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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 March 31, 2004
OR o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROMTO.    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 o Indication by check mark whether the registrant is an accelerated file (as
defined by Rule 12b-2 of the Exchange Act) Yes x No o As of April 30, 2004 registrant had outstanding 75,546,039 shares of
Common Stock.




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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 March 31, 2004 (unaudited) and
December 31, 2003
    
    
    3Condensed Consolidated Statements of Operations for the three months ended
March 31, 2004 and 2003 (unaudited)
    
    
    4Condensed Consolidated Statements of Cash Flows for the three months ended
March 31, 2004 and 2003 (unaudited)
    
    
    5Notes to Condensed Consolidated Financial Statements (unaudited)
    
    
    6EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2
  2




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TERAYON COMMUNICATION SYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands) March 31,
    
    December 31,2004
    
    2003(unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    76,060
    
    
    $
    30,188Short-term investments
    
    
    47,151
    
    
    
    108,452Accounts receivable, net
    
    
    28,814
    
    
    
    29,199Accounts receivable from related parties
    
    
    227
    
    
    
    600Other current receivables
    
    
    2,351
    
    
    
    3,662Inventory
    
    
    19,267
    
    
    
    16,364Other current assets
    
    
    2,272
    
    
    
    2,883Total current assets
    
    
    176,142
    
    
    
    191,348Property and equipment, net
    
    
    10,821
    
    
    
    11,871Restricted cash
    
    
    9,212
    
    
    
    9,212Other assets, net
    
    
    2,397
    
    
    
    2,809Total assets
    
    $
    198,572
    
    
    $
    215,240LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    21,362
    
    
    $
    26,049Accrued payroll and related expenses
    
    
    5,072
    
    
    
    6,537Deferred revenues
    
    
    4,451
    
    
    
    3,423Warranty reserves
    
    
    4,605
    
    
    
    5,509Accrued restructuring charges
    
    
    6,598
    
    
    
    4,500Accrued vendor cancellation charges
    
    
    1,399
    
    
    
    2,869Other accrued liabilities
    
    
    4,137
    
    
    
    5,036Interest payable and current portion of long-term debt
    
    
    542
    
    
    
    1,358Other current obligations
    
    
    28
    
    
    
    124Total current liabilities
    
    
    48,194
    
    
    
    55,405Long-term obligations
    
    
    3,472
    
    
    
    3,366Convertible subordinated notes
    
    
    65,081
    
    
    
    65,081Commitments and contingenciesStockholders equity:Common stock
    
    
    76
    
    
    
    75Additional paid in capital
    
    
    1,082,770
    
    
    
    1,082,036Accumulated deficit
    
    
    (997,807
    )
    
    
    (987,560
    )Deferred compensation
    
    
    
    
    
    
    (22
    )Treasury stock, at cost
    
    
    (773
    )
    
    
    (773
    )Accumulated other comprehensive loss
    
    
    (2,441
    )
    
    
    (2,368
    )Total stockholders equity
    
    
    81,825
    
    
    
    91,388Total liabilities and stockholders equity
    
    $
    198,572
    
    
    $
    215,240
 See accompanying notes. 3




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TERAYON COMMUNICATION SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited) Three Months EndedMarch 31,2004
    
    2003Revenues
    
    $
    40,988
    
    
    $
    20,057Related party revenues
    
    
    180
    
    
    
    2,211Total revenues
    
    
    41,168
    
    
    
    22,268Cost of revenues
    
    
    27,917
    
    
    
    18,511Cost of related party revenues
    
    
    854
    
    
    
    1,082Total cost of revenues
    
    
    28,771
    
    
    
    19,593Gross profit
    
    
    12,397
    
    
    
    2,675Operating expenses:Research and development
    
    
    9,467
    
    
    
    13,002Sales and marketing
    
    
    7,221
    
    
    
    6,729General and administrative
    
    
    2,436
    
    
    
    3,727Restructuring costs and asset write-offs
    
    
    3,367
    
    
    
    3,162Total operating expenses
    
    
    22,491
    
    
    
    26,620Loss from operations
    
    
    (10,094
    )
    
    
    (23,945
    )Interest income
    
    
    452
    
    
    
    902Interest expense
    
    
    (819
    )
    
    
    (837
    )Other income (expense)
    
    
    280
    
    
    
    (40
    )Loss before income tax expense
    
    
    (10,181
    )
    
    
    (23,920
    )Income tax expense
    
    
    (66
    )
    
    
    (69
    )Net loss
    
    $
    (10,247
    )
    
    $
    (23,989
    )Net loss per share, basic and diluted
    
    $
    (0.14
    )
    
    $
    (0.33
    )Shares used in per share calculation, basic and diluted
    
    
    75,516
    
    
    
    73,710
 See accompanying notes. 4




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TERAYON COMMUNICATION SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited) Three Months EndedMarch 31,2004
    
    2003Operating activities:Net loss
    
    $
    (10,247
    )
    
    $
    (23,989
    )Adjustments to reconcile net loss to net cash used in
operating activities:Depreciation
    
    
    1,842
    
    
    
    2,663Amortization related to stock options
    
    
    17
    
    
    
    4Lower of cost or market inventory provision
    
    
    623
    
    
    
    19Write-off and disposal of fixed assets
    
    
    124
    
    
    
    468Changes in operating assets and liabilities:Accounts receivable
    
    
    385
    
    
    
    483Accounts receivable from related parties
    
    
    373
    
    
    
    (969
    )Inventory
    
    
    (3,526
    )
    
    
    3,039Other current and non-current assets
    
    
    2,334
    
    
    
    3,212Accounts payable
    
    
    (4,687
    )
    
    
    (3,331
    )Accrued payroll and related expenses
    
    
    (1,465
    )
    
    
    (1,077
    )Deferred revenues
    
    
    1,028
    
    
    
    (8
    )Accrued warranty
    
    
    (904
    )
    
    
    (920
    )Accrued restructuring
    
    
    2,098
    
    
    
    216Accrued vendor cancellation charges
    
    
    (1,470
    )
    
    
    (4,618
    )Other accrued liabilities
    
    
    (1,655
    )
    
    
    (1,413
    )Interest payable
    
    
    
    
    
    
    (628
    )Net cash used in operating activities
    
    
    (15,130
    )
    
