**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM10-Q**

** **
| **ý**                                             | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|--------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------|
| ** **                                             | ** ** | ** **                                                                                    |
| **For the quarterly period ended September  30, 2004** |
| ** **                                             | ** ** | ** **                                                                                    |
| **o**                                                  | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                             |
| **Commission File Number: 000-25291**                  |

 

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**TUTSYSTEMS, INC.**

(Exact name of registrant as specified in its charter)

 
| **Delaware**                                                                | ** ** | **94-2958543**                        |
|-----------------------------------------------------------------------------|------------|---------------------------------------|
| (State or  other jurisdiction of  incorporation or organization)            |       | (I.R.S. Employer  Identification No.) |
|                                                                        |       |                                  |
| **6000 SW  Meadows Rd, Suite 200  Lake Oswego, Oregon**                     | ** ** | **97035**                             |
| (Address of  principal executive offices)                                   |       | (Zip Code)                            |
|                                                                        |       |                                  |
| Registrant’s telephone number, including area code: **(971) 217-0400** |

 

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

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inRule 12b-2 of the Exchange Act).

Yes  o  No  ý

 

Asof October 26, 2004,  25,077,391 sharesof the Registrant’s common stock, par value $0.001 per share, were issued andoutstanding.

 

 

 

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**TUT SYSTEMS, INC.**

 

**FORM 10-Q**

 

**INDEX**

** **
| **PART I.**       | **FINANCIAL INFORMATION**                                                                                                       |   |
|-------------------|---------------------------------------------------------------------------------------------------------------------------------|--------|
|              |                                                                                                                            |   |
| Item  1.          | Condensed  Consolidated Financial Statements (unaudited):                                                                       |   |
|              |                                                                                                                            |   |
|              | Condensed Consolidated  Balance Sheets as of December 31, 2003 and September 30, 2004                                           |   |
|              |                                                                                                                            |   |
|              | Condensed  Consolidated Statements of Operations for the three and nine months ended  September 30, 2003 and September 30, 2004 |   |
|              |                                                                                                                            |   |
|              | Condensed  Consolidated Statements of Cash Flows for the nine months ended September 30,  2003 and September 30, 2004           |   |
|              |                                                                                                                            |   |
|              | Notes  to Unaudited Condensed Consolidated Financial Statements                                                                 |   |
|              |                                                                                                                            |   |
| Item  2.          | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                     |   |
|              |                                                                                                                            |   |
| Item 3.           | Quantitative  and Qualitative Disclosures about Market Risk                                                                     |   |
|              |                                                                                                                            |   |
| Item 4.           | Controls and  Procedures                                                                                                        |   |
|              |                                                                                                                            |   |
| **PART II.** | **OTHER INFORMATION**                                                                                                           |   |
|              |                                                                                                                            |   |
| Item 1.           | Legal Proceedings                                                                                                               |   |
|              |                                                                                                                            |   |
| Item 6.      | Exhibits and  Reports on Form 8-K                                                                                               |   |
|              |                                                                                                                            |   |
| Signatures        |                                                                                                                            |   |

 

2

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**PART I.FINANCIAL INFORMATION**

 

**ITEM 1.                          CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

 

**TUT SYSTEMS, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(in thousands, except per share amounts)**

 
| ** **                                                                                                                                  | ** ** | **December 31,  2003** | ** ** | **September 30,  2004** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-------------------------|------------|
| ** **                                                                                                                                  | ** ** | ** **             | ** ** | **(unaudited)**         | ** ** |
| **ASSETS**                                                                                                                                  |       |                   |       |                    |       |
| Current assets:                                                                                                                             |       |                   |       |                    |       |
| Cash and cash equivalents                                                                                                                   |       | $                      | 14,370     |                    | $          | 9,253 |   |
| Accounts receivable, net of allowance for  doubtful accounts of $47 and $37 in 2003 and 2004, respectively                                  |       | 7,062                  |       | 5,122                   |       |
| Insurance settlement receivable                                                                                                             |       | 10,725                 |       | —                  |       |
| Inventories, net                                                                                                                            |       | 4,181                  |       | 4,447                   |       |
| Prepaid expenses and other                                                                                                                  |       | 1,026                  |       | 1,611                   |       |
| Total current assets                                                                                                                        |       | 37,364                 |       | 20,433                  |       |
| Property and equipment, net                                                                                                                 |       | 1,722                  |       | 1,893                   |       |
| Intangibles and other assets                                                                                                                |       | 3,685                  |       | 2,293                   |       |
| Total assets                                                                                                                                |       | $                      | 42,771     |                    | $          | 24,619 |   |
|                                                                                                                                        |       |                   |       |                    |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                               |       |                   |       |                    |       |
| Current liabilities:                                                                                                                        |       |                   |       |                    |       |
| Line of credit                                                                                                                              | ** ** | **$**                  | **—** |                    | $          | 2,562 |   |
| Accounts payable                                                                                                                            |       | 3,055                  |       | 3,102                   |       |
| Accrued liabilities                                                                                                                         |       | 1,516                  |       | 1,952                   |       |
| Legal settlement liability                                                                                                                  |       | 10,725                 | ** ** | **—**              | ** ** |
| Deferred revenue                                                                                                                            |       | 253                    |       | 161                     |       |
| Total current liabilities                                                                                                                   |       | 15,549                 |       | 7,777                   |       |
| Note payable                                                                                                                                |       | 3,523                  |       | 3,743                   |       |
| Other liabilities                                                                                                                           |       | 44                     |       | 4                       |       |
| Total liabilities                                                                                                                           |       | 19,116                 |       | 11,524                  |       |
| Commitments and contingencies (Note 7)                                                                                                      |       |                   |       |                    |       |
| Stockholders’ equity:                                                                                                                  |       |                   |       |                    |       |
| Preferred stock, $0.001 par value, 5,000  shares authorized, no shares issued and outstanding in 2003 and 2004,  respectively               |       | —                 |       | —                  |       |
| Common stock, $0.001 par value, 100,000  shares authorized, 20,274 and 20,469 shares issued and outstanding in 2003  and 2004, respectively |       | 20                     |       | 20                      |       |
| Additional paid-in capital                                                                                                                  |       | 305,777                |       | 306,106                 |       |
| Accumulated other comprehensive loss                                                                                                        |       | (89                    | )          | (150                    | )          |
| Accumulated deficit                                                                                                                         |       | (282,053               | )          | (292,881                | )          |
| Total stockholders’ equity                                                                                                             |       | 23,655                 |       | 13,095                  |       |
| Total liabilities and stockholders’ equity                                                                                             |       | $                      | 42,771     |                    | $          | 24,619 |   |

 

*The accompanying notes are an integral part of thesecondensed consolidated financial statements.*

 

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**TUT SYSTEMS, INC.**

 

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(in thousands, except per share amounts)**

