##### 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 June 30, 2004
OR [_] 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
(STATE OR OTHER JURISDICTION OF
INCORPORATION OR ORGANIZATION)
    
    77-0328533
(IRS EMPLOYER
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 [_] Indication by check mark whether the registrant is an accelerated file (as
defined by Rule 12b-2 of the Exchange Act) Yes [X] No [_] As of July 20, 2004 registrant had outstanding 75,562,071 shares of Common
Stock.




---



TABLE OF CONTENTS  PART I. FINANCIAL INFORMATIONITEM 1. FINANCIAL STATEMENTSCONDENSED CONSOLIDATED BALANCE SHEETSCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONSCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWSNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTSITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONSITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKITEM 4. CONTROLS AND PROCEDURESPART II. OTHER INFORMATIONITEM 1. LEGAL PROCEEDINGSITEM 5. OTHER INFORMATIONITEM 6. EXHIBITS AND REPORTS ON FORM 8-KSIGNATURESExhibit IndexEXHIBIT 10.24EXHIBIT 10.29EXHIBIT 10.30EXHIBIT 10.31EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2    Table of Contents  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. 
 PART I. FINANCIAL INFORMATION 
 ITEM 1. FINANCIAL STATEMENTS TERAYON COMMUNICATION SYSTEMS, INC.
INDEX TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS PageCondensed Consolidated Balance Sheets as of June 30, 2004 (unaudited) and
December 31,
2003
    
    
    3Condensed Consolidated Statements of Operations for the three and six months
ended June 30, 2004 and 2003
(unaudited)
    
    
    4Condensed Consolidated Statements of Cash Flows for the six months ended June
30, 2004 and 2003
(unaudited)
    
    
    5Notes to Condensed Consolidated Financial Statements(unaudited)
    
    
    6
 2




---



##### Table of Contents



TERAYON COMMUNICATION SYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands) June 30,
    
    December 31,2004
    
    2003(unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    47,783
    
    
    $
    30,188Short-term investments
    
    
    68,489
    
    
    
    108,452Accounts receivable, net
    
    
    26,779
    
    
    
    29,199Accounts receivable from related parties
    
    
    1,105
    
    
    
    600Other current receivables
    
    
    2,339
    
    
    
    3,662Inventory
    
    
    21,403
    
    
    
    16,364Other current assets
    
    
    1,982
    
    
    
    2,883Total current assets
    
    
    169,880
    
    
    
    191,348Property and equipment, net
    
    
    10,045
    
    
    
    11,871Restricted cash
    
    
    9,212
    
    
    
    9,212Other assets, net
    
    
    2,220
    
    
    
    2,809Total assets
    
    $
    191,357
    
    
    $
    215,240LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    16,480
    
    
    $
    26,049Accrued payroll and related expenses
    
    
    4,919
    
    
    
    6,537Deferred revenues
    
    
    5,091
    
    
    
    3,423Warranty reserves
    
    
    4,191
    
    
    
    5,509Accrued executive severance and restructuring charges
    
    
    9,070
    
    
    
    4,500Accrued vendor cancellation charges
    
    
    713
    
    
    
    2,869Other accrued liabilities
    
    
    4,382
    
    
    
    5,036Interest payable and current portion of long-term debt
    
    
    1,356
    
    
    
    1,358Other current obligations
    
    
    6
    
    
    
    124Total current liabilities
    
    
    46,208
    
    
    
    55,405Long-term obligations
    
    
    3,156
    
    
    
    3,366Convertible subordinated notes
    
    
    65,081
    
    
    
    65,081Commitments and contingenciesStockholders equity:Common stock
    
    
    76
    
    
    
    75Additional paid in capital
    
    
    1,082,811
    
    
    
    1,082,036Accumulated deficit
    
    
    (1,002,668
    )
    
    
    (987,560
    )Deferred compensation
    
    
    
    
    
    
    (22
    )Treasury stock, at cost
    
    
    (773
    )
    
    
    (773
    )Accumulated other comprehensive loss
    
    
    (2,534
    )
    
    
    (2,368
    )Total stockholders equity
    
    
    76,912
    
    
    
    91,388Total liabilities and stockholders equity
    
    $
    191,357
    
    
    $
    215,240
 See accompanying notes. 3




---



##### Table of Contents



TERAYON COMMUNICATION SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited) Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Revenues
    
    $
    40,138
    
    
    $
    29,964
    
    
    $
    80,560
    
    
    $
    50,404Related party revenues
    
    
    2,644
    
    
    
    635
    
    
    
    3,389
    
    
    
    2,463Total
revenues
    
    
    42,782
    
    
    
    30,599
    
    
    
    83,949
    
    
    
    52,867Cost of revenues
    
    
    27,046
    
    
    
    23,549
    
    
    
    55,598
    
    
    
    42,200Cost of related party revenues
    
    
    614
    
    
    
    187
    
    
    
    832
    
    
    
    1,128Total cost of
revenues
    
    
    27,660
    
    
    
    23,736
    
    
    
    56,430
    
    
    
    43,328Gross profit
    
    
    15,122
    
    
    
    6,863
    
    
    
    27,519
    
    
    
    9,539Operating expenses:Research and development
    
    
    8,516
    
    
    
    10,432
    
    
    
    17,984
    
    
    
    23,434Sales and marketing
    
    
    5,411
    
    
    
    6,560
    
    
    
    12,632
    
    
    
    13,290General and administrative
    
    
    2,953
    
    
    
    3,000
    
    
    
    5,388
    
    
    
    6,728Executive severance, restructuring costs and asset
write-offs
    
    
    3,579
    
    
    
    (115
    )
    
    
    6,946
    
    
    
    3,046Total operating expenses
    
    
    20,459
    
    
    
    19,877
    
    
    
    42,950
    
    
    
    46,498Loss from operations
    
    
    (5,337
    )
    
    
    (13,014
    )
    
    
    (15,431
    )
    
    
    (36,959
    )Interest income
    
    
    460
    
    
    
    909
    
    
    
    912
    
    
    
    1,811Interest expense
    
    
    (826
    )
    
    
    (814
    )
    
    
    (1,643
    )
    
    
    (1,651
    )Other income (expense)
    
    
    921
    
    
    
    (160
    )
    
    
    1,200
    
    
    
    (200
    )Loss before income tax expense
    
    
    (4,782
    )
    
    
    (13,079
    )
    
    
    (14,962
    )
    
    
    (36,999
    )Income tax expense
    
    
    (79
    )
    
    
    (60
    )
    
    
    (146
    )
    
    
    (129
    )Net loss
    
    $
    (4,861
    )
    
    $
    (13,139
    )
    
    $
    (15,108
    )
    
    $
    (37,128
    )Net loss per share, basic and diluted
    
    $
    (0.06
    )
    
    $
    (0.18
    )
    
    $
    (0.20
    )
    
    $
    (0.50
    )Shares used in per share calculation, basic and
diluted
    
    
    75,551
    
    
    
    73,721
    
    
    
    75,534
    
    
    
    73,715
 See accompanying notes. 4




---



##### Table of Contents



TERAYON COMMUNICATION SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited) Six Months EndedJune 30,2004
    
    2003Operating activities:Net loss
    
    $
    (15,108
    )
    
    $
    (37,128
    )Adjustments to reconcile net loss to net cash used in operating activities:Depreciation
    
    
    3,319
    
    
    
    5,155Amortization related to stock options
    
    
    17
    
    
    
    8Lower of cost or market inventory (provision) recovery
    
    
    969
    
    
    
