Furthermore, in October 2004, we announced our intention to cease
investment in future development of our CMTS product line and halt development
on future hardware upgrades. In connection with this action, we initiated a
worldwide reduction in force, which is likely to result in a restructuring
charge of approximately $3.2 million to $3.6 million in the quarter ending
December 31, 2004. We may incur additional material charges associated, and
may further reduce our workforce in connection, with this determination. We
also may face the same risks associated with our prior restructuring, as
discussed above, in connection with our determination to cease investment in
our CMTS product line. 41




---



##### Table of Contents



We may dispose of or
discontinue existing product lines, which may adversely impact our future
results. On an ongoing basis, we evaluate our various product offerings in order to
determine whether any should be discontinued or, to the extent possible,
divested. Moreover, the worldwide downturn in the telecommunications industry
led us to reassess our business strategy, which in turn caused us to
discontinue investment in certain product lines. Specifically, we have reduced
our investment in the telecom and satellite spaces. Beginning in July 2003, we
entered into two transactions to further decrease our telecom business. In
July 2003, we discontinued our Mainsail line of products and entered into an
agreement with a third party to supply warranty services for the Mainsail
products. In July 2003, we entered into an agreement with Verilink Corporation
(Verilink) to sell certain telecom assets associated with the Miniplex product
line to Verilink. Additionally, Verilink agreed to purchase related inventory
from us and assume all telecom warranty obligations with the exception of $2.4
million, which will continue to be our responsibility. To date, only nominal
claims have been made against this warranty obligation and we believe that the
likelihood of any material claim being made against us is remote. On April 2, 2004, we sold all of our ownership in Radwiz, Ltd., Ultracom
Communications Holdings Ltd. and Combox Ltd. to a third party for a cash
payment of $150,000. In connection with this disposition, the acquirer
received obsolete inventories with no book value, $0.2 million of selected net
assets, and $1.35 million of net liabilities related to these subsidiaries. We
recorded a net gain of $1.3 million on this transaction in the second quarter
of 2004. In October 2004, we also announced our determination to cease investment
in the CMTS product line and halt development of future CMTS hardware. In
connection with this determination, we expect to incur charges in the range of
$3.2 to $3.6 million related to employee termination costs, and may incur
additional material charges in connection with this decision. We cannot assure you that we correctly forecasted the right product lines
to dispose of or discontinue or that our decision to dispose of or discontinue various investments and
product lines is prudent if market conditions change. In addition, we cannot
assure you that the discontinuance of various product lines will reduce our
operating expenses or cause us to incur material charges associated
with such decision. Furthermore, future plans to discontinue existing product
lines entail various risks, including the risks that we will not be able to
find a buyer for a product line or the purchase price obtained will not be
equal to the book value of the assets for the product line. Other risks include managing the expectations of, and maintaining good
relations with, our customers who previously purchased disposed or discontinued
product lines, which could prevent us from selling other products to them in
the future. We may also incur other liabilities and costs associated with our
disposal or discontinuance of product lines. We need to develop and introduce new and enhanced products in a timely manner
to remain competitive. The markets in which we operate are characterized by rapidly changing
technologies, evolving industry standards, frequent new product introductions
and relatively short product life. The pursuit of necessary technological
advances and the development of new products require substantial time and
expense. For example, we made ten acquisitions during the period between 1999
and 2000. Due to various economic conditions, none of the products from our
acquired businesses have achieved the level of market acceptance that was
forecasted at the time of their acquisitions. Additionally, certain product
groups have not achieved the level of technological development needed to be
marketable or to expand the market. As a result, we recorded an aggregate of
approximately $576.8 million related to impairment charges and write-down of
in-process research and development related to the acquired technologies, both
of which negatively impacted our operating results in 2001 and 2002. To compete successfully in the markets in which we operate, we must
design, develop, manufacture and sell new or enhanced products that provide
increasingly higher levels of performance and reliability. However, we may not
be able to successfully develop or introduce these products, if our products
are not (i) cost effective, (ii) brought to market in a timely manner, (iii) in
accordance with evolving industry standards and architecture or (iv) fail to
achieve market acceptance. There is no assurance that the technologies we are
currently developing or intend to develop will achieve feasibility, or that
even if we are successful, the developed product will be accepted by the
market. We may not be able to recover the costs of existing and future product
developments and our failure to do so may materially and adversely impact our
business, financial condition and results of operations. We are exposed to the credit risk of our customers and to credit exposures in
weakened markets, which could result in material losses. 42