**(unaudited)**

 
| ** **                                                               | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                               | ** ** | **2003**                              | ** ** | **2004**                             | ** ** | **2003** | ** ** | **2004** | ** ** |
| Revenue:                                                                 |       |                                  |       |                                 |       |   |   |   |   |
| Product                                                                  |       | $                                     | 8,283      |                                 | $          | 6,668 |   | $ | 22,384 |   | $ | 17,932 |   |
| License and royalty                                                      |       | 239                                   |       | 4                                    |       | 604 |   | 40 |   |
| Total revenue                                                            |       | 8,522                                 |       | 6,672                                |       | 22,988 |   | 17,972 |   |
| Cost of goods sold                                                       |       | 3,751                                 |       | 4,102                                |       | 11,025 |   | 12,678 |   |
| Gross margin                                                             |       | 4,771                                 |       | 2,570                                |       | 11,963 |   | 5,294 |   |
| Operating expenses:                                                      |       |                                  |       |                                 |       |   |   |   |   |
| Sales and marketing                                                      |       | 1,848                                 |       | 2,001                                |       | 5,702 |   | 5,838 |   |
| Research and development                                                 |       | 1,887                                 |       | 1,844                                |       | 6,221 |   | 5,526 |   |
| General and administrative                                               |       | 1,018                                 |       | 1,044                                |       | 3,325 |   | 3,260 |   |
| Restructuring costs                                                      |       | 292                                   |       | —                               |       | 292 |   | — |   |
| Impairment of intangible assets                                          |       | —                                |       | —                               |       | 128 |   | 202 |   |
| Amortization of intangible assets                                        |       | 442                                   |       | 376                                  |       | 1,360 |   | 1,148 |   |
| Total operating expenses                                                 |       | 5,487                                 |       | 5,265                                |       | 17,028 |   | 15,974 |   |
|                                                                     |       |                                  |       |                                 |       |   |   |   |   |
| Loss from operations                                                     |       | (716                                  | )          | (2,695                               | )          | (5,065 | ) | (10,680 | ) |
| Interest and other (expense) income, net                                 |       | (26                                   | )          | (48                                  | )          | 67 |   | (148 | ) |
|                                                                     |       |                                  |       |                                 |       |   |   |   |   |
| Net loss                                                                 |       | $                                     | (742       | )                                    | $          | (2,743 | ) | $ | (4,998 | ) | $ | (10,828 | ) |
|                                                                     |       |                                  |       |                                 |       |   |   |   |   |
| Net loss per share, basic and diluted (Note  3)                          |       | $                                     | (0.04      | )                                    | $          | (0.13 | ) | $ | (0.25 | ) | $ | (0.53 | ) |
|                                                                     |       |                                  |       |                                 |       |   |   |   |   |
| Shares used in computing net loss per  share, basic and diluted (Note 3) |       | 20,040                                |       | 20,453                               |       | 19,912 |   | 20,361 |   |

 

*The accompanying notes are an integral part of thesecondensed consolidated financial statements.*

 

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**TUT SYSTEMS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands)**

**(unaudited)**

 
| ** **                                                                         | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                         | ** ** | **2003**                             | ** ** | **2004** | ** ** |
| Cash flows from operating activities:                                              |       |                                 |       |   |   |
| Net loss                                                                           |       | $                                    | (4,998     | ) | $ | (10,828 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities:       |       |                                 |       |   |   |
| Depreciation                                                                       |       | 796                                  |       | 972 |   |
| Provision (recovery) for doubtful accounts                                         |       | 30                                   |       | 5 |   |
| Provision for (reduction of) excess and  obsolete inventory and abandoned products |       | (775                                 | )          | 1,397 |   |
| Impairment of intangibles                                                          |       | 128                                  |       | 202 |   |
| Amortization of intangibles                                                        |       | 1,360                                |       | 1,148 |   |
| Deferred interest on note payable                                                  |       | 193                                  |       | 220 |   |
| Change in operating assets and liabilities,  net of businesses acquired:           |       |                                 |       |   |   |
| Accounts receivable                                                                |       | (5,246                               | )          | 1,935 |   |
| Inventories                                                                        |       | 841                                  |       | (1,663 | ) |
| Prepaid expenses and other assets                                                  |       | (447                                 | )          | (605 | ) |
| Accounts payable and accrued liabilities                                           |       | (2,649                               | )          | 444 |   |
| Deferred revenue                                                                   |       | (786                                 | )          | (92 | ) |
| Net cash used in operating activities                                              |       | (11,553                              | )          | (6,865 | ) |
| Cash flows from investing activities:                                              |       |                                 |       |   |   |
| Purchase of property and equipment                                                 |       | (745                                 | )          | (1,143 | ) |
| Net cash used in investing activities                                              |       | (745                                 | )          | (1,143 | ) |
| Cash flows from financing activities:                                              |       |                                 |       |   |   |
| Proceeds from line of credit                                                       |       | 3⁄4                               |       | 2,562 |   |
| Proceeds from issuances of common stock,  net                                      |       | 683                                  |       | 329 |   |
| Net cash provided by financing activities                                          |       | 683                                  |       | 2,891 |   |
| Net decrease in cash and cash equivalents                                          |       | (11,615                              | )          | (5,117 | ) |
| Cash and cash equivalents, beginning of  period                                    |       | 25,571                               |       | 14,370 |   |
| Cash and cash equivalents, end of period                                           |       | $                                    | 13,956     |   | $ | 9,253 |   |

 

*The accompanying notes are an integral part of thesecondensed consolidated financial statements.*

 

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**TUT SYSTEMS, INC.**

 

**NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

**(in thousands, except per share amounts)**

 

**NOTE1—DESCRIPTION OF BUSINESS:**

 

The Companydesigns, develops, and sells digital video processing systems that enabletelephony-based service providers to deliver broadcast quality digital videosignals over their networks. The Company also offers digital video processingsystems that enable private enterprise and government entities to transportvideo signals over satellite, fiber, radio, or copper facilities forsurveillance, distance learning, and TV production applications. The Companyalso offers broadband transport and service management products that enable theprovisioning of high-speed Internet access and other broadband data servicesover existing copper networks within hotels and private campus facilities.

 

Historically, the Company derived most of its sales from its broadbandtransport and service management products. In November 2002, the Companyacquired VideoTele.com, or VTC, from Tektronix, Inc. to extend its productofferings to include digital video processing systems. These video-basedproducts now represent a majority of the Company’s sales.

 

The Company has incurred substantial losses and negative cash flowsfrom operations since inception. For the nine months ended September 30, 2004,the Company incurred a net loss of $10,828 and negative cash flows fromoperating activities of $6,865, and has an accumulated deficit of $292,881 atSeptember 30, 2004. Management believes that the cash and cash equivalents asof September 30, 2004 are sufficient to fund its operating activities andcapital expenditure needs for the next twelve months.  However, in the event that general economicconditions worsen, the Company may require additional cash to fund itsoperations. In October 2004, the Company completed the sale of 4,600 shares ofits common stock at a price of $2.25 per share for gross proceeds of$10,350.  Net proceeds from the offeringwere approximately $8,700.  Failure togenerate positive cash flow in the future could have a material impact on theCompany’s ability to achieve its intended business objectives.

 

**NOTE2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:**

 

**Basis ofpresentation**

 

Theaccompanying condensed consolidated financial statements as of December 31,2003 and September 30, 2004 and for the three and nine months ended September30, 2003 and 2004 are unaudited. The unaudited interim condensed consolidatedfinancial statements have been prepared on the same basis as the annualfinancial statements and, in the opinion of management, reflect alladjustments, which include only normal recurring adjustments, necessary topresent fairly the Company’s financial position as of December 31, 2003 andSeptember 30, 2004, its results of operations for the three and nine monthsended September 30, 2003 and 2004 and its cash flows for the nine months endedSeptember 30, 2003 and 2004. These condensed consolidated financial statementsand the accompanying notes are unaudited and should be read in conjunction withthe Company’s audited financial statements included in the Company’s Annual Reporton Form 10-K/A, filed with the Securities and Exchange Commission on September2, 2004. The balance sheet as of December 31, 2003 was derived from auditedfinancial statements but does not include all disclosures required by generallyaccepted accounting principles. The results for the three and nine months endedSeptember 30, 2004 are not necessarily indicative of the expected results forany other interim period or the year ending December 31, 2004.