    (5,828
    )Write-off and disposal of fixed assets
    
    
    130
    
    
    
    485Changes in operating assets and liabilities:Accounts receivable
    
    
    2,420
    
    
    
    (6,845
    )Accounts receivable from related parties
    
    
    (505
    )
    
    
    277Inventory
    
    
    (6,008
    )
    
    
    8,560Other current and non-current assets
    
    
    2,813
    
    
    
    6,573Accounts payable
    
    
    (9,569
    )
    
    
    (4,087
    )Accrued payroll and related expenses
    
    
    (1,618
    )
    
    
    52Deferred revenues
    
    
    1,668
    
    
    
    1,047Accrued warranty
    
    
    (1,318
    )
    
    
    (434
    )Accrued
executive severance and restructuring
    
    
    4,570
    
    
    
    (1,248
    )Accrued vendor cancellation charges
    
    
    (2,156
    )
    
    
    (8,685
    )Other accrued liabilities
    
    
    (806
    )
    
    
    (1,836
    )Net cash used in operating activities
    
    
    (21,182
    )
    
    
    (43,934
    )Investing activities:Purchases of short-term investments
    
    
    (78,000
    )
    
    
    (107,058
    )Proceeds from sales and maturities of short-term investments
    
    
    117,429
    
    
    
    102,631Purchases of property and equipment
    
    
    (1,623
    )
    
    
    (1,355
    )Net cash provided by (used in) investing activities
    
    
    37,806
    
    
    
    (5,782
    )Financing activities:Principal payments on capital leases
    
    
    (178
    )
    
    
    (63
    )Proceeds from issuance of common stock
    
    
    781
    
    
    
    619Net cash provided by financing activities
    
    
    603
    
    
    
    556Effect of exchange rate changes
    
    
    368
    
    
    
    547Net increase (decrease) in cash and cash equivalents
    
    
    17,595
    
    
    
    (48,613
    )Cash and cash equivalents at beginning of period
    
    
    30,188
    
    
    
    117,079Cash and cash equivalents at end of period
    
    $
    47,783
    
    
    $
    68,466
 See accompanying notes. 5




---



##### Table of Contents



TERAYON COMMUNICATION SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited) 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, 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 generally accepted accounting principles in the
United States 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 generally
accepted accounting principles in the United States 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 June 30, 2004 and for the three and six months ended June 30,
2004 and 2003 have been included. Results for the three and six months ended June 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 generally accepted accounting principles in the United States
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, or APB,
Statement 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
    
    Six months endedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net loss, as reported
    
    $
    (4,861
    )
    
    $
    (13,139
    )
    
    $
    (15,108
    )
    
    $
    (37,128
    )Add: Stock-based compensation under APB
25
    
    
    
    
    
    
    3
    
    
    
    
    
    
    
    8Deduct: Stock option compensation expense
determined under fair value-based method
    
    
    (3,703
    )
    
    
    (5,411
    )
    
    
    (8,213
    )
    
    
    (11,588
    )Employee stock purchase plan
compensation expense determined
under fair value-based method
    
    
    (357
    )
    
    
    (301
    )
    
    
    (713
    )
    
    
    (1,280
    )Pro forma net loss
    
    $
    (8,921
    )
    
    $
    (18,848
    )
    
    $
    (24,034
    )
    
    $
    (49,998
    )Pro forma net loss per share, basic and diluted
    
    $
    (0.12
    )
    
    $
    (0.26
    )
    
    $
    (0.32
    )
    
    $
    (0.68
    )Shares used in computing pro forma net loss
per share, basic and diluted
    
    
    75,551
    
    
    
    73,721
    
    
    
    75,534
    
    
    
    73,715
 Inventory Inventory is stated at the lower of cost (first-in, first-out) or market.
The components of inventory are as follows (in thousands): June 30,
    
    December 31,2004
    
    2003Raw materials
    
    $
    3,597
    
    
    $
    1,440Work-in-process
    
    
    211
    
    
    
    660Finished goods
    
    
    17,595
    
    
    
    14,264Total inventory
    
    $
    21,403
    
    
    $
    16,364
 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 7




---



##### Table of Contents



goods and services and require the Company to purchase minimum quantities
of the suppliers products at a specified price. As of June 30, 2004, $27.0
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 for its inventory commitments. At June
30, 2004, accrued vendor cancellation charges were $0.7 million and the
remaining $26.3 million was attributable to open purchase orders in the normal
course of business. The remaining obligations are expected to become payable
at various times throughout 2004. For the three and six months ended June 30, 2004, the Company reversed
approximately $0.8 million and $2.1 million, respectively of accrued vendor
cancellation charges, which were previously recorded as cost of goods sold.
For the three and six months ended June 30, 2003, the Company reversed
approximately $2.1 million and $4.4 million, respectively of accrued vendor
cancellation charges. The Company reversed these charges as it was
able to negotiate downward certain vendor cancellation to more
favorable terms. Additionally, during the three and six months ended June 30, 2004, the Company reversed
approximately $0.3 million and $0.8 million, respectively, of inventory provisions,
which were previously recorded as cost of goods sold.  During the three and six months ended June 30, 2003,
the Company reversed approximately $1.0 million and $1.7 million, respectively of inventory provisions.
The Company reversed these provisions as it was able to sell inventory originally considered to be excess or obsolete. 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
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net loss
    
    $
    (4,861
    )
    
    $
    (13,139
    )
    
    $
    (15,108
    )
    
    $
    (37,128
    )Shares used in
computing basic
and diluted net
loss per share
    
    
    75,551
    
    
    
    73,721
    
    
    
    75,534
    
    
    
    73,715Basic and
diluted net
loss per share
    
    $
    (0.06
    )
    
    $
    (0.18
    )
    
    $
    (0.20
    )
    
    $
    (0.50
    )
 Options and warrants to purchase 15,836,009 and 17,394,492 shares of
common stock were outstanding at June 30, 2004 and June 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): Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net loss
    
    $
    (4,861
    )
    
    $
    (13,139
    )
    
    $
    (15,108
    )
    
    $
    (37,128
    )Cumulative translation
adjustments
    
    
    444
    
    
    
    516
    
    
    
    368
    
    
    
    547Change in unrealized loss on
available- for-sale
investments
    
    
    (537
    )
    
    
    (188
    )
    
    
    (534
    )
    
    
    (411
    )Total comprehensive net loss
    
    $
    (4,954
    )
    
    $
    (12,811
    )
    
    $
    (15,274
    )
    
    $
    (36,992
    )
 8




---



##### Table of Contents



Impact of Recently Issued Accounting Standards In January 2003, the Financial Accounting Standards Board (FASB) issued
FASB Interpretation No. 46 (FIN No. 46), Consolidation of Variable Interest
Entities, an interpretation of ARB No. 51. FIN No. 46 requires existing
unconsolidated variable interest entities to be consolidated by their primary
beneficiaries if the entities do not effectively disperse risks among parties
involved. Variable interest entities that effectively disperse risk will not be
consolidated unless a single party holds an interest or combination of
interests that effectively recombines risks that were previously dispersed.
FIN No. 46 also requires enhanced disclosure requirements related to variable
interest entities. FIN No. 46 was revised in December 2003 and is effective
for the first financial reporting period ending after March 15, 2004. The
Company adopted the provisions of FIN No. 46 for the fiscal quarter ending
March 31, 2004, and the adoption did not have a material impact on the
Companys financial statements. In March 2004, the FASB issued an exposure draft of a proposed standard
that, if adopted, will significantly change the accounting for employee stock
options and other equity-based compensation. The proposed standard would
require companies to expense the fair value of stock options on the grant date
and would be effective at the beginning of the Companys 2005 fiscal year. The
Company will evaluate the requirements of the final standard, which is expected
to be finalized in late 2004, to determine its impact on the Companys results
of operations. 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 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 9