    
    (26,849
    )Investing activities:Purchases of short-term investments
    
    
    (39,997
    )
    
    
    (35,308
    )Proceeds from sales and maturities of short-term investments
    
    
    101,301
    
    
    
    42,393Purchases of property and equipment
    
    
    (916
    )
    
    
    (666
    )Net cash provided by investing activities
    
    
    60,388
    
    
    
    6,419Financing activities:Principal payments on capital leases
    
    
    (50
    )
    
    
    (47
    )Proceeds from issuance of common stock
    
    
    740
    
    
    
    621Net cash provided by financing activities
    
    
    690
    
    
    
    574Effect of exchange rate changes
    
    
    (76
    )
    
    
    31Net increase (decrease) in cash and cash equivalents
    
    
    45,872
    
    
    
    (19,825
    )Cash and cash equivalents at beginning of period
    
    
    30,188
    
    
    
    117,079Cash and cash equivalents at end of period
    
    $
    76,060
    
    
    $
    97,254
 See accompanying notes. 5




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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 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 March 31, 2004 and for the three months ended March 31, 2004 and
2003 have been included. Results for the three months ended March 31, 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 restructuring
reserves. 6




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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 endedMarch 31,2004
    
    2003Net loss, as reported
    
    $
    (10,247
    )
    
    $
    (23,989
    )Add:
    
    Stock-based compensation under APB 25
    
    
    17
    
    
    
    4Deduct:
    
    Stock option compensation expense
determined under fair value-based method
    
    
    (4,509
    )
    
    
    (6,173
    )Employee stock purchase plan
compensation expense determined under
fair value-based method
    
    
    (357
    )
    
    
    (979
    )Pro forma net loss
    
    $
    (15,096
    )
    
    $
    (31,137
    )Pro forma net loss per share, basic and diluted
    
    $
    (0.20
    )
    
    $
    (0.42
    )Shares used in computing pro forma net loss per
share, basic and diluted
    
    
    75,516
    
    
    
    73,710
 Inventory Inventory is stated at the lower of cost (first-in, first-out) or market.
The components of inventory are as follows (in thousands): March 31,
    
    December 31,2004
    
    2003Raw materials
    
    $
    1,820
    
    
    $
    1,440Work-in-process
    
    
    726
    
    
    
    660Finished goods
    
    
    16,721
    
    
    
    14,264$
    19,267
    
    
    $
    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 goods and services and
require the Company to purchase minimum quantities of the suppliers products
at a specified price. As of March 31, 2004, $32.1 million of purchase
obligations were outstanding. The Company accrued for vendor cancellation
charges in amounts, which represented managements estimate of the Companys
exposure to vendors for its inventory commitments. At March 31, 2004, accrued
vendor 7




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cancellation charges were $1.4 million and the remaining $30.7 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 months ended March 31, 2004 and March 31, 2003, the Company
reversed approximately $1.3 million and $2.3 million, respectively of accrued
vendor cancellation, which was previously recorded as cost of goods sold.
Additionally, during the three months ended March 31, 2004 and March 31, 2003,
the Company reversed approximately $0.5 million and $0.6 million, respectively
of inventory provisions, which were previously recorded as cost of goods sold.
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 EndedMarch 31,2004
    
    2003Net loss
    
    $
    (10,247
    )
    
    $
    (23,989
    )Shares used in computing basic and diluted
net loss per share
    
    
    75,516
    
    
    
    73,710Basic and diluted net loss per share
    
    $
    (0.14
    )
    
    $
    (0.33
    )
 Options to purchase 16,527,067 and 13,594,894 shares of common stock were
outstanding at March 31, 2004 and March 31, 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 consists 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 EndedMarch 31,2004
    
    2003Net loss
    
    $
    (10,247
    )
    
    $
    (23,989
    )Cumulative translation adjustments
    
    
    (76
    )
    
    
    30Change in unrealized gain (loss) on available-for-sale investments
    
    
    3
    
    
    
    (223
    )Total comprehensive net loss
    
    $
    (10,320
    )
    
    $
    (24,182
    )
 8




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Impact of Recently Issued Accounting Standards In January 2003, the 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, which 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 fiscal
2005 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 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. The matter is now under
submission. 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, 9




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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. 3. Operating Segment Information The Company operates as one business segment. (in thousands)
    
    Three months endedMarch 31,2004
    
    2003Revenues by product:CPE products
    
    $
    23,776
    
    
    $
    13,665CMTS products
    
    
    11,135
    
    
    
    4,518Video products
    
    
    6,071
    
    
    
    2,833Other products
    
    
    186
    
    
    
    1,252Total revenues
    
    $
    41,168
    
    
    $
    22,268Revenues by geographic areas:United States
    
    $
    21,832
    
    
    $
    13,048Canada
    
    
    1,614
    
    
    
    2,595Europe, Middle East,
Africa Region (EMEA),excluding Israel
    
    
    7,924
    
    
    
    2,522Israel
    
    
    3,284
    
    
    
    343Japan
    
    
    2,394
    
    
    
    3,135Asia, excluding Japan
    
    
    4,095
    
    
    
    625South America
    
    
    25
    
    
    
    Total
    
    $
    41,168
    
    
    $
    22,268
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March 31,
    
    December 31,2004
    
    2003Long-lived assets:United States
    
    $
    18,080
    
    
    $
    19,630Canada
    
    
    705
    
    
    
    810Europe
    
    
    155
    
    
    
    175Israel
    
    
    3,415
    
    
    
    3,104Asia
    
    
    75
    
    
    
    173Total long-lived assets
    
    
    22,430
    
    
    
    23,892Total current assets
    
    
    176,142
    
    
    
    191,348Total assets
    
    $
    198,572
    
    
    $
    215,240
 One customer accounted for 10% or more of total revenues (24%) for the
three months ended March 31, 2004. Three customers accounted for 10% or more
of total revenues (26%, 14%, and 10%) for the three months ended March 31,
2003. No other customer accounted for more than 10% of revenues during these
periods. 4. Restructuring Charges and Asset Write-offs Restructuring First Quarter 2004 Restructuring During the first quarter of 2004, a restructuring plan was approved to
continue to conform expenses to revenue levels and to better position the
Company for future growth and eventual profitability. The Company 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 costs to exit an
aircraft lease, and $1.4 million related to costs for excess leased facilities.
Net costs accrued under this restructuring plan, assumes estimated sublease
income related to the aircraft and the excess leased facilities. As of March
31, 2004, the employment of 57 employees had been terminated, and the Company
had paid $0.7 million in termination costs. The amount of net
costs accrued under the 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 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 facility 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 will periodically re-evaluate and adjust the reserve, as necessary. As
of March 31, 2004, the Company paid $0.2 million of costs related to the
aircraft lease. The Company currently anticipates the remaining restructuring
accrual related to employee termination costs to be substantially utilized in
the second quarter 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. A summary of the first quarter 2004 accrued restructuring charges is as
follows (in thousands): Involuntary
    