 

**Revenuerecognition**

 

The Company generates revenue primarily from the sale of hardwareproducts, including third-party products, through professional services, andthrough the sale of its software products. The Company sells products throughdirect sales channels and through distributors. Generally, product revenue isgenerated from the sale of video processing systems and components and the saleof broadband transport and service management products. Turnkey solutionrevenue is principally generated by the sale of complete end-to-end videoprocessing systems that are designed, developed and produced according to abuyer’s specifications.

 

*Product revenue*

 

Product revenue is generated primarily from the sale of completeend-to-end video processing systems generally referred to as turnkey solutions.Turnkey solutions are multi-element arrangements, which consist of hardwareproducts, software products, professional services and post-contract support.Sales of turnkey solutions are classified as product revenue in the statementof operations.

 

Product revenue is also generated from the sale of video processingcomponent products and the sale of broadband transport and service managementproducts. The Company sells these products through its own direct saleschannels and also through distributors.

 

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The Company’srevenue recognition policies for turnkey solutions are in accordance withSOP 97-2, *Software Revenue Recognition*,as amended, which is the authoritative guidance for recognizing revenue onsoftware transactions and transactions in which software is more thanincidental to the arrangement. SOP 97-2 requires that revenue recognizedfrom software arrangements be allocated to each element of the arrangementbased on the relative fair values of the elements, such as hardware, softwareproducts, maintenance services, installation, training or other elements. UnderSOP 97-2, the determination of fair value is based on objective evidencethat is specific to the vendor. If such evidence of fair value for any undeliveredelement of the arrangement does not exist, all revenue from the arrangement isdeferred until such time that evidence of fair value does exist or until allelements of the arrangement are delivered, subject to certain limitedexceptions set forth in SOP 97-2, as amended. SOP 97-2 was amended inFebruary 1998 by SOP 98-4, *Deferral ofthe Effective Date of a Provision of SOP 97-2,*and was amendedagain in December 1998 by SOP 98-9, *Modificationof SOP 97-2, Software Revenue Recognition, with Respect to CertainTransactions*. Those amendments deferred and then clarified,respectively, the specification of what was considered vendor specificobjective evidence of fair value for the various elements in a multiple elementarrangement.

 

In the case of software arrangements which require significantproduction, modification or customization of software, which encompasses all ofthe Company’s turnkey arrangements, SOP 97-2 refers to the guidance inSOP 81-1, *Accounting for Performance ofConstruction-Type and Certain Production-Type Contracts*. The Companyrecognizes revenue for all turnkey arrangements in accordance withSOP 97-2 and SOP 81-1. Excluding the post contract support (“PCS”)element, for which the Company has established vendor specific objective evidenceof fair value (as defined by SOP 97-2), revenue from turnkey solutions isgenerally recognized using the percentage-of-completion method, as stipulatedby SOP 81-1. The percentage-of-completion method reflects the portion ofthe anticipated contract revenue that has been earned that is equal to theratio of labor effort expended to date to the anticipated final labor effort,based on current estimates of total labor effort necessary to complete theproject. Revenue from the PCS element of the arrangement is deferred at thepoint of sale and recognized over the term of the PCS period. Generally, theterms of the turnkey solution sales provide for billing of approximately 90% ofthe contract value of the arrangement prior to the time of delivery to the customersite, with an additional approximately 9% of the contract value billed uponsubstantial completion of the project and the balance upon customer acceptance.The contractual arrangements relative to turnkey solutions include customeracceptance provisions. However, such provisions are generally considered to beincidental to the arrangement in its entirety because customers are fullyobligated with respect to approximately 99% of the contract value irrespectiveof whether acceptance occurs or not.

 

For direct sales of video processing systems component products notincluded as part of turnkey solutions and the direct sale of broadbandtransport and service management products, the Company recognizes revenue whenpersuasive evidence of an arrangement exists, delivery has occurred, the fee isfixed or determinable, and collection is reasonably assured.

 

Significant management judgments and estimates must be made inconnection with the measurement of revenue in a given period. The Companyfollows specific and detailed guidelines for determining the timing of revenuerecognition. At the time of the transaction, the Company assesses a number offactors, including specific contract and purchase order terms, completion andtiming of delivery to the common-carrier, past transaction history with thecustomer, the creditworthiness of the customer, evidence of sell-through to theend user, and current payment terms. Based on the results of the assessment,the Company may recognize revenue when the products are shipped or deferrecognition of revenue until evidence of sell-through occurs and cash isreceived. In order to recognize revenue, the Company must also make a judgmentregarding collectibility of the arrangement fee. Management’s judgment ofcollectibility is applied on a customer-by-customer basis pursuant to theCompany’s credit review policy. The Company sells to customers for which thereis a history of successful collection and to new customers for which no similarhistory may exist. New customers are subject to a credit review process, whichevaluates the customers’ financial position and ability to pay. New customersare typically assigned a credit limit based on a review of their financialposition. Such credit limits are increased only after a successful collectionhistory with the customer has been established. If it is determined from theoutset of an arrangement that collectibility is not probable based upon theCompany’s credit review process, no credit is extended and revenue isrecognized on a cash-collected basis, after shipment has occurred or therevenue has been earned under the percentage-of-completion method.

 

The Company also maintains accruals and allowances for all cooperativemarketing and other programs, as necessary. Estimated sales returns andwarranty costs are based on historical experience and are recorded at the timerevenue is recognized, as necessary. The Company’s products generally carry aone year warranty from the date of purchase. To date, warranty costs have beeninsignificant to the overall financial statements taken as a whole.

 

*License and Royalty Revenue*

 

License androyalty revenue consists of non-refundable up-front license fees, some of whichmay offset initial royalty payments, and royalties received by the Company for productssold by its licensees. Currently, the majority of the Company’s license androyalty revenue is comprised of non-refundable license fees paid in advance.Such revenue is recognized ratably over the period during which post-contractcustomer support is expected to be provided or upon delivery and transfer ofagreed upon technical specifications in contracts where essentially no furthersupport obligations exist. Future license and royalty revenue is expected toconsist primarily of royalties received by the Company for products sold by itslicensees.

 

Should changes in conditions cause the Company to determine that thecriteria for revenue recognition are not met for certain

 

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future transactions, revenuerecognition for any reporting period could be adversely affected.

 

**Inventories**

 

Inventoriesare stated at the lower of cost or market. Cost is computed using standard costwhich approximates actual cost on a first-in, first-out basis. The Companyrecords provisions to write down its inventory and related purchase commitmentsfor estimated obsolescence or unmarketable inventory equal to the differencebetween the cost of the inventory and the estimated market value based uponassumptions about the future demand and market conditions. If actual futuredemand or market conditions are less favorable than those estimated by theCompany, additional inventory provisions may be required.

 

**Allowancefor doubtful accounts**

 

TheCompany maintains an allowance for doubtful accounts for estimated lossesresulting from the inability of its customers to make payments. These estimatedallowances are periodically reviewed and take into account customers’ paymenthistory and information regarding customers’ creditworthiness that is known tothe Company. If the financial condition of any of its customers were todeteriorate, resulting in their inability to make payments, an additionalallowance would be required.

 

**Accountingfor long-lived assets**

 

The Company periodically assesses the impairment of long-lived assets.An impairment review is performed whenever events or changes in circumstancesindicate that the carrying value may not be recoverable.

 

Factors considered important which could trigger an impairment reviewinclude, but are not limited to, significant underperformance relative toexpected historical or projected future operating results, significant changesin the manner of use of the acquired assets or the strategy for the overallbusiness, significant negative industry or economic trends, a significantdecline in the stock price for a sustained period and the Company’s marketcapitalization relative to net book value.

 

When management determines that the carrying value may not berecoverable based upon the existence of one or more of the above indicators ofimpairment, any impairment measured is based on a projected discounted cashflow method using a discount rate commensurate with the risk inherent in theCompany’s current business model.