---



##### Table of Contents



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, and the plaintiffs in the Bertramcase may still seek
review of the Court of Appeals decision. The Company believes that the
allegations in both the class action and the Bertramcase are without merit,
and the Company intends to contest these matters vigorously. These matters,
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. 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 our 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. (in thousands) Three months ended
    
    Six months endedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Revenues by product:CMTS products
    
    $
    10,291
    
    
    $
    8,631
    
    
    $
    21,588
    
    
    $
    13,199CPE products
    
    
    24,983
    
    
    
    17,004
    
    
    
    48,597
    
    
    
    30,649Video products
    
    
    7,508
    
    
    
    3,699
    
    
    
    13,579
    
    
    
    6,532Other products
    
    
    
    
    
    
    1,265
    
    
    
    185
    
    
    
    2,487Total revenues
    
    $
    42,782
    
    
    $
    30,599
    
    
    $
    83,949
    
    
    $
    52,867Revenues by geographic areas:United States
    
    $
    21,226
    
    
    $
    17,672
    
    
    $
    43,058
    
    
    $
    31,179Canada
    
    
    224
    
    
    
    (309
    )
    
    
    1,838
    
    
    
    736Europe, Middle East, Africa
Region (EMEA), excluding
Israel
    
    
    7,041
    
    
    
    7,369
    
    
    
    14,965
    
    
    
    10,700Israel
    
    
    5,931
    
    
    
    399
    
    
    
    9,215
    
    
    
    811Japan
    
    
    3,294
    
    
    
    3,646
    
    
    
    5,688
    
    
    
    6,812Asia, excluding Japan
    
    
    5,037
    
    
    
    1,811
    
    
    
    9,132
    
    
    
    2,610South America
    
    
    29
    
    
    
    11
    
    
    
    53
    
    
    
    19Total
    
    $
    42,782
    
    
    $
    30,599
    
    
    $
    83,949
    
    
    $
    52,867
 June 30,
    
    December 31,2004
    
    2003Long-lived assets:United States
    
    $
    17,311
    
    
    $
    19,630Canada
    
    
    576
    
    
    
    810Europe
    
    
    138
    
    
    
    175Israel
    
    
    3,391
    
    
    
    3,104Asia
    
    
    61
    
    
    
    173Total long-lived assets
    
    
    21,477
    
    
    
    23,892Total current assets
    
    
    169,880
    
    
    
    191,348Total assets
    
    $
    191,357
    
    
    $
    215,240
 Two
customers accounted for 10% or more of total revenues (25% and 12%)
for the three months ended June 30, 2004. Two customers accounted for 10% or
more of total revenues (23% and 10%) for the six months ended June 30, 2004.
Five customers accounted for 10% or more of total revenues (16%, 13%, 13%, 13%,
and 12%) for the three months ended June 30, 2003. Three customers accounted
for 10% or more of total revenues (28%, 11%, and 10%) for the six months ended
June 30, 2003. 4.
Executive Severance, Restructuring Charges and Asset Write-offs Executive Severance In June 2004, the Company entered into separation agreements with two
executive officers. The Company recorded a severance provision of $1.7 million
related to termination costs for these officers. Most of the separation costs
are expected to be 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 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
related to additional costs for excess leased facilities, which were
contemplated in the first quarter plan. Net costs accrued under this
restructuring plan, included estimated sublease income from the aircraft and
the excess leased facilities. As of June 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 assumes that the Company will 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 11




---



##### Table of Contents



assumptions relevant to the aircraft and real estate market conditions as
of the date of the Companys plan, the time it would be likely to take until
the aircraft and excess facilities would be fully sub-leased. Even though it
is the intent of the Company to sublease, assign or sell its interests in the
aircraft and excess facilities at the earliest possible time, the Company
cannot determine with certainty a fixed date by which such events will 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 quarter of 2004, the Company re-evaluated the first quarter
2004 restructuring charge for the aircraft lease termination. Based on market
conditions and new assumptions provided by the Companys broker, the Company
increased the charge for the aircraft lease termination by $0.8 million. A summary of the first and second quarter 2004 accrued restructuring
charges is as follows (in thousands): Aircraft
    
    ExcessInvoluntary
    
    Lease
    
    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
    )
    
    
    (618
    )
    
    
    (238
    )
    
    
    (1,651
    )Revaluation
    
    
    
    
    
    
    812
    
    
    
    (63
    )
    
    
    749Balance at June 30, 2004
    
    $
    157
    
    
    $
    1,128
    
    
    $
    2,222
    
    
    $
    3,507
 2003
Restructuring 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 $2.7 million
remained accrued at June 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
June 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
    
    
    (619
    )Balance at June 30, 2004
    
    $
    3,881
 12




---



##### Table of Contents



Asset Write-offs For the six months ended June 30, 2004, the Company wrote off $0.1
million, of fixed assets, which were determined to have no remaining useful
life. For the six months ended June 30, 2003, the Company wrote off $0.5
million 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 June 30, 2004 or June 30, 2003. 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). Additionally, Harmonic is an authorized, non-exclusive reseller of
certain of the Companys video products. For the three and six months ended
June 30, 2004, related party revenue included $2.6 million and $3.4 million,
respectively, of revenue from Harmonic. For the three and six months ended
June 30, 2003, related party revenue included $0.6 million and $1.0 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 six months ended June 30, 2003, the Company recognized $1.5 million of
Rogerss related party revenue, net of amortization of co-marketing expense. In the six months ended June 30, 2004, the Company paid Mr. Krstajic
$30,000 for consulting service provided to the Company. In December 2001, the Company entered into a co-marketing arrangement with
Rogers to promote the Companys brand and identify 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 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 six months ended June 30, 2003,
totaled approximately $1.4 million and $2.8 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 $1.1 million at June 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 $150,000. 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. 13




---



##### Table of Contents



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 six months ended June 30, 2003 and 2004, is as
follows (in thousands): Additions
    
    Expiration
    
    Charges forBalance at
    
    Charged
    
    of
    
    Warranty
    
    Balance atBeginning
    
    to
    
    Accrued
    
    Services
    
    End ofof Period
    
    Expenses
    
    Warranty
    
    Provided
    
    PeriodSix months ended
June 30, 2003Warranty reserve
    
    $
    8,607
    
    
    
    1,010
    
    
    
    
    
    
    
    (1,444
    )
    
    $
    8,173Six months
ended June 30, 2004Warranty reserve
    
    $
    5,509
    
    
    
    1,922
    
    
    
    (1,300
    )
    
    
    (1,940
    )
    