    Aircraft Lease
    
    Excess LeasedTerminations
    
    Termination
    
    Facilities
    
    TotalTotal charge
    
    $
    952
    
    
    $
    934
    
    
    $
    1,375
    
    
    $
    3,261Cash payments
    
    
    (693
    )
    
    
    (153
    )
    
    
    
    
    
    
    (846
    )Balance at March 31, 2004
    
    $
    259
    
    
    $
    781
    
    
    $
    1,375
    
    
    $
    2,415
 11




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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 Restructuring During 2001, a restructuring plan was approved and the Company incurred
restructuring charges in the amount of $12.7 million of which $2.9 million
remained accrued at March 31, 2004, all of which related to costs 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 March 31, 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
    
    
    (317
    )Balance at March 31, 2004
    
    $
    4,183
 Asset Write-offs For the three months ended March 31, 2004 and March 31, 2003, the Company
wrote off $0.1 million and $0.5 million, respectively, of fixed assets, which
were determined to have no remaining useful life. 5. Related Party Transactions Lewis Solomon, a member of the Companys Board of Directors and a member
of the Companys Audit 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 months ended March 31, 2004 and March 31, 2003, related party revenue
included $0.2 million and $0.4 million, respectively, of revenue from Harmonic. Alek Krstajic, a member of the Companys Board of Directors and Audit
Committee, 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. In the three months ended March 31, 2003,
the Company recognized $1.8 million of Rogerss related party revenue, net of
amortization of co-marketing expense. In the first quarter of 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 assets 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. The
Company charged approximately $0.15 million to related party revenues in 12




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the three months ended March 31, 2003, and no amount was recorded in the
three months ended March 31, 2004. Cost of related party revenues in the Companys consolidated statements of
operations consists of direct and indirect costs. Accounts receivable from
Harmonic totaled approximately $0.2 million at March 31,
2003 and 2004. None of the
related parties is a supplier to the Company. 6. Product Warranties The Company provides for estimated product warranty expenses when it sells
the related products. Because warranty estimates are forecasts that are 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 three months ended March 31, 2003 and
2004, is as follows (in thousands): Charges forBalance at
    
    Additions
    
    Expiration of
    
    Warranty
    
    Balance atBeginning of
    
    charged to
    
    accrued
    
    Services
    
    End ofPeriod
    
    expenses
    
    warranty
    
    Provided
    
    PeriodQuarter ended March 31, 2003
Warranty reserve
    
    $
    8,607
    
    
    
    243
    
    
    
    0
    
    
    
    (1,163
    )
    
    $
    7,687Quarter ended March 31, 2004
Warranty reserve
    
    $
    5,509
    
    
    
    1,076
    
    
    
    (835
    )
    
    
    (1,145
    )
    
    $
    4,605
 7. Subsequent Events 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
total of approximately $150,000. In connection with this purchase, the
acquirer received selected assets, liabilities, and inventories related to
these subsidiaries. The Company currently expects to record a gain on this
transaction in the second quarter of 2004. During the second quarter of 2004, the Company further consolidated
certain leased facilities. In connection with this consolidation, the Company
will seek to sublease additional space in its Santa Clara, California facility
and record additional restructuring charges of approximately $1.5 million to
$2.0 million. 13




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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
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. We also largely completed our transition to a
new Original Design Manufacturer (ODM) in Asia during the first quarter of 2004
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. We had a net loss of
$10.2 million or $0.14 per share for the quarter ended March 31, 2004. 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 currently 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. At March 31, 2004, we had approximately $123.2 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 14




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quarter 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. Critical Accounting Policies There have been no material changes to any other of our critical
accounting policies and estimates as disclosed in our report on Form 10-K for
the year ended December 31, 2003. Results of Operations Three Months Ended March 31, 2004 Revenues (in thousands) For the three months
    
    % Change for the threeended
    
    months endedMarch 31,
    
    March 31,2004
    
    2003
    
    2004/2003Revenues
    
    $
    41,168
    
    
    $
    22,268
    
    
    
    85
    %
 We sell directly to broadband service providers, and to a lesser extent
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 85% to $41.2 million for the quarter ended March
31, 2004 compared to $22.3 million in the quarter ended March 31, 2003,
primarily due to increased sales of our DOCSIS modems and Video products, as
well as increased deployments of our CMTSs by cable operators, slightly offset
by declining sales of our proprietary S-CDMA products. 15




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Revenues by Groups of Similar Products (in thousands)
    
    For the three months
    
    % Change for theended
    
    three months endedMarch 31,
    
    March 31,2004
    
    2003
    
    2004/2003Revenues by product:CPE products
    
    $
    23,776
    
    
    $
    13,665
    
    
    
    74
    %CMTS products
    
    
    11,135
    
    
    
    4,518
    
    
    
    146
    %Video products
    
    
    6,071
    
    
    
    2,833
    
    
    
    114
    %Other products
    
    
    186
    
    
    
    1,252
    
    
    
    (85
    %)Total revenues
    
    $
    41,168
    
    
    $
    22,268
    
    
    