 

During the nine months ended September 30, 2004, the Company determinedthat certain of the technology acquired as part of the purchase of the ViagateTechnologies, Inc. assets in September 2001 had become impaired.  As a result, the Company incurred a loss of$202 to write-off the technology.

 

Future events could causethe Company to conclude that impairment indicators exist. Any resultingimpairment loss could have a material adverse impact on the Company’s financialcondition and results of operations.

 

**Accountingfor stock based compensation**

 

TheCompany accounts for stock-based employee compensation arrangements inaccordance with the provisions of Accounting Principles Board Opinion No. 25(“APB No. 25”), “Accounting for Stock Issued to Employees,” FinancialAccounting Standard Board Interpretation No. 44 (“FIN 44”), “Accounting forCertain Transactions Involving Stock Compensation—an Interpretation of APB 25,”and complies with the disclosure provisions of Statement of FinancialAccounting Standard No. 148 (“SFAS No. 148”), “Accounting for Stock-BasedCompensation, Transition and Disclosure.” Under APB No. 25, compensationexpense is based on the difference, if any, on the date of the grant, betweenthe fair market value of the Company’s stock and the exercise price. The Companyaccounts for stock issued to non-employees in accordance with the provisions ofSFAS No. 148 and the Emerging Issues Task Force (“EITF”) Issue No. 96-18,“Accounting for Equity Instruments that are Issued to other than Employees forAcquiring, or in Conjunction with Selling Goods or Services.”

 

TheCompany amortizes stock-based compensation using the straight-line method overthe remaining vesting periods of the related options, which is generally fouryears. Pro forma information regarding net loss and earnings per share ispresented and has been determined as if the Company had accounted for employeestock options under the fair value method of SFAS No. 123, as amended by SFASNo. 148.

 

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Thefollowing table illustrates the effect on net loss and earnings per share ifthe Company had applied the fair value recognition provisions of SFAS No. 123,as amended by SFAS No. 148, to stock-based employee compensation:

 
| ** **                                                                                                                              | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                                                              | ** ** | **2003**                              | ** ** | **2004**                             | ** ** | **2003** | ** ** | **2004** | ** ** |
| Net loss – as reported                                                                                                             |       | $                                     | (742       | )                                    | $          | (2,743 | ) | $ | (4,998 | ) | $ | (10,828 | ) |
| Adjustment:                                                                                                                             |       |                                  |       |                                 |       |   |   |   |   |
| Total stock-based employee compensation  expense determined under a fair value based method for all grants, net of  related tax effects |       | (816                                  | )          | (497                                 | )          | (2,853 | ) | (1,902 | ) |
| Net loss – pro forma                                                                                                               |       | $                                     | (1,558     | )                                    | $          | (3,240 | ) | $ | (7,851 | ) | $ | (12,730 | ) |
| Basic and diluted net loss per share – as  reported                                                                                |       | $                                     | (0.04      | )                                    | $          | (0.13 | ) | $ | (0.25 | ) | $ | (0.53 | ) |
| Basic and diluted net loss per share – pro  forma                                                                                  |       | $                                     | (0.08      | )                                    | $          | (0.16 | ) | $ | (0.39 | ) | $ | (0.63 | ) |
|                                                                                                                                         |            |                                       |            |                                      |            |  |  |  |  |  |  |  |  |  |

 

Thefair value of options issued pursuant to the option plans and at the grant datewere estimated using the Black-Scholes model. The Black-Scholes option-pricingmodel was developed for use in estimating the fair value of traded options thathave no vesting restrictions and are fully transferable. Option-pricing modelsrequire the input of highly subjective assumptions including the expected stockprice volatility. The Company uses projected volatility rates, which are basedupon historical volatility rates trended into future years. Because employeestock options have characteristics significantly different from those of tradedoptions, and because changes in the subjective input assumptions can materiallyaffect the fair value estimate, in management’s opinion, the existing models donot necessarily provide a reliable single measure of the fair value of options.

 

Theeffects of applying pro forma disclosures of net loss and net loss per shareare not likely to be representative of the pro forma effects on net loss/incomeand net loss/earnings per share in the future years, as the number of futureshares to be issued under these plans is not known and the assumptions used todetermine the fair value can vary significantly.

 

**Recentaccounting pronouncements**

 

In January 2003, the Financial Accounting Standards Board, the(“FASB”) issued FASB Interpretation No. 46 (FIN 46), “Consolidationof Variable Interest Entities, an Interpretation of ARB No. 51, ConsolidatedFinancial Statements,” which was subsequently revised in December 2003with the issuance of FIN46-R. This interpretation requires certain variableinterest entities to be consolidated by the primary beneficiary of the entityif the equity investors in the entity do not have the characteristics of acontrolling financial interest or do not have sufficient equity at risk for theentity to finance its activities without additional subordinated financialsupport from other parties. Application of this Interpretation is required infinancial statements for periods ending after March 15, 2004. The adoptionof this Interpretation in the nine months ended September 30, 2004 did not havea material impact on the Company’s results of operations, financial position orcash flows.

 

**Reclassifications**

 

Certain reclassificationshave been made to prior period balances in order to conform to the currentperiod presentation.

 

**NOTE 3—NETLOSS PER SHARE:**

 

Basic and diluted net lossper share is computed using the weighted average number of common sharesoutstanding. Options were not included in the computation of diluted net lossper share because the effect would be antidilutive.

 

The calculation of net lossper share follows:

 
| ** **                                                               | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                               | ** ** | **2003**                              | ** ** | **2004**                             | ** ** | **2003** | ** ** | **2004** | ** ** |
| Net loss per share, basic and diluted:                                   |       |                                  |       |                                 |       |   |   |   |   |
| Net loss                                                                 |       | $                                     | (742       | )                                    | $          | (2,743 | ) | $ | (4,998 | ) | $ | (10,828 | ) |
| Net loss per share, basic and diluted                                    |       | $                                     | (0.04      | )                                    | $          | (0.13 | ) | $ | (0.25 | ) | $ | (0.53 | ) |
| Shares used in computing net loss per  share, basic and diluted          |       | 20,040                                |       | 20,453                               |       | 19,912 |   | 20,361 |   |
| Antidilutive securities not included in net  loss per share calculations |       | 3,132                                 |       | 4,320                                |       | 3,132 |   | 4,320 |   |
|                                                                          |            |                                       |            |                                      |            |  |  |  |  |  |  |  |  |  |

 

9

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**NOTE4—COMPREHENSIVE LOSS:**

 

Comprehensive loss includesnet loss, unrealized gains and losses on investments, and foreign currencytranslation adjustments that have been previously excluded from net loss andreflected instead in stockholders’ equity. The following table sets forth thecalculation of comprehensive loss:

 
| ** **                               | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                               | ** ** | **2003**                              | ** ** | **2004**                             | ** ** | **2003** | ** ** | **2004** | ** ** |
| Net loss                                 |       | $                                     | (742       | )                                    | $          | (2,743 | ) | $ | (4,998 | ) | $ | (10,828 | ) |
| Unrealized losses on other assets        |       | (43                                   | )          | 12                                   |       | (41 | ) |   |   |
| Foreign currency translation adjustments |       | (12                                   | )          | (8                                   | )          | (24 | ) | (20 | ) |
| Net change in other comprehensive loss   |       | (12                                   | )          | (51                                  | )          | (12 | ) | (61 | ) |
| Total comprehensive loss                 |       | $                                     | (754       | )                                    | $          | (2,794 | ) | $ | (5,010 | ) | $ | (10,889 | ) |

 