    $
    4,191
 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, market and sell cable modem termination systems (CMTS),
customer premise equipment (CPE) products, including cable modems, and digital
video equipment. Our revenues are 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 2003, we completed the transition from selling proprietary-based
products to selling standards-based products using the Data Over Cable System
Interface Specification (DOCSIS) 2.0 specification. Due primarily to the
adoption of DOCSIS 2.0, we now generate DOCSIS CMTS and cable modem sales to
U.S. cable operators as well as to global customers. Our gross margins fluctuate from period to period primarily as a result of
the 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.
To date a majority of our total revenues have been generated from sales of our
CPE products. We anticipate that the erosion of average selling prices (ASPs)
of our CPE products will continue. We also believe that the widespread
adoption of industry specifications, such as the DOCSIS specifications, will
further erode ASPs. We are working to mitigate pressures on our gross margins
by continuing to focus on product manufacturing cost reductions, especially 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 six
months ended June 30, 2004, we had a net loss of $4.9 million and $15.1
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 and CMTS 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 grow the CMTS business, we will attempt to
capitalize on our DOCSIS 2.0 expertise and provide application solutions for
DOCSIS 2.0 advanced services, including voice over Internet Protocol (VoIP) and
commercial services. 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. Secondly, we will
continue to focus on lowering product costs for our CPE products through our
new ODM relationship in Asia and the introduction of our new lower cost
semiconductor, which is used in our CPE products. In our CMTS business, we
will continue to reduce costs through improved designs, better leveraging of
our contract manufacturer supply network, and the reduction of sole source
components. Finally, as discussed below, we expect to benefit from a lower
expense base resulting in part from restructuring activities in the first and
second quarters of 2004 combined with continued focus on cost containment.
Beginning in the second quarter of 2004, we anticipate annual savings of
approximately $10.0 million derived from restructuring activities.
Furthermore, as part of our restructuring efforts to refocus our business, we
will continue to divest unprofitable product lines in an effort to focus on
growing our business and redirect our resources. However, despite these
efforts, we may not succeed in attaining profitability in the near future, if
at all. 15




---



##### Table of Contents



At June 30, 2004, we had approximately $116.3 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 half 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, Jerry Chase was appointed as the
Companys new Chief Executive Officer, and Arthur Taylor, the
Companys Chief Financial Officer, resigned. Critical Accounting Policies 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 Six Months Ended June 30, 2004 and June 30, 2003 Revenues (in thousands) % Change for
    
    % Change forFor the three
    
    For the six
    
    the three
    
    the six monthsmonths ended
    
    months ended
    
    months ended
    
    endedJune 30,
    
    June 30,
    
    June 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003
    
    2004/2003
    
    2004/2003Revenues
    
    $
    42,782
    
    
    $
    30,599
    
    
    $
    83,949
    
    
    $
    52,867
    
    
    
    40
    %
    
    
    59
    %
 We sell directly to broadband service providers, and to a lesser extent,
indirectly through resellers. Revenues related to our sales are recognized
when: (1) persuasive evidence of an arrangement exists, (2) delivery has
occurred or services rendered, (3) the selling price is fixed or determinable,
and (4) collectibility is reasonably assured. A provision is made for
estimated product returns as product shipments are made. Our existing
agreements typically do not grant return rights beyond those provided by the
warranty. Revenue arrangements with resellers are generally recognized when
product is shipped to the resellers as we generally do not grant return rights
beyond those provided by the warranty. Our revenues increased 40% to $42.8 million for the quarter ended June 30,
2004 compared to $30.6 million in the quarter ended June 30, 2003, primarily
due to increased sales of our DOCSIS modems and video products, increased
deployments of our CMTSs by cable operators, and increased sales of our legacy
Multigate circuit-switch product, slightly offset by the lack of sales of our
proprietary S-CDMA products in the second quarter of 2004 which were present in
2003. Our revenues increased 59% to $83.9 million for the six months ended June
30, 2004 compared to $52.9 million for the six months ended June 30, 2003,
primarily due to increased sales of our DOCSIS modems and video products,
increased deployments of our CMTSs by cable operators, and increased sales of
our legacy circuit-switch voice product, slightly offset by decreased sales of
our proprietary S-CDMA products. We expect total revenues to decline slightly
in the third quarter of 2004 compared to the first and 16




---



##### Table of Contents



second quarters of 2004 primarily due to a decrease in sales of our CPE
products including our Multigate circuit-switch product line, partially offset by increased sales of our video products. Revenues by Groups of Similar Products (in thousands) % Change for
    
    % Change forFor the three
    
    For the six
    
    the three
    
    the six monthsmonths ended
    
    months ended
    
    months ended
    
    endedJune 30,
    
    June 30,
    
    June 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003
    
    2004/2003
    
    2004/2003Revenues by
product:CMTS products
    
    $
    10,291
    
    
    $
    8,631
    
    
    $
    21,588
    
    
    $
    13,199
    
    
    
    19
    %
    
    
    64
    %CPE products
    
    
    24,983
    
    
    
    17,004
    
    
    
    48,597
    
    
    
    30,649
    
    
    
    47
    %
    
    
    59
    %Video products
    
    
    7,508
    
    
    
    3,699
    
    
    
    13,579
    
    
    
    6,532
    
    
    
    103
    %
    
    
    108
    %Other products
    
    
    
    
    
    
    1,265
    
    
    
    185
    
    
    
    2,487
    

    
    
    
    
    
    
    (93
    %)Total revenues
    
    $
    42,782
    
    
    $
    30,599
    
    
    $
    83,949
    
    
    $
    52,867
    
    
    
    40
    %
    
    
    59
    %
 CMTS
revenues increased 19% for the quarter ended June 30, 2004 compared
to the quarter ended June 30, 2003, and increased 64% for the six months ended
June 30, 2004 compared to the six months ended June 30, 2003. This increase
was due to additional deployment of our DOCSIS products into new markets,
primarily in the U.S. We
have intensified our efforts to win new CMTS business through more direct
engagement with key potential customers, specifically in Asia, Japan, and
Europe. We are optimistic this may continue to yield improved results in the
near future as we generate additional revenues from existing customers, acquire
new customers, and increase the amount of sales into second and third tier
North American-based multiple system operators (MSOs). Additionally, we are
reviewing the opportunities available in the CMTS market and are assessing
potentially viable strategies for growth and profitability, including
leveraging what we believe to be a leadership position in commercial services.
We expect CMTS revenues to be relatively flat in the third quarter of 2004
compared to the first and second quarters of 2004. CPE
revenues increased 47% for the quarter ended June 30, 2004 compared to
the quarter ended June 30, 2003, due to an increase in modem sales, and to a
lesser extent, an increase in sales of our legacy circuit-switch voice product
in Europe. The number of DOCSIS modems sold increased from approximately 0.3
million units in the second quarter of 2003 to approximately 0.5 million units
in the second quarter of 2004. CPE revenues increased 59% for the six months
ended June 30, 2004 compared to the six months ended June 30, 2003, due to an
increase in modem sales and an increase in sales of our legacy circuit-switch
voice product. The number of DOCSIS modems sold increased from approximately
0.6 million units in the six months ended June 30, 2003 to approximately 1.0
million units in the six months ended  June 30, 2004. The intensely
competitive nature of the market for broadband products has resulted in
significant price erosion of ASPs. However, we believe that our full
transition to an ODM in Asia, which was substantially completed in the first
quarter of 2004, and the introduction of our new lower cost modem
semiconductor, which is used in out CPE products, may allow us to remain
competitive in the marketplace and maintain favorable margins on these
products. Additionally, during the second quarter we experienced exceptionally
strong demand for our legacy Multigate circuit-switch product line, which is
sold primarily to one customer in Europe. We anticipate revenue generated by
the legacy circuit-switch business to be substantially lower going forward.
Consequently, we expect total CPE revenues to decline in the third quarter of
2004 compared to the first and second quarters of 2004. Revenues from video products increased 103% for the quarter ended June 30,
2004 compared to the quarter ended June 30, 2003, and increased 108% for the
six months ended June 30, 2004 compared to the six months ended June 30, 2003,
due to increased sales to United States MSOs of our DM 6400 Cherrypicker video
product. We are encouraged by the prospects for the video business to grow and 17