---



##### Table of Contents



Most of our sales are on an open credit basis, with payment terms of 30 to
60 days typically in the United States, and because of local customs or
conditions, longer in some markets outside the United States. Beyond our open
credit arrangements, we have also experienced a request for customer financing
and facilitation of leasing arrangements, which we have not provided to date
and do not expect to provide in the future. We expect demand for enhanced open
credit terms, for example, longer payment terms, customer financing and leasing
arrangements to continue and believe that such arrangements are a competitive
factor in obtaining business. Our decision not to provide these types of
financing arrangements may adversely affect our ability to sell product, and
therefore, our revenue, operations and business. Because of the current condition in the global economy, our exposure to
credit risks relating to sales on an open-credit basis has increased. Although
we monitor and attempt to mitigate the associated risk, there can be no
assurance that our efforts will be effective in reducing credit risk.
Additionally, there have been significant insolvencies and bankruptcies among
our customers, which have and may continue to cause us to incur economic and
financial losses. There can be no assurance that additional losses would not
be incurred and that such losses would not be material. Although these losses
have generally not been material to date, future losses, if incurred, could
harm our business and have a material adverse effect on our operating results
and financial condition. We have and we may seek to expand our business through acquisitions;
acquisitions could disrupt our business operations and harm our operating
results. In order to expand our business, we may make strategic acquisitions of
other companies or certain assets. We plan to continue to evaluate
opportunities for strategic acquisitions from time to time, and may make an
acquisition at some future point. However, the current volatility in the stock
market and the current price of our common stock may adversely affect our
ability to make such acquisitions. Any acquisition that we make involves
substantial risks, including the following:  
    
    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. Acquisitions may also cause us to:  
    
    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. Mergers and acquisitions of high-technology companies are inherently
risky, and no assurance can be given that our future acquisitions will be
successful and will not materially adversely affect our business, operating
results or financial condition. Failure to manage and successfully integrate
acquisitions we make could harm our business and operating results in a
material way. Even when an acquired company has already developed and marketed
products, there can be no assurance that product enhancements will be made in a
timely fashion or that all pre-acquisition due diligence will have identified
all possible issues that might arise with respect to such products. 43




---



##### Table of Contents



We made ten acquisitions during the period between 1999 and 2000. Due to
various economic conditions, none of the products from our acquired businesses
have achieved the level of market acceptance that was forecasted at the time of
their acquisitions. Additionally, certain product groups have not achieved the
level of technological development needed to be marketable or to expand the
market. We recorded impairment losses of approximately $4.0 million and $572.8
million of intangible assets related to these acquisitions in December 31, 2002
and 2001, respectively. As of September 30, 2004, no intangible assets from
these acquisitions remained. Our products are subject to safety approvals and certifications. In the United States, our products are required to meet certain safety
requirements. For example, we are required to have our products certified by
Underwriters Laboratory in order to meet federal requirements relating to
electrical appliances to be used inside the home. Outside the United States,
our products are subject to the regulatory requirements of each country in
which the products are manufactured or sold. These requirements are likely to
vary widely. We may be unable to obtain on a timely basis or at all the
regulatory approvals that may be required for the manufacture, marketing and
sale of our products. We are vulnerable to earthquakes, disruptions to our power supply, labor issues
and other unexpected events. Our corporate headquarters, as well as the majority of our research and
development activities and some manufacturing operations are located in
California, an area known for seismic activity. In addition, the operations of
some of our key suppliers and manufacturers are also located in this area and
in other areas known for seismic activity, such as Taiwan. An earthquake, or
other significant natural disaster, could result in an interruption in our
business or the operations of one or more of our key suppliers. Our California
operations may also be subject to disruptions in power supply, such as those
that occurred in 2001. Our business may also be impacted by labor issues
related to our operations and/or those of our suppliers, service providers, or
customers. Such an interruption could harm our operating results. We may not
carry sufficient business interruption insurance to compensate for any losses
that we may sustain as a result of any natural disasters or other unexpected
events. Various export licensing requirements could materially and adversely affect our
business or require us to significantly modify our current business practices. Various government export regulations may apply to the encryption or other
features of our products. We may have to make certain filings with the
government in order to obtain permission to export certain of our products. In
the past, we may have inadvertently failed to file certain export applications
and notices, and we may have to make certain filings and request permission to
continue exportation of any affected products without interruption while these
applications are pending. If we do have to make such filings, we cannot assure
you that we will obtain permission to continue exporting the affected products
or that we will obtain any required export approvals now or in the future. If
we do not receive the required export approvals, we may be unable to ship those
products to certain customers located outside of the United States. In
addition, we may be subject to fines or other penalties due to the failure to
file certain export applications and notices. New laws and regulations affecting corporate governance may impede our ability
to retain and attract board members and executive officers, and increase the
costs associated with being a public company. On July 30, 2002, President George W. Bush signed into law the
Sarbanes-Oxley Act of 2002. The new act is designed to enhance corporate
responsibility through new corporate governance and disclosure obligations,
increase auditor independence, and tougher penalties for securities fraud. In
addition, the Securities and Exchange Commission and Nasdaq have adopted rules
in furtherance of the act. This act and the related new rules and regulations
will likely have the effect of increasing the complexity and cost of our
companys corporate governance and the time our executive officers spend on
such issues, and may increase the risk of personal liability for our board
members, chief executive officer, chief 44