**NOTE5—BALANCE SHEET COMPONENTS:**

 
| ** **                                                         | ** ** | **December 31,  2003** | ** ** | **September 30,  2004** | ** ** |
|--------------------------------------------------------------------|------------|------------------------|------------|-------------------------|------------|
| Inventories, net:                                                  |       |                   |       |                    |       |
| Finished goods                                                     |       | $                      | 4,015      |                    | $          | 5,485 |   |
| Raw materials                                                      |       | 391                    |       | 190                     |       |
| Allowance for excess and obsolete inventory  and abandoned product |       | (225                   | )          | (1,228                  | )          |
|                                                               |       | $                      | 4,181      |                    | $          | 4,447 |   |
| Property and equipment:                                            |       |                   |       |                    |       |
| Computers and software                                             |       | $                      | 1,328      |                    | $          | 1,787 |   |
| Test equipment                                                     |       | 2,277                  |       | 2,941                   |       |
| Office equipment                                                   |       | 41                     |       | 56                      |       |
|                                                               |       | 3,646                  |       | 4,784                   |       |
| Less: accumulated depreciation                                     |       | (1,924                 | )          | (2,891                  | )          |
|                                                               |       | $                      | 1,722      |                    | $          | 1,893 |   |
| Accrued liabilities:                                               |       |                   |       |                    |       |
| Professional Services                                              |       | $                      | 494        |                    | $          | 858 |   |
| Compensation                                                       |       | 652                    |       | 837                     |       |
| Other                                                              |       | 370                    |       | 257                     |       |
|                                                               |       | $                      | 1,516      |                    | $          | 1,952 |   |

 

The Company recorded aprovision for inventory within cost of goods sold totaling $402 in the threemonths ended September 30, 2004, and $1,397 in the nine months ended September30, 2004, related to the costs of raw materials and finished goods in excess ofwhat the Company reasonably expected to sell in the foreseeable future as ofthe third quarter of 2004.  The Companyalso reduced inventory costs to market value.

 

Intangible and other assets:

 
|                             |   |   |   | **As of December 31, 2003** |       |
|----------------------------------|--------|--------|--------|-----------------------------|------------|
|                             |   |   |   | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Intangibles** |   |
| Intangible and other assets:     |   |   |   |                        |       |   |   |   |   |
| Completed technology and patents |   |   |   | $                           | 8,125      |   | $ | (5,003 | ) | $ | 3,122 |   |
| Contract backlog                 |   |   |   | 247                         |       | (247 | ) | — |   |
| Customer list                    |   |   |   | 86                          |       | (14 | ) | 72 |   |
| Maintenance contract renewals    |   |   |   | 50                          |       | (12 | ) | 38 |   |
| Trademarks                       |   |   |   | 315                         |       | (52 | ) | 263 |   |
|                             |   |   |   | $                           | 8,823      |   | $ | (5,328 | ) | 3,495 |   |
|                             |   |   |   |                        |       |   |   |   |   |
| Other non-current assets         |   |   |   |                        |       |   |   | 190 |   |
|                             |   |   |   |                        |       |   |   | $ | 3,685 |   |

 

10

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| ** **                       | ** ** | **As of September 30, 2004** | ** ** |
|----------------------------------|------------|------------------------------|------------|
| ** **                       | ** ** | **Gross  Carrying  Amount**  | ** ** | **Accumulated  Amortization** | ** ** | **Net  Intangibles** | ** ** |
| Amortized intangible assets:     |       |                         |       |   |   |   |   |
| Completed technology and patents |       | $                            | 7,922      |   | $ | (6,101 | ) | $ | 1,821 |   |
| Contract backlog                 |       | 247                          |       | (247 | ) | — |   |
| Customer list                    |       | 86                           |       | (24 | ) | 62 |   |
| Maintenance contract renewals    |       | 50                           |       | (19 | ) | 31 |   |
| Trademarks                       |       | 315                          |       | (86 | ) | 229 |   |
|                             |       | $                            | 8,620      |   | $ | (6,477 | ) | 2,143 |   |
|                             |       |                         |       |   |   |   |   |
| Other non-current assets         |       |                         |       |   |   | 150 |   |
|                             |       |                         |       |   |   | $ | 2,293 |   |

 

During thenine months ended September 30, 2004, the Company determined that certain ofthe technology acquired as part of the purchase of the assets of ViagateTechnologies, Inc. in September 2001 had become impaired.  As a result, the Company incurred a loss of$202 to write-off the technology.

 

The aggregate amortizationexpense for the three months ended September 30, 2003 and 2004 was $442 and$376, respectively and $1,360 and $1,148 for the nine months ended September30, 2003 and 2004.

 

Minimum future amortizationexpense as of September 30, 2004 is as follows:

 
| Remainder of 2004 |   | $   | 376    |   |
|-------------------|--------|-----|--------|--------|
| 2005              |   | 875 |   |
| 2006              |   | 424 |   |
| 2007              |   | 363 |   |
| Thereafter        |   | 105 |   |
|              |   | $   | 2,143  |   |

 

**NOTE 6 –LINE OF CREDIT**

 

On September 23, 2004, theCompany entered into a  revolving assetbased credit facility (“credit facility”), with Silicon Valley Bank (“theBank”). This facility has a term of two years and expires on September 23,2006. All borrowings under this facility are classified as currentliabilities.  Borrowings under the creditfacility are formula based and limited to the lesser of $7.0 million or anamount based on a percentage of eligible accounts receivable and eligibleinventories.   Based on the maximumpercentages of eligible accounts receivable and eligible inventory levels,borrowings under this facility were $2,562 million as of September 30, 2004.The annual interest rate as of September 30, 2004 was 5.25%.  The interest rate is equal to the bank’s baserate, or prime rate, currently at 4.75%, plus 0.5%. The rate may increase by1.0% if the Company does not meet certain financial covenants. The creditfacility is secured by all of the Company’s assets, and contains variouscovenants.  For further discussion of thecredit facility, please see the discussion of the facility under “Liquidity andCapital Resources” in Item 2.  TheCompany repaid the borrowings under this facility in October 2004.

 

**NOTE 7–COMMITMENTSAND CONTINGENCIES:**

 

*Lease obligations*

 

The Company leases equipmentand office, assembly and warehouse space under non-cancelable operating leasesthat expire from 2004 through 2007.

 

Minimum future leasepayments under operating leases as of September 30, 2004 are as follows:

 
| Remainder of 2004 |   | $      | 233    |   |
|-------------------|--------|--------|--------|--------|
| 2005              |   | 731    |   |
| 2006              |   | 52     |   |
| Thereafter        |   |   | 27     |   |
|              |   | $      | 1,043  |   |

 

*Purchase commitments*

 

The Company hadnon-cancelable commitments to purchase finished goods inventory totaling $1,009and $479 in aggregate at December 31, 2003 and September 30, 2004,respectively.