    85
    %
 CPE revenues increased 74% for the quarter ended March 31, 2004 compared
to the quarter ended March 31, 2003, due to an increase in modem sales and an
increase in sales of our legacy circuit switch voice product into Europe. The
number of DOCSIS modems sold increased from approximately 0.2 million units in
the first quarter of 2003 to approximately 0.5 million units in the first
quarter of 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 completed in the first quarter of 2004,
and the introduction of our new lower cost modem semiconductor may allow us to
remain competitive in the marketplace and maintain favorable margins on these
products. CMTS revenues increased 146% for the quarter ended March 31, 2004 compared
to the quarter ended March 31, 2003, due to increased deployment of our DOCSIS
products into new markets, primarily in the U.S. We currently expect CMTS revenues to
continue to increase in 2004 as we generate additional revenues from existing
customers, acquire new customers in Asia and the Europe, Middle East, Africa
(EMEA) regions, and increase the amount of sales into second and third
tier North American based Multiple System Operators (MSOs). Revenues from Video products increased 114% for the quarter ended March
31, 2004 compared to the quarter ended March 31, 2003, due to increased sales
to United States MSOs of our DM 6400 Cherrypicker Video product. We are very encouraged by the
prospects for the Video business to grow and currently believe that we will continue to
see increased sales of Video products as demand for high definition television
(HDTV) and other digital video services, including digital ad insertion, grows
in 2004. Other revenues decreased 85% for the quarter ended March 31, 2004 compared
to the quarter ended March 31, 2003, due to decreased sales of our legacy
Telecom products. We expect sales of Telecom products to be minimal in 2004. Revenues by Geographic Region % Change for the(in thousands)
    
    For the three months ended
    
    three months endedMarch 31,
    
    March 31,2004
    
    2003
    
    2004/2003Revenues by geographic areas:United States
    
    $
    21,832
    
    
    $
    13,048
    
    
    
    67
    %Canada
    
    
    1,614
    
    
    
    2,595
    
    
    
    (38
    %)Europe, Middle East,
Africa Region (EMEA),
excluding Israel
    
    
    7,924
    
    
    
    2,522
    
    
    
    214
    %Israel
    
    
    3,284
    
    
    
    343
    
    
    
    857
    %Japan
    
    
    2,394
    
    
    
    3,135
    
    
    
    (24
    %)Asia, excluding Japan
    
    
    4,095
    
    
    
    625
    
    
    
    555
    %South America
    
    
    25
    
    
    
    
    
    
    
    Total
    
    $
    41,168
    
    
    $
    22,268
    
    
    
    85
    %
 Revenues in the United States increased 67% to $21.8 million in the first
quarter of 2004, up from $13.0 million in the first quarter of 2003, due to
increased sales of DOCSIS 2.0 CMTSs and modems as well as video products to
United States MSOs. Revenues in the EMEA, Israel, and Asia, excluding Japan 16




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regions also increased in the same period due to increased sales of DOCSIS
2.0 CMTSs products. During the first quarter of 2004, we continued to
emphasize sales to our United States, EMEA, and other Asian customers while
placing a lower emphasis on other locations such as Canada and South America.
In 2004, we currently expect revenues to continue to increase in the United States, Asian
and EMEA markets. One customer accounted for 10% or more of total revenues
(24%) for the three months ended March 31, 2004. Three customers accounted for
10% or more of total revenues (26%, 14%, and 10%) for the three months ended
March 31, 2003. No other customer accounted for more than 10% of revenues
during these periods. Related Party Revenues % Change for the(in thousands)
    
    For the three months ended
    
    three months endedMarch 31,
    
    March 31,2004
    
    2003
    
    2004/2003Related party revenues:Harmonic revenues
    
    $
    180
    
    
    $
    379
    
    
    
    (53
    %)Rogers revenues
    
    
    
    
    
    
    1,832
    
    
    
    Total related party revenues
    
    $
    180
    
    
    $
    2,211
    
    
    
    (92
    %)
 Related party revenues decreased 92% in the first quarter of 2004,
compared to the first quarter of 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 related party revenues in the first quarter of 2003. Lewis
Solomon, another member of our board of directors, is a member of the board of
directors of Harmonic. All revenues attributable to Harmonic were included in
related party revenues in the first quarter of 2004 and 2003. The decline in
related party revenues was also due to a decrease of sales of our Video
products to Harmonic in the first quarter of 2004 as compared to the same
period 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. The amount charged
against total revenues in the three months ended March 31, 2003, totaled
approximately $0.15 million. No further amounts of this co-marketing
arrangement are 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 % Change for the(in thousands)
    
    For the three months ended
    
    three months endedMarch 31,
    
    March 31,2004
    
    2003
    
    2004/2003Cost of revenues
    
    $
    27,917
    
    
    $
    18,511
    
    
    
    51
    %Cost of related party revenues
    
    
    854
    
    
    
    1,082
    
    
    
    (21
    )%Total cost of goods sold
    
    $
    28,771
    
    
    $
    19,593
    
    
    
    47
    %Gross profit
    
    $
    12,397
    
    
    $
    2,675
    
    
    
    363
    %
 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 first quarter of 2004, cost
of goods sold was approximately 70% of revenues compared to 88% of revenues in
the first quarter of 17




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2003. Cost of goods sold for the three months ended March 31, 2004 and
March 31, 2003 included the benefit of reversals of approximately $1.8 million
and $2.9 million, respectively, of inventory provisions, which were previously
recorded as cost of goods sold. We reversed these provisions as we were able to
sell inventory originally considered to be in excess and obsolete. In
addition, we were able to negotiate downward certain vendor cancellation claims
to terms more favorable to us. In the first quarter of 2004, related party cost of revenues decreased
compared to the first quarter of 2003 due to lower sales of our Video products
to Harmonic in the first quarter of 2004 as well as classification of cost of
revenues to Rogers as related party cost of sales in the first quarter of 2003. Our gross profit increased 363% to $12.4 million or 30% of sales in the
quarter ended March 31, 2004 compared to $2.7 million, or 12% of sales in the
same period in 2003. The increase in our gross profit was primarily related to
an increase in revenues during this period, an improved sales mix, higher
margin video and CMTS products constituting a higher proportion of sales, and
lower product manufacturing costs for modems. 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 % Change for the(in thousands)
    
    For the three months ended
    
    three months endedMarch 31,
    
    March 31,2004
    
    2003
    
    2004/2003Research and development
    
    $
    9,467
    
    
    $
    13,002
    
    
    
    (27
    %)Sales and marketing
    
    $
    7,221
    
    
    $
    6,729
    
    
    
    7
    %General and administrative
    
    $
    2,436
    
    
    $
    3,727
    
    
    
    (35
    %)
 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 27% to $9.5 million or 23% of sales in the first
quarter of 2004 from $13.0 million or 58% of sales in the same period in 2003.
The $3.5 million decrease in research and development expenses was attributable
to $1.2 million of reductions in employee related expenses. The decrease in
research and development expenses also included reductions of $0.3 million of
outside engineering consultants and $2.0 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 18