---



##### Table of Contents



financial officer and other executives involved in our companys corporate
governance process. As a result, it may become more difficult for us to
attract and retain board members and executive officers involved in the
corporate governance process. In addition, we have experienced, and will
continue to experience, increased costs associated with being a public company,
including additional professional and independent auditor fees. Our stock price has been and is likely to continue to be highly volatile. The trading price of our common stock has been and is likely to continue
to be highly volatile. Our stock price could be subject to extreme
fluctuations in response to a variety of factors, including the following:  
    
    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. In addition, the stock markets in general, and the Nasdaq National Market
and the stock price of broadband services and technology companies in
particular, have experienced extreme price and volume volatility. This
volatility and decline has affected many companies irrespective of or
disproportionately to the operating performance of these companies.
Additionally, industry factors may materially adversely affect the market price
of our common stock, regardless of our actual operating performance. 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. We adopted a stockholder rights plan pursuant to which we distributed one
right for each outstanding share of common stock held by stockholders of record
as of February 20, 2001. Because the rights may substantially dilute the stock
ownership of a person or group attempting a take-over of us, even if such a
change in control is beneficial to our stockholders, without the approval of
our board of directors, the plan could make it more difficult for a third party
to acquire us, or a significant percentage of our outstanding capital stock,
without first negotiating with our board of directors. Additionally,
provisions of our Certificate of Incorporation and our Bylaws could make it
more difficult for a third party to acquire control of us in a transaction not
approved by our Board of Directors, and we are subject to the anti-takeover
provisions of Section 203 of the Delaware General Corporation Law, which could
also have the effect of delaying or preventing our acquisition by a third
party. In the event we are unable to satisfy regulatory requirements relating to
internal controls, or if these internal controls over financial reporting are
not effective, our business and our stock price could suffer. Section 404 of Sarbanes-Oxley requires companies to do a comprehensive and
costly evaluation of their internal controls. As a result, during our fiscal
year ending December 31, 2004, we will be required to perform an evaluation of
our internal controls over financial reporting and have our auditor publicly
attest to such evaluation. We have prepared an internal plan of action for
compliance, which includes a timeline and scheduled activities with respect to
preparation of such evaluation. Our efforts to comply with Section 404 and
related regulations regarding our managements required assessment of internal
control over financial reporting and our independent auditors attestation of
that assessment has required, and continues to require, the commitment of
significant financial and managerial resources. While we anticipate being able
to fully implement the requirements relating to internal controls and all other
aspects of Section 404 in a timely fashion, we cannot be certain as to the
timing of completion of our evaluation, testing and remediation actions or the
impact of the same on our operations since there is no precedent available by
which to measure compliance adequacy. If we fail to timely complete this
evaluation, or if our auditors cannot timely attest to our evaluation, we could
be subject to regulatory investigations or sanctions, costly litigation or a
loss of public confidence in our internal controls, which could have an adverse
effect on our business and our stock price. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Interest Rate Risk. Our exposure to market risk for changes in interest rates relates
primarily to our investment portfolio. The primary objective of our investment
activities is to preserve principal while maximizing 45