 

11

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*Contingencies*

 

***Whalenv. Tut Systems, Inc. et al***

 

On October 30,2001, the Company and certain of its current and former officers and directorswere named as defendants in *Whalen v. TutSystems, Inc. et al.,*Case No. 01-CV-9563, a purported securitiesclass action lawsuit filed in the United States District Court for the SouthernDistrict of New York. An amended complaint was filed on December 5, 2001. Aconsolidated amended complaint was filed on April 19, 2002. The consolidatedamended complaint asserts that the prospectuses from the Company’s January 29,1999 initial public offering and its March 23, 2000 secondary offering failedto disclose certain alleged actions by the underwriters for the offerings. Thecomplaint alleges claims against the Company and certain of its current andformer officers and directors under Section 11 of the Securities Act of 1933,as amended, and under Section 10(b) and Rule 10b-5 of the Securities ExchangeAct of 1934, as amended, and alleges claims against certain of its current andformer officers and directors under Sections 15 and 20(a) of the SecuritiesAct. The complaint also names as defendants the underwriters for the Company’sinitial public offering and secondary offering. Similar suits were filed in the Southern District of New York challengingover 300 other initial public offerings and secondary offerings conducted in1999 and 2000.  Therefore, for pretrialpurposes, the *Whalen* action isbeing coordinated with the approximately 300 other suits before United StatesDistrict Court Judge Shira Scheindlin of the Southern District of New Yorkunder the matter *In Re Initial PublicOffering Securities Litigation. *Theindividual defendants in the *Whalen*action, namely, Nelson Caldwell, Salvatore D ‘Auria and Matthew Taylor, weredismissed without prejudice by an October 9, 2002 Order of the Court, approvingthe parties’ October 1, 2002 Stipulation of Dismissal.  On February 19, 2003, the Court issued anOpinion and Order denying the Company’s motion to dismiss.

 

A stipulationof settlement for the claims against the issuer-defendants, including theCompany, was submitted to the Court on June 14, 2004 in the *In Re Initial Public Offering Securities Litigation*.  The settlement is subject to a number ofconditions, most of which are outside of the Company’s control, includingapproval by the Court.  The underwritersnamed as defendants in the *In Re InitialPublic Offering Securities Litigation* (collectively, the“underwriter-defendants”), including the underwriters named in the *Whalen* suit, are not parties to thestipulation of settlement.

 

Thestipulation of settlement provides that, in exchange for a release of claimsagainst the settling issuer-defendants, the insurers of all of the settlingissuer-defendants will provide a surety undertaking to guarantee plaintiffs a$1 billion recovery from the non-settling defendants, including theunderwriter-defendants. The ultimate amount, if any, that may be paid on behalfof the Company will therefore depend on the final terms of the settlement,including the number of issuer-defendants that ultimately participate in thefinal settlement, and the amounts, if any, recovered by the plaintiffs from theunderwriter-defendants and other non-settling defendants.

 

In the event that all or substantially all of the issuer-defendantsparticipate in the final settlement, the amount that may be paid to theplaintiffs on behalf of the Company could range from zero to approximately $3.5million, depending on plaintiffs’ recovery from the underwriter-defendants andfrom other non-settling parties.  If theplaintiffs recover at least $1 billion from the underwriter-defendants, nosettlement payments would be made on behalf of the Company under the proposedterms of the settlement.  If theplaintiffs recover less than $1 billion, the Company believes that its insurance will likely cover some or all ofits share of any payments towards satisfying plaintiffs’ $1 billionrecovery deficit. Management estimates that its range of loss relative to thismatter is zero to $3.5 million. Presently there is no more likely pointestimate of loss within this range. As a consequence of the uncertaintiesdescribed above regarding the amount the Company will ultimately be required topay, if any, as of September 30, 2004, the Company has not accrued a liabilityfor this matter.

 

12

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*** ***

***Inre Tut Systems, Inc. Securities Litigation*, CivilAction No. C-01-2659-JCS (the “Securities Litigation Action”).**

 

BeginningJuly 12, 2001, nine putative stockholder class action lawsuits were filedin the United States District Court for the Northern District of Californiaagainst the Company and certain of its current and former officers anddirectors. The complaints were filed on behalf of a purported class of investorswho purchased the Company’s stock during the period between July 20, 2000and January 31, 2001, seeking unspecified damages. The complaints allegethat the Company and certain of its current and former officers and directorsmade false and misleading statements about the Company’s business during theputative class period. Specifically, the complaints allege violations ofSection 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended. Thecomplaints were consolidated under the name *Inre Tut Systems, Inc. Securities Litigation*, Master File No.C-01-2659-CW (the “Securities Litigation Action”). Lead plaintiffs and leadcounsel for plaintiffs were appointed. Plaintiffs filed a consolidated classaction complaint on February 4, 2002. Defendants filed a Motion to Dismisson March 29, 2002. On August 15, 2002, the Court granted in part anddenied in part the Motion to Dismiss. On September 23, 2002, plaintiffsfiled an amended complaint. Defendants filed a Motion to Dismiss the amendedcomplaint, and on August 6, 2003 the Court granted in part that Motion. OnSeptember 24, 2003, defendants answered the remaining allegations of theamended complaint. Defendants reached a settlement of the Securities LitigationAction in December 2003. Subject to preliminary and final approval by theCourt, the Company’s insurance carriers agreed to pay $10 million, on behalf ofthe Company, to settle the suit. The settlement includes a release of alldefendants. The insurance carriers paid the settlement amount to plaintiffs’escrow agent in January 2004. The Court preliminarily approved the settlementon February 24, 2004 and finally approved the settlement on May 14,2004.  In the second quarter of 2004, theamounts were paid by the Company’s insurance carriers and the $10 million wasremoved from the insurance settlement receivable and the legal settlementliability.The settlement became final on September 15, 2004, the date when theappeals period ended.

 

***Lefkowitzv. D’Auria, et al***

 

On March 19, 2003, Chesky Lefkowitz, a stockholder of the Company,filed a derivative complaint entitled *Lefkowitzv. D’Auria, et al.*, No. RG03087467, in the Superior Court of theState of California, County of Alameda, against certain of the Company’scurrent and former officers and directors. The complaint alleges causes ofaction for breach of fiduciary duty, gross negligence, breach of contract,unjust enrichment, and improper insider stock trading based on the same factualallegations contained in the Securities Litigation Action. The complaint seeksunspecified damages against the individual defendants on behalf of the Company,equitable relief, and attorneys’ fees. On May 21, 2003, the Company andthe individual defendants filed separate demurrers to the complaint. TheCompany and the individual defendants reached a settlement of the derivativeaction in December 2003. The settlement involves the Company’s adoption ofcertain corporate governance measures and payment of attorneys’ fees andexpenses to the derivative plaintiff’s counsel in the amount of $722,000 and anincentive award to the derivative plaintiff in the amount of $3,000. TheCompany has recorded a liability in its financial statements for the proposedamount of the settlement. In addition, because the insurance carrier involvedin this suit agreed to pay the entire $725,000 settlement amount and,therefore, recovery from the insurance carrier was probable, a receivable wasalso recorded for the same amount. Accordingly, there is no impact to thestatement of operations because the amounts of the settlement and the insurancerecovery fully offset each other. The settlement was approved by the Court onJanuary 12, 2004, and, shortly thereafter, the insurance carrier paid thesettlement amount to the derivative plaintiff’s counsel. Therefore, in thefirst quarter of 2004, the $725,000 was removed from the insurance settlementreceivable and the legal settlement liability. The settlement includes a release of the Company and the individual defendants.

 

The Company is subject to other legal proceedings, claims andlitigation arising in the ordinary course of business. The Company’s managementdoes not expect that the ultimate costs to resolve these matters will have amaterial adverse effect on the Company’s consolidated financial position,results of operations, or cash flows.