---



##### Table of Contents



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 2004. We currently
anticipate video revenues will increase in the third quarter of 2004 compared
to the first and second quarters of 2004, primarily due to revenues associated
with video product deployment at Fox Broadcasting Company. The Company had no sales of its legacy telecom products in the second
quarter of 2004. Other revenues decreased 93% for the six months ended June
30, 2004 compared to the six months ended June 30, 2003, due to significantly
decreased sales of our legacy telecom products. We expect sales of telecom
products to be minimal in 2004. Revenues by Geographic Region (in thousands) % Changefor the
    
    % Changethree
    
    for the sixFor the three months
    
    For the six
    
    months
    
    monthsended
    
    months ended
    
    ended
    
    endedJune 30,
    
    June 30,
    
    June 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003
    
    2004/2003
    
    2004/2003Revenues by
geographic areas:United States
    
    $
    21,226
    
    
    $
    17,672
    
    
    $
    43,058
    
    
    $
    31,179
    
    
    
    20
    %
    
    
    38
    %Canada
    
    
    224
    
    
    
    (309
    )
    
    
    1,838
    
    
    
    736
    
    
    
    172
    %
    
    
    150
    %Europe, Middle
East, Africa
Region (EMEA),
excluding
Israel
    
    
    7,041
    
    
    
    7,369
    
    
    
    14,965
    
    
    
    10,700
    
    
    
    (4
    )%
    
    
    40
    %Israel
    
    
    5,931
    
    
    
    399
    
    
    
    9,215
    
    
    
    811
    
    
    
    1,386
    %
    
    
    1,036
    %Japan
    
    
    3,294
    
    
    
    3,646
    
    
    
    5,688
    
    
    
    6,812
    
    
    
    (10
    )%
    
    
    (17
    )%Asia, excluding
Japan
    
    
    5,037
    
    
    
    1,811
    
    
    
    9,132
    
    
    
    2,610
    
    
    
    178
    %
    
    
    250
    %South America
    
    
    29
    
    
    
    11
    
    
    
    53
    
    
    
    19
    
    
    
    164
    %
    
    
    184
    %Total
    
    $
    42,782
    
    
    $
    30,599
    
    
    $
    83,949
    
    
    $
    52,867
    
    
    
    40
    %
    
    
    59
    %
 Revenues in the United States increased 20% to $21.2 million in the second
quarter of 2004 compared to the same period in 2003, and increased 38% to $43.1
million in the six months ended June 30, 2004, compared to the same period in
2003, due to increased sales of DOCSIS 2.0 CMTSs and modems as well as video
products to United States MSOs. Revenues in Canada and Asia,
excluding Japan, also increased due to increased sales of DOCSIS 2.0 CMTSs products. Revenues
in Israel increased due to increased sales of our legacy Multigate
circuit-switch product. During the first half of 2004, we emphasized sales to
our United States and other Asian customers while placing a lower emphasis on
other locations such as Canada, EMEA, and South America. In 2004, we currently
expect revenues to continue to increase in the United States and Asian markets.
However, overall revenues are expected to be flat or down in the third quarter
of 2004. Two customers accounted for 10% or more of total revenues (25% and
12%) for the three months ended June 30, 2004. Two customers accounted for 10%
or more of total revenues (23% and 10%) for the six months ended June 30, 2004.
Five customers accounted for 10% or more of total revenues (16%, 13%, 13%,
13%, and 12%) for the three months ended June 30, 2003. Three customers
accounted for 10% or more of total revenues (28%, 11%, and 10%) for the six
months ended June 30, 2003. No other customer accounted for more than 10% of
revenues during these periods. 18




---



##### Table of Contents



Related Party Revenues (in thousands) % Changefor the
    
    % Changethree
    
    for the sixFor the three months
    
    For the six
    
    months
    
    monthsended
    
    months ended
    
    ended
    
    endedJune 30,
    
    June 30,
    
    June 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003
    
    2004/2003
    
    2004/2003Related party revenues:Harmonic revenues
    
    $
    2,644
    
    
    $
    635
    
    
    $
    3,389
    
    
    $
    1,010
    
    
    
    316
    %
    
    
    236
    %Rogers revenues
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,453
    
    
    
    
    
    
    
    Total related
party revenues
    
    $
    2,644
    
    
    $
    635
    
    
    $
    3,389
    
    
    $
    2,463
    
    
    
    316
    %
    
    
    38
    %
 Related party revenues increased 316% in the second quarter of 2004,
compared to the second quarter of 2003. Related party revenues increased 38%
in the six months ended June 30, 2004, compared to the six months ended June
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
classified as revenues after the first quarter 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 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 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) % Changefor the
    
    % Changethree
    
    for the sixFor the three months
    
    For the six
    
    months
    
    monthsended
    
    months ended
    
    ended
    
    endedJune 30,
    
    June 30,
    
    June 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003
    
    2004/2003
    
    2004/2003Cost of revenues
    
    $
    27,046
    
    
    $
    23,549
    
    
    $
    55,598
    
    
    $
    42,200
    
    
    
    15
    %
    
    
    32
    %Cost of related party
revenues
    
    
    614
    
    
    
    187
    
    
    
    832
    
    
    
    1,128
    
    
    
    228
    %
    
    
    (26
    )%Total cost of goods sold
    
    $
    27,660
    
    
    $
    23,736
    
    
    $
    56,430
    
    
    $
    43,328
    
    
    
    (17
    )%
    
    
    (30
    )%Gross profit
    
    $
    15,122
    
    
    $
    6,863
    
    
    $
    27,519
    
    
    $
    9,539
    
    
    
    120
    %
    
    
    188
    %
 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 six months ended
June 30, 2004, cost of goods sold was approximately 65% and 67% of revenues,
respectively, compared to 78% and 82% of revenues, respectively, in the same
periods in 2003. Additionally, during the three and six months ended June 30, 2004, we reversed
approximately $0.3 million and $0.8 million, respectively, of inventory provisions, which were
previously recorded as cost of goods sold.  During the three and six months ended June 30, 2003,
we reversed approximately $1.0 million and $1.7 million, respectively of inventory provisions.
We reversed these provisions as we were able to sell inventory originally considered to be excess
or obsolete. 19




---



##### Table of Contents



For the three and six months ended June 30, 2004, we reversed
approximately $0.8 million and $2.1 million, respectively, of accrued vendor
cancellation charges, which were previously recorded as cost of goods sold.
For the three and six months ended June 30, 2003, we reversed approximately
$2.1 million and $4.4 million, respectively, of accrued vendor cancellation
charges.  We were able
to negotiate downward certain vendor cancellation claims to terms more
favorable to us. In the three months ended June 30, 2004, related party cost of revenues
increased compared to the same period in 2003 due to higher sales of our video
products to Harmonic. In the six months ended June 30, 2004, related party
cost of revenues decreased compared to the same period in 2003 due to
classification of cost of revenues to Rogers as related party cost of sales in
the first quarter of 2003. Our gross profit increased 120% to $15.1 million or 35% of sales in the
three months ended June 30, 2004 compared to $6.9 million, or 22% of sales in
the same period in 2003. Our gross profit increased 188% to $27.5 million or
33% of sales in the six months ended June 30, 2004 compared to $9.5 million, or
18% of sales in the same period in 2003. The increase in our gross profit was
primarily related to a favorable product line sales mix as we recorded a larger
proportion of sales from our higher margin video and Multigate products, as
well as lower product manufacturing costs for our modem business due largely to
the benefits gained from moving to a large manufacturer ODM model,
a more moderate rate of modem ASP erosion and the benefits from the reversal of
inventory and vendor cancellation claims, described above. 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 and the U.S. for our CMTS, CPE, and video products, which
may provide us with more competitive component pricing, economies of scale, and
improved manufacturing capabilities. Our endeavor to shift our product mix
from CPE revenues to higher margin CMTS and digital video product revenues,
should enable us to increase our margins. However, there are no assurances
that we will succeed in selling a greater percentage of higher margin products
or reducing our product manufacturing costs. Operating Expenses (in thousands) % Changefor the three
    