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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 increased by $0.5 million to $7.2 million or 18% of sales in
the first quarter of 2004 from $6.7 million or 30% of sales in the same period
in 2003. The increase in sales and marketing expenses was primarily due to
$0.3 million in increased employee expenses due to increased headcount. The
increase in sales and marketing expenses also included $0.4 million of
increased spending for outside consultants, $0.1 million of increased travel
costs, partially offset by $0.3 million of overall sales and marketing cost
reductions. We currently expect sales and marketing expenses to continue to
increase in 2004 as we recruit additional sales and marketing personnel to sell
our higher margin Video products. 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. General
and administrative expenses decreased by $1.3 million to $2.4 million or 6% of
sales in the quarter ended March 31, 2004 from $3.7 million or 17% of sales in
the same period in 2003. The decrease was primarily due to $0.7 million in
reduced employee expenses due to lower headcount including $0.3 million of
severance expense in the first quarter of 2003 related to the termination of an
executive officer, $0.7 million of overall general and administrative cost
decreases, partially offset by $0.1 million of increased spending for outside
consultants. In connection with our worldwide restructuring plans in the first
and second quarters of 2004, we currently expect general and administrative
expenses to be lower than in 2003. Restructuring Costs and Asset Write-offs (in thousands)
    
    For the three monthsMarch 31,2004
    
    2003Restructuring charges
    
    $
    3,261
    
    
    $
    2,745Long-lived assets written-off
    
    
    106
    
    
    
    417Restructuring costs and asset write-offs
    
    $
    3,367
    
    
    $
    3,162
 Restructuring
Costs.During the first quarter of 2004, we initiated a
restructuring plan. 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. As of March 31, 2004, the employment of
57 employees had been terminated, and we paid $0.7 million in termination costs
and $0.2 million of costs related to the aircraft lease. We anticipate the
remaining restructuring accrual related to employee termination costs to be
substantially utilized in the second quarter of 2004. The remaining
restructuring accrual related to the aircraft lease is expected to be
substantially utilized for servicing operating lease payments or negotiated
buyout 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 or negotiating a buyout of
operating lease commitments, through October 2009. 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 them, which is based on information
provided 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 periodically re-evaluate and adjust the reserve,
as necessary. 19




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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. In the
second and third quarter of 2003, we reversed $0.1 million of previously
accrued termination costs related to this restructuring. At March 31, 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 March 31, 2004, restructuring charges of $1.2 million remained
accrued. As of March 31, 2004, the employment of 153 employees had been
terminated, and we paid $2.2 million in termination costs and $0.2 million in
excess facility costs. We currently anticipate the remaining restructuring
accrual, primarily relating to excess leased facilities, will be utilized for
servicing operating lease payments or negotiating a buyout of operating lease
commitments, through 2005. In 2001 we incurred restructuring charges of $12.7 million. Of the total
restructuring charges recorded, $3.2 million related to employee termination
costs covering 293 technical, production, and administrative employees. The
remaining $9.5 million of restructuring charges related primarily to costs for
excess leased facilities. As of March 31, 2004, restructuring charges of $2.9
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-offs.For the three months ended March 31, 2004 and March 31,
2003, we wrote off $0.1 million and $0.5 million, respectively, of fixed
assets, which were determined to have no remaining useful life. Non-operating Expenses % Change for the(in thousands)
    
    For the three months ended
    
    three months endedMarch 31,
    
    March 31,2004
    
    2003
    
    2004/2003Interest income
    
    $
    452
    
    
    $
    902
    
    
    
    (50
    %)Interest expense
    
    $
    (819
    )
    
    $
    (837
    )
    
    
    (2
    %)Other income (expense) expense.
    
    $
    280
    
    
    $
    (40
    )
    
    
    (800
    %)
 Interest Income. Interest income decreased 50% to $0.5 million in the
first quarter of 2004 compared to $0.9 million in the same period in 2003. The
decrease in interest income 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 first quarter of 2004 compared to the same period in 2003 as no
Notes were repurchased in 2003 or 2004. Other Income (Expense).Other income (expense) is generally comprised of
realization of foreign currency translations and realized gains or losses on
investments. Other income increased to $0.3 million in the first quarter of
2004 compared to the same period in 2003, primarily due to a gain on the sale
of inventory to Verilink, Inc. in 2004. Income Taxes (in thousands)
    
    For the three monthsMarch 31,2004
    
    2003Income tax expense
    
    $
    (66
    )
    
    $
    (69
    )
 20




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We have generated losses since our inception. In the first quarter of
2004 and 2003, we recorded an income tax expense related primarily to foreign
taxes. Litigation Beginning in April 2000, several plaintiffs filed class action lawsuits in
federal court against us and certain of our officers and directors. Later that
year, the cases were consolidated in the United States District Court, Northern
District of California as In re Terayon Communication Systems, Inc. Securities
Litigation. The Court then appointed lead plaintiffs who filed an amended
complaint. In 2001, the Court granted in part and denied in part defendants
motion to dismiss, and plaintiffs filed a new complaint. In 2002, the Court
denied defendants motion to dismiss that complaint, which, like the earlier
complaints, alleges that the defendants violated the federal securities laws by
issuing materially false and misleading statements and failing to disclose
material information regarding our technology. On February 24, 2003, 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. The matter is now under submission. We believe that the allegations in both the class action and the Bertram
case 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. 21




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##### 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 March 31, 2004, we had approximately $76.1 million in cash and cash
equivalents and $47.2 million in short-term investments. Cash used in operating activities for the quarter ended March 31, 2004 was
$15.1 million compared to $26.8 million used in the same period in 2003. In the
first quarter of 2004, significant uses of cash from operating activities
included $10.2 million loss from operations, $4.7 million decrease in accounts
payable, and $4.7 million of increase in gross inventory. Inventory levels
increased at March 31, 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 quarter ended March 31, 2003, significant uses of cash
from operating activities included a $24.0 million loss from operations, and a
$4.6 million decrease in vendor cancellation reserves as we paid down these
obligations, partially offset by a $3.2 million decrease in other assets, and
$3.0 million decrease in inventory. Cash provided by investing activities for the quarter ended March 31, 2004
was $60.4 million compared to cash provided by investing activities of $6.4
million in the same period in 2003. Investing activities consisted primarily of
net purchases and sales of short-term investments in the first quarter of 2004
and 2003. Cash provided by investing activities increased in the first quarter
of 2004 and 2003 due to movement of short-term investments to cash and cash
equivalents to fund operations. Cash provided by financing activities was $0.7 million in the first
quarter of 2004 compared to $0.6 million in the same period in 2003 primarily
due to proceeds from the exercise of stock options and the sale of shares of
common stock through our Employee Stock Purchase Plan. We did not repurchase
any Notes in 2003 or 2004. 22