 

**NOTE8—SEGMENT INFORMATION:**

 

The Companycurrently targets its sales and marketing efforts to both public and privateservice providers and users across two related markets. The Company currentlyoperates in a single business segment as there is only one measurement ofprofitability for its operations. Revenue is attributed to the followingcountries based on the location of customers:

 
| ** **          | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **          | ** ** | **2003**                              | ** ** | **2004**                             | ** ** | **2003** | ** ** | **2004** | ** ** |
| United States       |       | $                                     | 6,999      |                                 | $          | 4,971 |   | $ | 18,839 |   | $ | 14,125 |   |
| International:      |       |                                  |       |                                 |       |   |   |   |   |
| Ireland             |       | —                                |       | 472                                  |       | 545 |   | 1,201 |   |
| Canada              |       | 911                                   |       | 465                                  |       | 1,619 |   | 1,279 |   |
| China               |       | 181                                   |       | 390                                  |       | 512 |   | 421 |   |
| Korea               |       | —                                |       | 162                                  |       | — |   | 162 |   |
| All other countries |       | 431                                   |       | 212                                  |       | 1,473 |   | 784 |   |
|                |       | $                                     | 8,522      |                                 | $          | 6,672 |   | $ | 22,988 |   | $ | 17,972 |   |

 

13

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No individual customeraccounted for greater than 10% of the Company’s revenue for the three and ninemonths ended September 30, 2004.  Noindividual customer accounted for greater than 10% of the Company’s revenue forthe nine months ended September 30, 2003. One customer, Oxford Networks, accounted for 15% of the Company’srevenue for the three months ended September 30, 2003.

 

*Products*

 

The Company designs, develops, and sells video processing systems andbroadband transport and service management products. Video processing systemsinclude both digital TV headend systems and video systems. The digital TVheadend system enables telephony-based service providers to transport broadcastquality digital video signals across their networks and our digital videotransmission systems optimize the delivery of video signals across enterprise,government and education networks. The broadband transport and servicemanagement products enable the transmission of broadband data over a singlepair of copper wire for broadband internet applications across multi-tenantcomplexes such as hotels, apartments and private campus facilities.

 

Revenue relatingto the broadband transport and service management products was $1,959 and$1,711 for the three months ended September 30, 2003 and 2004, respectively and$6,148 and $5,715 for the nine months ended September 30, 2003 and 2004,respectively. Revenue related to video processing systems was $6,563 and $4,961for the three months ended September 30, 2003 and 2004, respectively and$16,840 and $12,257 for the nine months ended September 30, 2003 and 2004,respectively.

 

**NOTE9 – SUBSEQUENT EVENT**

 

In October2004, the Company completed the sale of 4,600 shares of its common stock at aprice of $2.25 per share for gross proceeds of $10,350.  Net proceeds from the offering wereapproximately $8,700.

 

14

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**ITEM 2.****                  ****MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONAND RESULTS OF OPERATIONS**

 

*The section entitled “Management’s Discussion and Analysisof Financial Condition and Results of Operations” set forth below contains“forward-looking statements” within the meaning of Section 27A of theSecurities Act of 1933, as amended, and Section 21E of the SecuritiesExchange Act of 1934, as amended. When used herein, the words “anticipates,”“believes,” “continue,” “could,” “estimates,” “expects,” “intends,” “may,”“plans,” “seeks,” “should,” “will” or the negative of these terms or similarexpressions are generally intended to identify forward-looking statements. Wehave based these forward-looking statements on our current expectations andprojections about future events. Such forward-looking statements are subject tovarious risks and uncertainties that could cause actual results to differmaterially from those projected in such statements. Readers are cautioned notto place undue reliance on these forward-looking statements, which speak onlyas of the date hereof. The forward-looking statements contained in thisquarterly report include statements about the following: (1) our belief thatthere is and will continue to be growing demand for video services in the future(2) our belief that video products will provide most of our growthopportunities for the foreseeable future, (3) our belief that the numberof telco video subscribers will grow significantly between 2004 and 2008 andthat this market space will continue to become more competitive,(4) ourexpectation that we will see growing demand for our products in the future,(5) our expectation that we will compete with larger public companies aswe begin to target larger telco customers, (6) our expectation that emergingadvancements in video compression technology will allow more efficienttransport of video streams, (7) our expectation that digital subscriberline or DSL technology will continue to dominate telco broadband networks forthe foreseeable future, (8) our belief that new controls and procedureshave addressed the conditions identified by our auditors as materialweaknesses, (9) our expectation that we will maintain our sales and marketingexpenses at levels consistent with our future revenue expectations, (10) ourexpectation that capital expenditures for research and development in 2004 willremain comparable to capital expenditures in 2003 (11) our expectation that ourresearch and development expenses will increase throughout the remainder of2004, (12) our expectation that capital expenditures in 2004 will be comparableto 2003 and that these capital expenditures will be funded from operations,(13)our expectation that negative cash flows from operating activities willdecrease over the next several quarters, (14) our anticipation that we willcontinue to be able to borrow money under our line of credit with SiliconValley Bank (15) our expectation that we will pay accrued interest on the noteissued to Tektronix beginning January 31, 2006,(16) our belief that ourcash and cash equivalents as of September 30, 2004 are sufficient to fund ouroperating activities and capital expenditure needs for the next twelve months,(17) our expectation that revenue from broadband transport and servicemanagement products will decline slightly for the remainder of 2004, (18) ourexpectation that future license and royalty revenue will be minimal in futureperiods, (9) our anticipation that our sales and operating margins willcontinue to fluctuate, (20) our expectation that revenue for the fourth quarterof 2004 will exceed $7.0 million, (21) our anticipation that we will generallycontinue to invoice foreign sales in U.S. dollars, (22) our intention tocontinue to evaluate new acquisition candidates, divesture and diversificationstrategies, and (23) our expectation that customers outside of the UnitedStates will represent a significant and growing portion of our revenue.*

 

*The cautionary statements contained under the caption**“AdditionalRisk Factors that Could Affect Our Operating Results and the Market Price ofOur Stock” and other similar statements contained elsewhere in this report,identify important factors with respect to such forward-looking statements,including certain risks and uncertainties that could cause our actual results,performance or achievements expressed or implied by such forward-lookingstatements.*

 

*Although we believe that the expectations reflected in suchforward-looking statements are based upon reasonable assumptions, no assurancecan be given that such expectations will be attained or that any deviationswill not be material. We disclaim any obligation or undertaking to disseminateany updates or revision to any forward-looking statement contained herein orreflect any change in our expectations with regard thereto or any change inevents, conditions or circumstances on which any such statement is based.*

 

**Overview**

 

***OurBusiness***

 

We design, develop, and sell digital video processing systems thatenable telephony-based service providers to deliver broadcast quality digitalvideo signals across their networks. We refer to these systems as digital TVheadends or video content processing systems. We also offer digital videoprocessing systems that enable private enterprise and government entities totransport video signals across satellite, fiber, radio, or copper facilitiesfor surveillance, distance learning, and TV production applications.

 

We also offer broadband transport and servicemanagement products that enable the provisioning of high speed Internet accessand other broadband data services over a single pair of copper wire forbroadband internet applications across multi-tenant complexes such as hotels,apartments and private campus facilities.

 

***OurHistory***

 

Prior to November 2002, most of our sales were derived from ourbroadband transport and service management products. In 2000 and 2001, weacquired three companies (FreeGate Corporation, Xstreamis Limited andActiveTelco, Inc.) and the assets from two other companies (OneWorld Systems, Inc.and ViaGate Technologies, Inc.) in order to expand our sales of broadbandtransport and service management products. However, the significant downturn inthe world economy in general, and the telecommunications market in particular,beginning in late 2000 had a severe and sustained adverse effect on ourbusiness, financial condition and results

 

15

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of operations. Our sales of broadband transport and service managementproducts decreased substantially beginning in 2001, which required us to take anumber of restructuring efforts and incur significant impairment and othercharges in order to realign our cost structure in light of the economicenvironment. For the period January 1, 2001 through December 31,2002, we incurred an aggregate of $32.6 million in intangible assetimpairment charges and $11.5 million in restructuring charges. In 2003,sales from our broadband transport and service management products stabilized,as we began to experience an improvement in sales of broadband transport andservice management products to the hospitality industry.