    % Change forFor the three months
    
    For the six
    
    months
    
    the six monthsended
    
    months ended
    
    ended
    
    endedJune 30,
    
    June 30,
    
    June 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003
    
    2004/2003
    
    2004/2003Research and
development
    
    $
    8,516
    
    
    $
    10,432
    
    
    $
    17,984
    
    
    $
    23,434
    
    
    
    (18
    )%
    
    
    (23
    %)Sales and marketing
    
    $
    5,411
    
    
    $
    6,560
    
    
    $
    12,632
    
    
    $
    13,290
    
    
    
    (18
    )%
    
    
    (5
    )%General and
administrative
    
    $
    2,953
    
    
    $
    3,000
    
    
    $
    5,388
    
    
    $
    6,728
    
    
    
    (2
    )%
    
    
    (20
    )%
 Research and Development.Research and development expenses consist
primarily of personnel costs, internally designed prototype material
expenditures, and expenditures for outside engineering consultants, equipment
and supplies required to develop and enhance our products. Research and
development expenses decreased 18% to $8.5 million or 20% of sales in the three
months ended June 30, 2004 from $10.4 million or 34% of sales in the same
period in 2003. The $1.9 million decrease in research and development expenses
was attributable to $0.8 million of reductions in employee related expenses.
The 20




---



##### Table of Contents



decrease in research and development expenses also included reductions of
$1.2 million in purchases of materials, costs incurred to develop prototypes,
and other research and development expenses, partially offset by an increase of
$0.1 million of outside engineering consultants. Research and development expenses decreased 23% to $18.0 million or 21% of
sales in the six months ended June 30, 2004 from $23.4 million or 44% of sales
in the same period in 2003. The $5.4 million decrease in research and
development expenses was attributable to $2.1 million of reductions in employee
related expenses. The decrease in research and development expenses also
included reductions of $0.2 million of outside engineering consultants and $3.1
million of reductions in purchases of materials, costs incurred to develop
prototypes, and other research and development expenses. We believe it is
critical for the Company 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 although at
slightly lower levels. In connection with our worldwide restructuring plans in
the first and second quarters of 2004, we currently expect research and
development expenses to continue to decrease in 2004. 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 18% to $5.4 million or 13% of sales in the three
months ended June 30, 2004 from $6.6 million or 21% of sales in the same period
in 2003. The $1.1 million decrease in sales and marketing expenses was
primarily due to $0.1 million of decreased travel costs, $0.7 million of
reductions related to aircraft costs now included in restructuring charges, and
$0.7 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 $0.2 million of increased spending for outside consultants. Sales and marketing expenses decreased 5% to $12.6 million or 15% of sales
in the six months ended June 30, 2004 from $13.3 million or 25% of sales in the
same period in 2003. The $0.7 million decrease in sales and marketing expenses
was primarily due to $0.8 million of reductions related to aircraft costs now
included in restructuring charges, and $0.9 million of overall sales and
marketing cost reductions. These reductions were partially offset by $0.4
million in increased employee expenses in sales and marketing and $0.6 million
of increased spending for outside consultants. We currently expect sales and
marketing expenses to continue to remain flat for the remainder of 2004. General and Administrative. General and administrative expenses consist
primarily of salary and benefits for administrative officers and support
personnel, travel expenses and legal, accounting and consulting fees. Overall
general and administrative expenses remained flat at $3.0 million or 7% of
sales for the three months ended June 30, 2004 from $3.0 million or 10% 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 an executive officer.
Beginning in the second quarter of 2004, we now record all severance expenses associated with the
termination of executive officers in "Executive Severance, Restructuring Costs and Asset Write-offs." General and administrative expenses decreased by $1.3 million to $5.4
million or 6% of sales for the six months ended June 30, 2004 from $6.7 million
or 13% of sales in the same period in 2003. The decrease was primarily due to
$1.2 million in reduced employee expenses including $0.3 million of severance
expense in the first quarter of 2003 related to the termination of an executive
officer, $0.9 million of overall general and administrative cost decreases,
partially offset by $0.7 million of increased spending for outside consultants
and $0.1 million increase of travel expenses. In connection with our worldwide
restructuring plans in the first and second quarters of 2004, we currently
expect general and administrative expenses to continue to be lower than in
2003. 21




---



##### Table of Contents



Executive Severance, Restructuring Costs and Asset Write-offs (in thousands) For the sixFor the three months ended
    
    months endedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Executive severance charges
    
    $
    1,682
    
    
    $
    
    
    
    $
    1,682
    
    
    $
    Restructuring charges
    
    
    1,148
    
    
    
    
    
    
    
    4,409
    
    
    
    2,676Long-lived assets written-off
    
    
    
    
    
    
    
    
    
    
    106
    
    
    
    485Revaluation of restructuring charges
    
    
    749
    
    
    
    (115
    )
    
    
    749
    
    
    
    (115
    )Executive
severance, restructuring costs
and asset write-offs
    
    $
    3,579
    
    
    $
    (115
    )
    
    $
    6,946
    
    
    $
    3,046
 Executive
Severance Charges In June 2004, we entered into separation
agreements with two executive officers. We recorded a severance
provision of $1.7 million related to termination costs for these
officers. Most of the separation costs are expected to be paid in the
third quarter of 2004 with nominal amounts paid for employee benefits
paid through the third quarter of 2005. Restructuring CostsDuring the first quarter of 2004, we initiated a
restructuring plan to conform expenses to 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 plan. As of June 30,
2004, the employment of 58 employees had been terminated, and we paid $0.8
million in termination costs, $0.6 million of costs related to the aircraft
lease, and $0.3 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 or negotiating
buyouts of operating lease commitments, 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. Additionally, in the second quarter of 2004,
we revalued the restructuring reserve in accordance with SFAS 146 and recorded
an additional provision to increase restructuring costs, primarily associated
with the aircraft lease, by $0.7 million. 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. Even though it
is our intent to sublease, assign or sell our interests in the aircraft and
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 June
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 June 30, 2004, restructuring charges of $1.2 million remained
accrued. As of June 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. 22




---



##### Table of Contents



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 June 30, 2004, restructuring charges of $2.7
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. Asset Write-offsFor the six months ended June 30, 2004, we wrote off $0.1
million 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 June
30, 2004. For the six months ended June 30, 2003, we wrote off $0.5 million,
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 June 30, 2003. Non-Operating Expenses (in thousands) % Changefor the three
    
    % Change forFor the three
    
    For the six
    
    months
    
    the six monthsmonths ended
    
    months ended
    
    ended
    
    endedJune 30,
    
    June 30,
    
    June 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003
    
    2004/2003
    
    2004/2003Interest income
    
    $
    460
    
    
    $
    909
    
    
    $
    912
    
    
    $
    1,811
    
    
    
    (49
    %)
    
    
    (50
    %)Interest
expense
    
    $
    (826
    )
    