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##### Table of Contents



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 $15.6 million. Through March 31, 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 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 restructurings
plan, which resulted in a reduction in workforce, consolidation of certain
facilities, and reduction or elimination of discretionary costs and programs.
We expect to record total charges in the range of approximately $5.0 million to
$5.5 million associated with these realignments. 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 March 31, 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
    
    yearsCapital Lease Obligations
    
    $
    0.1
    
    
    $
    0.1
    
    
    $
    
    
    
    $
    
    
    
    $
    Unconditional Purchase Obligations
    
    
    32.1
    
    
    
    32.1
    
    
    
    
    
    
    
    
    
    
    
    Long Term Debt
    
    
    68.4
    
    
    
    
    
    
    
    1.6
    
    
    
    65.1
    
    
    
    1.7Operating Lease Obligations
    
    
    23.6
    
    
    
    6.7
    
    
    
    9.0
    
    
    
    6.1
    
    
    
    1.8Aircraft Lease
    
    
    4.2
    
    
    
    1.5
    
    
    
    2.7
    
    
    
    
    
    
    
    Total Contractual Commitments
    
    $
    128.4
    
    
    $
    40.4
    
    
    $
    13.3
    
    
    $
    71.2
    
    
    $
    3.5
 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 March 31, 2004, we had approximately $32.1 million of purchase
obligations, of which $1.4 million is included in the Consolidated Balance
Sheets as accrued vendor 23




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cancellation charges, and the
remaining $30.7 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 March 31, 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 March 31, 2004, we had an
accumulated deficit of $997.8 million. We believe that we will continue to
experience 24




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##### 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 $10.2 million in the
first quarter of 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, cash equivalents and short term investments used in the first
quarter of 2004 was $15.4 million as compared to $27.1 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. 25




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##### 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 March 31, 2004, $32.1
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 quarter 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. For example, one customer accounted for more than 10% of our total
revenues for the quarter ended March 31, 2004 (24%). Three customers accounted
for more than 10% of our total revenues for the quarter ended March 31, 2003
(26%, 14%, 10%). 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. 26




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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. 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 27




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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. 28




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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, 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. 29




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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. 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 30




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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 $32.1 million as of
March 31, 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, we paid for the amount insured
under the Reliance policy, which was $2.5 million. We are dependent on key third-party suppliers and any failure by them to
deliver components could limit our ability to satisfy customer demand. We manufacture all of our products using components or subassemblies
procured from third-party suppliers, including semiconductors. Some of these
components are available from a sole source and others are available from
limited sources. A majority of our sales are from products containing one or
more components that are available only from sole source suppliers.
Additionally, some of our components are custom parts that are produced to our
specifications, and it may be difficult to move the manufacturing of such
components from one vendor to another vendor. Any interruption in the operations of our vendors of sole source or custom
product parts could adversely affect our ability to meet our scheduled product
deliveries to customers. If we are unable to obtain a sufficient supply of
components, including semiconductors, from our current sources, we could
experience difficulties in obtaining alternative sources or in altering product
designs to use alternative components. Resulting delays or reductions in
product shipments could damage customer relationships and expose us to
potential damages that may arise from our inability to supply our customers
with products. Further, a significant increase in the price of one or more of
these components, such as our semiconductor 31




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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 quarters ended March 31, 2004 and March 31, 2003, approximately 47% 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. 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 32




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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 $3.5 million
and $0.8 million for the quarters ending March 31, 2004 and March 31, 2003,
respectively. Our research and development operations may be significantly
affected by conditions in Israel. Since the establishment of the State of
Israel in 1948, a number of armed conflicts have taken place between Israel and
its Arab neighbors and a state of hostility, varying in degree and intensity,
has led to security and economic problems for Israel. Hostilities within
Israel have continued over the past year, which could disrupt some of our
operations. We could be adversely affected by any major hostilities involving
Israel. As a result of the hostilities and unrest presently occurring within
Israel, the future of the peace efforts between Israel and its Arab neighbors
is uncertain. A number of our employees based in Israel are currently
obligated to perform annual military reserve duty and are subject to being
called to active duty at any time under emergency circumstances. We cannot
assess the full impact of these requirements and the hostilities on our
workforce, business or operations if conditions should change, and we cannot
predict the effect of any expansion or reduction of these obligations or the
hostilities. We may be unable to provide adequate customer support. Our ability to achieve our planned sales growth and retain current and
future customers will depend in part upon the quality of our customer support
operations. Our customers generally require significant support and training
with respect to our products, particularly in the initial deployment and
implementation stages. Spikes in demand of our support services may cause us
to be unable to serve our customers. We may not have adequate personnel to
provide the levels of support that our customers may require during initial
product deployment or on an ongoing basis especially during peak periods. Our
inability to provide sufficient support to our customers could delay or prevent
the successful deployment of our products. In addition, our failure to provide
adequate support could harm our reputation and relationships with our customers
and could prevent us from selling product to existing customers or gaining new
customers. The deployment process for our equipment may be lengthy and may delay the
receipt of new orders and cause fluctuations in our revenues. The timing of deployment of our equipment can be subject to a number of other
risks, including the availability of skilled engineering and technical
personnel, the availability of other equipment such as fiber optic cable, and
the need for local zoning and licensing approvals. We believe that changes in
our customers deployment plans have delayed, and may in the future delay, the
receipt of new orders. Since the majority of our sales have been to relatively
few customers, a delay in equipment deployment with any one customer has in the
past had, and could in the future, have a material adverse effect on our sales
for a particular quarter. 33