---



##### Table of Contents



yields without significantly increasing risk. This is accomplished by
investing in widely diversified short-term investments, consisting primarily of
investment grade securities, substantially all of which mature within the next
twenty-four months. A hypothetical 50 basis point increase in interest rates
would result in an approximate $8,000 decline (less than 1%) in the fair value
of our available-for-sale securities. Foreign Currency Risk. A substantial majority of our revenue, expense and capital purchasing
activity are transacted in U.S. dollars. However, we do enter into transactions
from Belgium, United Kingdom, Hong Kong, Canada, Japan, Brazil, Korea, China
and Israel denominated in local currencies and invoice some of our
sales in Europe in Euros.  A hypothetical adverse change of
10% in exchange rates would result in a decline in income before taxes of
approximately $36,000. All of the potential changes noted above are based on sensitivity analyses
performed on our financial positions at September 30, 2004. Actual results may
differ materially. ITEM 4. CONTROLS AND PROCEDURES As of the end
of the period covered by this report, we carried out an evaluation, under the
supervision and with the participation of our Chief Executive Officer and Chief
Financial Officer, of the effectiveness of the design and operation of our
disclosure controls and procedures. Based on this evaluation, our
Chief Executive Officer and Chief Financial Officer identified a
deficiency in our disclosure controls and procedures as of September
30, 2004, due to an inadequacy of communication between certain parts
of the organization and the finance department. In connection with the review of our
financial statements for the third quarter of 2004, Ernst & Young LLP, our independent registered public accountants, advised our Audit Committee
that they considered this deficiency to be a material weakness under standards established by
the Public Company Accounting Oversight Board. This
 material weakness related to an accrual of severance for an executive officer
in an incorrect reporting period, which Ernst &  Young LLP believed to
be related to the inadequacy of
communication between certain parts of the organization and the finance department. The accrual
is reflected in the condensed consolidated financial statements for the three and
nine month period ended September 30, 2004. Under the direction of our Audit Committee and with the participation of our
senior management, we have taken steps designed to strengthen our disclosure
controls and procedures and internal controls to address the material weakness
identified by Ernst and Young. We have, on an immediate basis, taken steps
 to improve our internal controls and our control environment. We have
implemented steps to ensure that senior members of our  finance department
review all press releases before they are released and all resignations of
executive staff are communicated promptly to senior members of our finance
department. We will continue to monitor the communication channels between our senior
management and our finance department and will take prompt action, as
necessary, to further strengthen our disclosure controls and procedures and
internal controls to comply with Sarbanes-Oxley compliance procedures.
Moreover, we will continue our
efforts to identify, assess and correct any additional material weaknesses in
our internal controls. We believe the corrective steps taken to improve our disclosure controls
and procedures and internal controls described above have enabled our Chief
Executive Officer and Chief Financial Officer to conclude that our disclosure
controls and procedures are now effective in timely alerting them to material
information required to be included in this Quarterly Report on Form 10-Q for
the quarter ended September 30, 2004. Other than as described above, there has been no other change in our internal control over
financial reporting that occurred during our most recent fiscal quarter that has materially
affected or is reasonably likely to materially affect our internal control over financial reporting. We intend to
review and evaluate the design and effectiveness of our disclosure controls and
procedures on an ongoing basis and to improve our controls and procedures over
time and to correct any deficiencies that we may discover in the future.  Our
goal is to ensure that our senior management has timely access to all material
financial and non-financial information concerning our business.  While we believe
the present design of our disclosure controls and procedures is effective to
achieve our goal, future events affecting our business may cause us to significantly
modify our disclosure controls and procedures. PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS See Litigation under Part I, Item 2, Managements Discussion and
Analysis of Financial Condition and Results of Operations. ITEM 5. OTHER INFORMATION As reported in a recent Current Report on Form 8-K filed with the
Securities and Exchange Commission, we had determined to defer the 2004 annual
meeting of stockholders, originally scheduled for August 10, 2004, for a brief
period of time. We have now scheduled the 2004 annual meeting for December 16,
2004, with a record date of October 20, 2004. ITEM 6. EXHIBITS (a) EXHIBITS 46




---



##### Table of Contents



10.32
    
    Employment Agreement dated August 2, 2004, between the Registrant
and Edward Lopez.10.33
    
    Letter Agreement dated July 22, 2004, between
the Registrant and Jerry Chase.10.34
    
    Severance Agreement dated July 22, 2004, between the
Registrant and Jerry Chase.10.35
    
    Proprietary Information and
Inventions Agreement dated July 22, 2004 between the Registrant and
Jerry Chase.10.36
    
    Aircraft Sublease Agreement dated August 24, 2004
between the Registrant and United Furniture Equipment Rental, Inc.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.
 47




---



##### Table of Contents



SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. Date: November 9, 2004
    TERAYON COMMUNICATION SYSTEMS, INC.By /s/ Edward LopezEdward Lopez
Acting Chief Financial Officer
 48




---



##### Table of Contents



INDEX TO EXHIBITS NUMBER
    
    DESCRIPTION10.32
    
    Separation Agreement dated August 2, 2004, between the Registrant
and Edward Lopez.10.33
    
    Employment Agreement dated
July 22, 2004, between
the Registrant and Jerry Chase.10.34
    
    Severance Agreement dated July 22, 2004, between the
Registrant and Jerry Chase.10.35
    
    Proprietary Information and
Inventions Agreement dated July 22, 2004 between the Registrant and
Jerry Chase.10.36
    
    Aircraft Sublease Agreement dated August 24, 2004
between the Registrant and United Furniture Equipment Rental, Inc.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.