    $
    (814
    )
    
    $
    (1,643
    )
    
    $
    (1,651
    )
    
    
    (1
    %)
    
    
    Other income (expense)
    
    $
    921
    
    
    $
    (160
    )
    
    $
    1,200
    
    
    $
    (200
    )
    
    
    
    
    
    
    
 Interest Income. Interest income decreased 49% to $0.5 million in the
second quarter of 2004 compared to $0.9 million in the same period in 2003.
Interest income decreased 50% to $0.9 million in the six months ended June 30,
2004 compared to $1.8 million in the same period in 2003. The decrease in
interest income in both periods was primarily due to lower invested average
cash balances, as well as lower 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 second quarter of 2004 and the six months ended June 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 Communication 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
    
    For the sixended
    
    months endedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Income tax expense
    
    $
    (79
    )
    
    $
    (60
    )
    
    $
    (146
    )
    
    $
    (129
    )
 We have generated losses since our inception. In the three and six months
ended June 30, 2004 and 2003, we recorded an income tax expense related
primarily to foreign taxes. 23




---



##### Table of Contents



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, 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, and the plaintiffs in the Bertramcase may still seek
review of the Court of Appeals decision. We believe that the allegations in
both the class action and the Bertramcase are without merit, and we intend to
contest these matters vigorously. These matters, 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. 24




---



##### Table of Contents



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. 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 June 30, 2004, we had approximately $47.8 million in cash and cash
equivalents and $68.5 million in short-term investments. Cash used in operating activities for the six months ended June 30, 2004
was $21.2 million compared to $43.9 million used in the same period in 2003. In
the six months ended June 30, 2004, significant uses of cash from operating
activities included $15.1 million loss from operations, $9.6 million decrease
in accounts payable, and $6.0 million of increase in gross inventory.
Inventory levels increased at June 30, 2004 when compared to December 31, 2003
due to increased CMTS and modem inventories in order to meet service levels
established with our key customers. In the six months ended June 30, 2003,
significant uses of cash from operating activities included a $37.1 million
loss from operations, and a $8.7 million decrease in vendor cancellation
reserves as we paid down these obligations, $4.1 million increase in accounts
payable, partially offset by a $6.6 million decrease in other assets, and $8.6
million decrease in inventory. Cash provided by investing activities for the six months ended June 30,
2004, was $37.8 million compared to cash used in investing activities of $5.8
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 six months ended June
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 six
months ended June 30, 2003 was primarily due to movement of short-term
investments to cash and cash equivalents to fund operations. 25




---



##### Table of Contents



Cash provided by financing activities was $0.6 million in the six months
ended June 30, 2004 and 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 June 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. We currently 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,
primarily through sales of more profitable products, and decrease costs. In
the first and second quarters of 2004, we initiated a restructuring plan, which
resulted in a reduction in workforce, consolidation of certain facilities, and
reduction or elimination of discretionary costs and programs. Beginning in the
second quarter of 2004, we currently anticipate annual savings to be
approximately $10.0 million. These statements are forward-looking in nature
and involve risks and uncertainties. Actual results may vary as a result of a
number of factors, including those discussed under the risk factor Our
Operating Results May Fluctuate below and elsewhere. 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. 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, 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 June 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
    
    $
    27.0
    
    
    $
    27.0
    
    
    $
    
    
    
    $
    
    
    
    $
    Long Term Debt
    
    
    68.4
    
    
    
    
    
    
    
    1.6
    
    
    
    65.1
    
    
    
    1.7Operating Lease Obligations
    
    
    21.2
    
    
    
    6.3
    
    
    
    7.8
    
    
    
    6.1
    
    
    
    1.0Aircraft Lease
    
    
    3.8
    
    
    
    2.3
    
    
    
    1.5
    
    
    
    
    
    
    
    Total Contractual Commitments
    
    $
    120.4
    
    
    $
    35.6
    
    
    $
    10.9
    
    
    $
    71.2
    
    
    $
    2.7
 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 June 30, 2004, we had approximately $27.0 million of purchase
obligations, of which $0.7 million is included in the consolidated balance
sheets as accrued vendor 26




---



##### Table of Contents



cancellation charges, and the remaining $26.3 million is attributable to open
purchase orders. The remaining obligations are expected to become payable at
various times through 2004. We had restricted cash of $9.2 million at June 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
    
    
    8.2
    
    
    
    0.5
    
    
    
    
    
    
    
    7.5
    
    
    
    0.2Total Commercial Commitments
    
    $
    9.2
    
    
    $
    0.8
    
    
    $
    0.7
    
    
    $
    7.5
    
    
    $
    0.2
 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. In March 2004, in
connection with our worldwide restructuring, we notified the lessor of our
intentions to locate a sub-lessor or purchaser for our remaining obligations
under this lease. Impact of Recently Issued Accounting Standards In January 2003, the Financial Accounting Standards Board (FASB) issued
FASB Interpretation No. 46 (FIN No. 46), Consolidation of Variable Interest
Entities, an interpretation of ARB No. 51. FIN No. 46 requires existing
unconsolidated variable interest entities to be consolidated by their primary
beneficiaries if the entities do not effectively disperse risks among parties
involved. Variable interest entities that effectively disperse risk will not be
consolidated unless a single party holds an interest or combination of
interests that effectively recombines risks that were previously dispersed.
FIN No. 46 also requires enhanced disclosure requirements related to variable
interest entities. FIN No. 46 was revised in December 2003 and is effective
for the first financial reporting period ending after March 15, 2004. We
adopted the provisions of FIN No. 46 for the fiscal quarter ending March 31,
2004. The adoption of FIN No. 46 did not have a material impact on our
financial statements. In March 2004, the FASB issued an exposure draft of a proposed standard
that, if adopted, will significantly change the accounting for employee stock
options and other equity-based compensation. The proposed standard would
require companies to expense the fair value of stock options on the grant date
and would be effective at the beginning of the 2005 fiscal year. We will
evaluate the requirements of the final standard, which is expected to be
finalized in late 2004, to determine the impact on our results of operations. 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 June 30, 2004, we had an
accumulated deficit of $1,002.7 million. We believe that we will
continue to experience 27




---



##### Table of Contents



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 2004 as compared to 2003, we still incurred
losses of $4.9 million and
$15.1 million, respectively, in the three and six months ended June 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 six months ended June 30, 2004 was $21.2
million compared to $43.9 million used in the same period in 2003.
Additionally, we generally have been 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 been experiencing 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. 28




---



##### Table of Contents



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 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 June 30, 2004, $27.0
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 the first half of 2004, and we anticipate that unit ASPs of our
products may 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
Cable Modem Termination Systems (CMTSs) and digital video management systems,
and lower margin, higher volume Customer Premise Equipment (CPE) products, such
as modems. In 2004, we expect that sales of our low-margin CPE products will
continue to make up a significant portion of our revenues. 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. Two customers accounted for 10% or more of total revenues
(25% and
12%) for the three months ended June 30, 2004. Two customers accounted for 10%
or more of total revenues (23% and 10%) for the six months ended June 30, 2004.
Five customers accounted for 10% or more of total revenues (16%, 13%, 13%,
13%, and 12%) for the three months ended June 30, 2003. Three customers
accounted for 10% or more of total revenues (28%, 11%, and 10%) for the six
months ended June 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. 29




---



##### 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, such as our CMTSs, 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. 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. 30




---



##### Table of Contents



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
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. 31




---



##### Table of Contents



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. We expect this erosion to
continue. The ASPs for our products are likely to continue to decline 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.
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 rapidly 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 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, 32