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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 the 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 disrupt and be harmful to our business. In addition, if we are unable to hire qualified
personnel as needed, 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 be unable to
continue to attract and retain qualified personnel necessary for the
development of our business. We do not have key person insurance coverage for
the loss of any of our employees. Any officer or employee can terminate his or
her relationship with us at any time. Our employees are not bound by
non-competition agreements with us. Additionally, turnover in personnel and the recruitment and retention of a
new executive staff, if necessary, could create a number of 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 34




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willingness to buy products from us and adversely affect market acceptance
or perception of our products. Any such errors or delays in releasing new
products or new versions of products or allegations of unsatisfactory
performance could cause us to lose revenue or market share, increase our
service costs, cause us to incur substantial costs in redesigning the products,
subject us to liability for damages and divert our resources from other tasks,
any one of which could materially and adversely affect our business, results of
operations and financial condition. Although we have limitation of liability
provisions in our standard terms and conditions of sale, they may not be
effective as a result of federal, state or local laws or ordinances or
unfavorable judicial decisions in the United States or other countries. The
sale and support of our products also entails the risk of product liability
claims. We maintain insurance to protect against certain claims associated
with the use of our products, but our insurance coverage may not adequately
cover any claim asserted against us. In addition, even claims that ultimately
are unsuccessful could result in our expenditure of funds in litigation and
divert managements time and other resources. We may be unable to adequately protect or enforce our intellectual property rights. We rely on a combination of patent, trade secret, copyright and trademark
laws and contractual restrictions to establish and protect proprietary rights
in our products. Even though we seek to establish and protect proprietary
rights in our products, there are risks. We cannot be assured that any patent,
trademark, copyright or other intellectual property rights owned by us will not
be invalidated, circumvented or challenged, that such intellectual property
rights will provide competitive advantages to us or that any of our pending or
future patent applications will be issued with the scope of the claims sought
by us, if at all. We cannot be assured that others will not develop
technologies that are similar or superior to our technology, duplicate our
technology or design around the patents that we own. In addition, effective
patent, copyright and trade secret protection may be unavailable or limited in
certain foreign countries in which we do business or may do business in the
future. Our pending patent applications may not be granted. Even if they are
granted, the claims covered by any patent may be reduced from those included in
our applications. Any patent might be subject to challenge in court and,
whether or not challenged, might not be broad enough to prevent third parties
from developing equivalent technologies or products without a license from us. We believe that the future success of our business will depend on our
ability to translate the technological expertise and innovation of our
employees into new and enhanced products. We have entered into confidentiality
and invention assignment agreements with our employees, and we enter into
non-disclosure agreements with many of our suppliers, distributors and
appropriate customers so as to limit access to and disclosure of our
proprietary information. These contractual arrangements, as well as statutory
protections, may not prove sufficient to prevent misappropriation of our trade
secrets or technology or deter independent third-party development of similar
technologies. In addition, the laws of 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. 35




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We pursue the registration of our trademarks in the United States and have
applications pending to register several of our trademarks throughout the
world. However, the laws of certain foreign countries might not protect our
products or intellectual property rights to the same extent as the laws of the
United States. Effective trademark, copyright, trade secret and patent
protection may not be available in every country in which our products may be
manufactured, marketed or sold. Third party claims of infringement or other claims against us could adversely
affect our ability to market our products, require us to redesign our products
or seek licenses from third parties, and seriously harm our operating results
and disrupt our business. As is typical in the industry in which we operate, we have been and may
from time to time be notified of claims that we may be infringing intellectual
property rights owned by third parties. We also have in the past agreed to,
and may from time to time in the future agree to, indemnify a customer of our
technology or products for claims against the customer by a third party based
on claims that our technology or products infringe patents of that third party.
We further believe that companies may be increasingly subject to infringement
claims as distressed companies and individuals attempt to generate cash by
enforcing their patent portfolio against a wide range of products. These types
of claims, meritorious or not, can result in costly and time-consuming
litigation; divert managements attention and other resources; require us to
enter into royalty arrangements; subject us to damages or injunctions
restricting the sale of our products, require us to indemnify our customers for
the use of the allegedly infringing products; require us to refund payment of
allegedly infringing products to our customers or to forgo future payments;
require us to redesign certain of our products; or damage our reputation. Our
failure to obtain a license for key intellectual property rights from a third
party for technology used by us could cause us to incur substantial liabilities
and to suspend the manufacturing of products utilizing the technology.
Alternatively, we could be required to expend significant resources to develop
non-infringing technology with no assurances that we would be successful in
such endeavors. The occurrence of any of the above events could materially and
adversely affect our business, results of operations and financial condition. Our indebtedness could adversely affect our financial condition; we may incur
substantially more debt. As of March 31, 2004, we had approximately $68.6 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
$123.2 million at March 31, 2004, from $138.6 million at December 31, 2003. If
our operating losses are more 36




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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 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 quarter of 2004,
which has resulted in personnel reduction. These reductions 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. Our employees are
not bound by non-competition agreements with us. Additionally, we may face
wrongful termination, discrimination, or other claims from employees affected
by the reduction related to their employment and termination. We could incur
substantial costs in defending ourselves or our employees against such claims,
regardless of the merits of such actions. Furthermore, such matters could
divert the attention of our employees, including management, away from our
operations, harm productivity, harm our reputation and increase our expenses.
We cannot assure you that our restructuring efforts will be successful, and we
may need to take additional restructuring efforts, including additional
personnel reduction, in the future. 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. In April 2004, we sold all of our ownership in Radwiz, Ltd., Ultracom
Communications Holdings Ltd., and Combox Ltd. to a third party for a total of
approximately $150,000. In connection with this 37




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purchase, the acquirer received assets, liabilities, and inventories
related to these subsidiaries. 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. To compete successfully in the markets in which we operate, we must
design, develop, manufacture and sell new or enhanced products that provide
increasingly higher levels of performance and reliability. However, we may not
be able to successfully develop or introduce these products, if our products
are not (i) cost effective, (ii) brought to market in a timely manner, (iii) in
accordance with evolving industry standards and architecture or (iv) fail to
achieve market acceptance. There is no assurance that the technologies we are
currently developing or intend to develop will achieve feasibility, or that
even if we are successful, the developed product will be accepted by the
market. We may not be able to recover the costs of existing and future product
developments and our failure to do so may materially and adversely impact our
business, financial condition and results of operations. We are exposed to the credit risk of our customers and to credit exposures in
weakened markets, which could result in material losses. 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. 38




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We have and we may seek to expand our business through acquisitions;
acquisitions could disrupt our business operations and harm our operating
results. In order to expand our business, we may make strategic acquisitions of
other companies or certain assets. We plan to continue to evaluate
opportunities for strategic acquisitions from time to time, and may make an
acquisition at some future point. However, the current volatility in the stock
market and the current price of our common stock may adversely affect our
ability to make such acquisitions. Any acquisition that we make involves
substantial risks, including the following:  
    
    difficulties in integrating the operations, technologies,
products and personnel of an acquired company;
    
    diversion of managements attention from normal daily
operations of the business;
    
    potential difficulties in completing projects associated with
in-process research and development;
    
    difficulties in entering markets in which we have no or
limited direct prior experience and where competitors in such
markets have stronger market positions;
    
    initial dependence on unfamiliar supply chains or relatively small supply partners;
    
    insufficient revenues to offset increased expenses associated with acquisitions; and
    
    the potential loss of key employees of the acquired companies. Acquisitions may also cause us to:  
    
    issue common stock that would dilute our current stockholders percentage ownership;
    
    assume liabilities;
    
    record goodwill and non-amortizable intangible assets that
will be subject to impairment testing and potential periodic
impairment charges;
    
    incur amortization expenses related to certain intangible assets;
    
    incur large and immediate write-offs; or
    
    become subject to litigation. Mergers and acquisitions of high-technology companies are inherently
risky, and no assurance can be given that our future acquisitions will be
successful and will not materially adversely affect our business, operating
results or financial condition. Failure to manage and successfully integrate
acquisitions we make could harm our business and operating results in a
material way. Even when an acquired company has already developed and marketed
products, there can be no assurance that product enhancements will be made in a
timely fashion or that all pre-acquisition due diligence will have identified
all possible issues that might arise with respect to such products. 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 March 31, 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. 39




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We are vulnerable to earthquakes, disruptions to our power supply, labor issues
and other unexpected events. Our corporate headquarters, as well as the majority of our research and
development activities and some manufacturing operations are located in
California, an area known for seismic activity. In addition, the operations of
some of our key suppliers and manufacturers are also located in this area and
in other areas known for seismic activity, such as Taiwan. An earthquake, or
other significant natural disaster, could result in an interruption in our
business or the operations of one or more of our key suppliers. Our California
operations may also be subject to disruptions in power supply, such
as those that occurred
in 2001. Our business may also be impacted by labor issues related to our
operations and/or those of our suppliers, service providers, or customers.
Such an interruption could harm our operating results. We may not carry
sufficient business interruption insurance to compensate for any losses that we
may sustain as a result of any natural disasters or other unexpected events. Various export licensing requirements could materially and adversely affect our
business or require us to significantly modify our current business practices. Various government export regulations may apply to the encryption or other
features of our products. We may have to make certain filings with the
government in order to obtain permission to export certain of our products. In
the past, we may have inadvertently failed to file certain export applications
and notices, and we may have to make certain filings and request permission to
continue exportation of any affected products without interruption while these
applications are pending. If we do have to make such filings, we cannot assure
you that we will obtain permission to continue exporting the affected products
or that we will obtain any required export approvals now or in the future. If
we do not receive the required export approvals, we may be unable to ship those
products to certain customers located outside of the United States. In
addition, we may be subject to fines or other penalties due to the failure to
file certain export applications and notices. New laws and regulations affecting corporate governance may impede our ability
to retain and attract board members and executive officers, and increase the
costs associated with being a public company. On July 30, 2002, President George W. Bush signed into law the
Sarbanes-Oxley Act of 2002. The new act is designed to enhance corporate
responsibility through new corporate governance and disclosure obligations,
increase auditor independence, and tougher penalties for securities fraud. In
addition, the Securities and Exchange Commission and Nasdaq have adopted rules
in furtherance of the act. This act and the related new rules and regulations
will likely have the effect of increasing the complexity and cost of our
companys corporate governance and the time our executive officers spend on
such issues, and may increase the risk of personal liability for our board
members, chief executive officer, chief 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; 40




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
    
    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. 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 $90,000 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 $119,000. All of the potential changes noted above are based on sensitivity analyses
performed on our financial positions at March 31, 2004. Actual results may
differ materially. 41




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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 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 2002.31.2
    
    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.  (b)
    
    REPORTS ON FORM 8-K The Company furnished the following Current Reports on Form 8-K
during the three months ended March 31, 2004:  1.
    
    On January 12, 2004, the Company filed a report on
Form 8-K announcing that it would present an overview of the
Company to investors at the Sixth Annual Needham & Company
Growth Conference on Tuesday, January 6, 2004.2.
    
    On January 27, 2004, the Company filed a report on
Form 8-K announcing via press release the Companys financial
results for the fourth quarter ended December 31, 2003.3.
    
    On January 29, 2004, the Company filed a report on
Form 8-K announcing that on January 9, 2004, it had issued a
press release announcing the conference call scheduled for
January 27, 2004 to release the financial results for the
quarter ended December 31, 2003, on January 12, 2004, the
Company issued a press release announcing the appointment of
Michael Adams to Vice President, Video Architecture Technology,
and on January 20, 2004, the Company issued a press release
announcing Adelphia Communications, Inc., deployed the Terayon
DM 6400 Network CherryPicker in more than 40 of its cable
headends in order to deliver HDTV (High Definition TV) service
in its Northeast, Central and Southeast divisions.4.
    
    On February 2, 2004, the Company filed a report on
Form 8-K announcing that FOX Broadcasting Company has chosen the
new Terayon BP 5100 broadcast platform to 42




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power its HD broadcast delivery system. Terayon is working in
concert with Thomson Broadcast & Media Solutions in this effort.5.
    
    On March 2, 2004, the Company filed a report on Form
8-K announcing that Jupiter Telecommunications (J-COM Broadband)
is using the Terayon BW 3500 DOCSIS® 2.0 Cable Modem Termination
System (CMTS) and Terayon TJ 735x cable modems. 43




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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: May 10, 2004
    TERAYON COMMUNICATION SYSTEMS, INC.By /s/ Arthur T. TaylorArthur T. TaylorChief Financial Officer 44




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EXHIBIT INDEX ExhibitNumber
    
    Description31.1
    
    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.