---



##### Table of Contents



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. 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.
For example, Comcast acquired AT&T Broadband in 2003. 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. 33




---



##### Table of Contents



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 $27.0 million as of
June 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 34




---



##### Table of Contents



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 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 June 30, 2004 and June 30, 2003, approximately 50%
and 42%, respectively, of our net revenues were from customers outside of the
U.S. For the six months ended June 30, 2004 and June 30, 2003, approximately
49% and 41%, 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. 35




---



##### Table of Contents



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,
Canada, Japan, Hong Kong, Korea, China and Brazil in local currencies. Since
we have also elected to take payment in Euros 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 $7.1 million
and $4.7 million for the three months ended June 30, 2004 and June 30, 2003,
respectively. Revenues generated by our business in Israel were $12.6 million
and $5.5 million for the six months ended June 30, 2004 and June 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. 36




---



##### Table of Contents



The deployment process for our equipment may be lengthy and may delay the
receipt of new orders and cause fluctuations in our revenues. 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 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. 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 37




---



##### Table of Contents



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, turnover in personnel, and the recruitment and retention of
a new senior management staff, could create a number of transitional challenges
for us. We have experienced and may continue to experience turnover in key
personnel. We recently announced the resignation of our former Chief Executive
Officer and the appointment of a new Chief Executive Officer,
effective in September 2004 as well as the resignation of our
Chief Operating Officer and Chief Financial Officer. These transitional issues
have caused, and may cause, disruptions to our business. We have established an
interim executive committee of the Board of Directors to oversee the general
operation of our business until the new Chief Executive Officer comes
into office in September 2004 and have appointed a cable industry consultant to
serve as interim head of our data business until no later than August 31, 2004.
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. 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. 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 38




---



##### Table of Contents



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 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. 39




---



##### Table of Contents



Our indebtedness could adversely affect our financial condition; we may incur
substantially more debt. As of June 30, 2004, we had approximately $68.2 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 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. In addition and 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
$116.3 million at June 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, which in turn may affect our revenue in the
future. 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. Although a few of our senior executive officers have
limited non-competition agreements with us, our employees are generally not
bound by non-competition agreements. 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 40




---



##### Table of Contents



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. We may dispose of 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. We cannot assure you that we correctly forecasted the right product lines
to discontinue or that our decision to 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. 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. 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. 41




---



##### Table of Contents



We are exposed to the credit risk of our customers and to credit exposures in
weakened markets, which could result in material losses. 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 42




---



##### Table of Contents



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. 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 June 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. 43




---



##### Table of Contents



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 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. 44




---



##### Table of Contents



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 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 $17,000 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. A hypothetical adverse change of
10% in exchange rates would result in a decline in income before taxes of
approximately $445,000. All of the potential changes noted above are based on sensitivity analyses
performed on our financial positions at June 30, 2004. Actual results may
differ materially. 
 ITEM 4. CONTROLS AND PROCEDURES As of the end of the period covered by 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 concluded
that our disclosure controls and procedures are effective in timely alerting
them to material information required to be presented in this report. There has been no change in our internal controls over financial reporting
that occurred during our most recent fiscal quarter that has materially
affected or is reasonably likely to materially affect our internal controls
over financial reporting. 
 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 have determined to defer the 2004 annual
meeting of stockholders, originally scheduled for August 10, 2004, for a brief
period of time. We are committed to move forward with the annual
meeting process as soon as practicable and will provide further information
about the date of the 2004 annual meeting, the anticipated mailing of the proxy
materials and revised deadlines for stockholder proposals as soon as reasonably
practicable. 
 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) EXHIBITS  31.1
    
    Certification of the Chief Executive Officer Pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002. 45




---



##### Table of Contents



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 2002.10.24
    
    Agreement dated January 23, 2004, between the Registrant
and YAS Corporation.10.29
    
    Separation Agreement dated July 15, 2004, between the Registrant
and Douglas Sabella.10.30
    
    Transition Agreement dated June 21, 2004, between the Registrant
and Zaki Rakib.10.31
    
    Employment Agreement dated June 21, 2004, between the
Registrant and Selim (Shlomo) Rakib. 46




---



##### Table of Contents



(b) REPORTS ON FORM 8-K The Company furnished the following Current Reports on Form 8-K
during the three months ended June 30, 2004:  1.
    
    On April 15, 2004, the Company filed a report on Form
8-K announcing it had issued a press release announcing that
Adelphia Communications, Inc. deployed more than 200 Terayon BW
DOCSIS 2.0 CMTSs, and announcing it had issued a press release
announcing new members of its BP (Broadcast Platform) line of
digital video solutions.2.
    
    On April 21, 2004, the Company filed a report on Form
8-K announcing it had issued a press release announcing that
Triveni Digital and the Company have jointly developed a highly
integrated, multi-functional, HDTV broadcast distribution system
and announcing that the Company is demonstrating the advanced
capabilities of its two flagship video products at NAB2004 in
Las Vegas.3.
    
    On April 30, 2004, the Company filed a report on Form
8-K announcing it had issued a press release announcing the
Companys financial results for the first quarter ended March
31, 2004.4.
    
    On May 5, 2004, the Company filed a report on Form
8-K announcing it had issued a press release announcing that the
Company and Triveni Digital won three prestigious awards at NAB
Tradeshow, the Company helped cable television accelerate their
transition to All Digital operation with CP 7600 Decoder, and
the Company is demonstrating the full range of its family of
advanced FLEXable Solutions at the 2004 National Show.5.
    
    On May 18, 2004, the Company filed a report on Form
8-K announcing it had issued a press release announcing the
introduction of the Companys FLEXable Commercial Services
solution, which allows commercial-grade voice and data services
that work with existing internal networks and back-office
infrastructure, an alliance between the Company and Juniper
Networks to create flexible network architectures for delivering
broadband services over cable networks, that Kinetic Strategies
has named the Company the number two provider of cable modems
worldwide, and that it has signed a partnership agreement with
TANDBERG Television.6.
    
    On June 2, 2004, the Company filed a report on Form
8-K announcing it had issued a press release announcing the
resignation of Dr. Zaki Rakib as Chief Executive Officer
effective no later than August 31, 2004 and the appointment of
Howard W. Speaks, Jr. to the Companys board of directors.7.
    
    On June 10, 2004, the Company filed a report on Form
8-K announcing it had issued a press release announcing it is
holding its 2004 Annual Meeting of Stockholders on August 10,
2004.8.
    
    On June 16, 2004, the Company filed a report on Form
8-K announcing it had issued a press release announcing the
resignation of Douglas Sabella as Chief Operating Officer,
effective July 16, 2004.9.
    
    On June 23, 2004, the Company filed a report on Form
8-K announcing it had issued a press release announcing that the
Company creates ground-breaking opportunities for advertisers to
target local audiences through high definition television
programming. 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: July 26, 2004
    TERAYON COMMUNICATION SYSTEMS, INC.By
    /s/ Arthur T. TaylorArthur T. TaylorChief Financial Officer
 48




---



##### Table of Contents



Exhibit Index  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 2002.10.24
    
    Agreement dated January 23, 2004, between the Registrant
and YAS Corporation.10.29
    
    Separation Agreement dated July 15, 2004, between the Registrant
and Douglas Sabella.10.30
    
    Transition Agreement dated June 21, 2004, between the Registrant
and Zaki Rakib.10.31
    
    Employment Agreement dated June 21, 2004, between the
Registrant and Selim (Shlomo) Rakib.