 

With ourNovember 2002 acquisition of Tektronix’s subsidiary VTC, we extended ourproduct offerings to add video processing systems for digital TV headends andfor the transmission of video signals over private and government networks. Theacquisition of VTC resulted in significant changes in our business, including:(1) changes in our organizational structure and employee staffing;(2) relocation of our administrative offices, executive offices (as ofJanuary 2004) and a significant portion of our operations from Pleasanton,California to Lake Oswego, Oregon, the prior headquarters of VTC; (3) anexpansion of our sales and marketing efforts to include VTC products; and(4) a reprioritization of our research and development efforts to focus onproducts that we acquired in our acquisition of VTC. With our acquisition ofVTC, sales of video processing systems now represent a majority of our totalrevenue and will provide most of our growth opportunities for the foreseeablefuture.

 

We earn revenue primarily by selling video content processing systemsboth directly and through resellers to telecommunications service providers. Wealso earn revenue by selling video transmission systems to TV broadcasters,government agencies and educational institutions, and by selling broadbandtransport and service management products directly and through distributors tothe hospitality industry and to owners of private multi-tenant campusfacilities.

 

Prior to our acquisition of VTC, international sales represented 56.3%and 43.0% of our total sales in 2001 and 2002, respectively. Since ouracquisition of VTC, international sales have represented a smaller percentageof our overall business relative to prior years, though international sales arestill a material portion of our total sales. In 2003, international salesrepresented 18.4% of our total sales and for the three and nine months endedSeptember 30, 2004, international sales represented 25.5% and 21.4%,respectively, of our total sales.

 

*Material Trends and Uncertainties*

 

We pay close attention to and monitor various trends and uncertaintiesemerging in the markets we serve. There is a growing demand by independentoperating telephone companies to offer video services to their customer base.According to a report released by InStat/MDR in May 2004, the number of telcovideo subscribers worldwide will increase from 755,000 at the end of 2003 toover 14.0 million by the end of 2008. While this growing market presentsopportunities to serve a larger customer base, we are also seeing the emergenceof intense competition as more companies compete to sell digital TV headendproducts. We expect this market space will continue to become more competitivein the future. As we begin to target larger telco customers, we expect tocompete with larger public companies, including Harmonic, Motorola and TandbergTelevision. Our immediate competitors in the digital TV headend markets areprimarily small private companies that are focused on a more narrow productline than ours and thereby may be able to devote substantially more targetedresources to developing, marketing and selling new products than we are ableto. In addition, these companies may become targets for acquisition by largercompanies, in which case we would face competitors with substantially greatername recognition, and technical, financial and marketing resources than wehave.

 

The emergence of new technologies to serve the digital TV headendmarket means that we must continue to invest in these new technologies tomaintain our market position.  Digitalsubscriber line (“DSL”) technologies use sophisticated modulation schemes topack data onto copper wires.  DSLtechnologies are sometimes referred to as “last mile” technologies because theyare used only for connections from a telephone switching station to a home oroffice, not between switching stations. The limitations on the amount of data that can be transmitted in a fixedamount of time (“bandwidth”) and distance limitations of the copper based lastmile constrain both the number of video channels that may be deliveredsimultaneously over a DSL network and the number of customers that arereachable from a telco central office. Emerging advancements in video compression technology will soon enablehigh quality video streams to be transported at lower data transfer rates or“bit rates” than currently deployed. These emerging compression advancements also introduce the possibilityof delivering high-definition television over bandwidth constrained asymmetricDSL, or ADSL, lines for the first time. ADSL is a new technology that allows more data to be sent over existingcopper telephone lines.  Additionally,there are DSL advancements emerging that expand the available bandwidth fromthe telco to the subscriber thereby supporting higher DSL bit rates over longerdistances.  As our products continue toincorporate these new technological advancements we expect demand for ourproducts will increase since they will enable more telcos to reach a higherpercentage of their customers with a larger number of video channels.

 

While DSL technologies will continue to dominate telco broadbandnetworks for the foreseeable future, telephone companies are beginning toconstruct fiber optic networks to their customers’ homes. Thoughfiber-to-the-home will eliminate bandwidth limitations on delivering higherspeed data services and high-quality video offerings, telephone companiesdeploying fiber-to-the-home will require advanced video processing systems,such as our Astria Product line, to convert signals between multiple protocolsused in their networks.

 

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The digitalmedia industry continues to be intensely competitive.  We are continuingto focus on developing technologies and introducing new products and we expectthat our research and development expenses will increase throughout theremainder of 2004. We continue to aggressively market our new and existingproducts and to expand our marketing efforts domestically andinternationally.  Nevertheless, ouroperations have been subject, and will continue to be subject, to pressure fromweakness in the overall technology sector as well as the digital mediaindustry.  During the first threequarters of 2004, our sales cycle generally increased and customers delayed purchasing decisions. The deferral ofcustomer orders reduced our expected revenue in the first three quarters of2004 compared with prior periods and compared with what we had expected forthose quarters. We believe the lengthening of the purchase decision byprospective customers is the result of several factors affecting the overalldigital TV headend market. In discussions with our customers, certain of thosecustomers have indicated to us that factors causing these delays include, butare not limited to, their anticipation of the introduction of advancedcompression technologies later this year and early next year, customers’decisions to use more efficient data transmission technologies (decisions thatsome of our customers wish to make before they commit to purchasing headends)and customers’ decisions about using emerging video signal encryptiontechnologies (decisions that some of our customers wish to make before theycommit to purchasing headends). Therefore, given the opportunities offered bythe growing number of telcos deploying video services and the lengthening ofthe sales cycle, we expect to maintain our sales and marketing expenses atlevels consistent with our future revenue expectations.

 

We have beenoperating at a loss since inception and, based on expected revenue, we willcontinue to operate at a loss for the remainder of 2004.  As we announced on September 20, 2004, we expectrevenue during the fourth quarter of 2004 will be approximately $7.0million.  However, the deferral ofcustomer orders we experienced during the first three quarters of 2004 maycontinue, which may result in reduced revenue in the future.

 

***Internal Controlsand Disclosure Controls and Procedures***

 

Our ChiefExecutive Officer and Chief Financial Officer carried out an evaluation of theeffectiveness of our disclosure controls and procedures (as defined inRule 13a-15(e) under the Exchange Act) as of September 30, 2004. Thisevaluation included various steps that our Chief Executive Officer and ChiefFinancial Officer undertook in an effort to ensure that our disclosure controlsand procedures are designed to ensure that information required to be disclosedin our SEC reports is recorded, processed, summarized and reported within thetime periods specified by the SEC and accumulated and communicated to ourmanagement, including our Chief Executive Officer and Chief Financial Officer,to allow timely discussions regarding required disclosure. This evaluation alsoincluded consideration of our internal controls and procedures for thepreparation of our financial statements. As of September 30, 2004, our ChiefExecutive Officer and Chief Financial Officer have concluded that ourdisclosure control and procedures are effective.

 

InJanuary 2004 in connection with the completion of its audit of ourfinancial statements for the year ended December 31, 2003,PricewaterhouseCoopers LLP, the Company’s independent registered publicaccounting firm, advised management and the audit committee of the Board ofDirectors that it had identified deficiencies in our internal controls andprocesses relating to inventory management and reporting that it considers tobe material weaknesses, as defined by Statement on Auditing StandardsNo. 60, “Communication of Internal Control Related Matters Noted in anAudit.” The material weaknesses that PricewaterhouseCoopers LLP identifiedrelated to inventory controls and the accounts payable process for theCompany’s VideoTele.com business, which the Company acquired inNovember 2002. Specifically:

 

1.                                       Our internalcontrols are inadequate to properly record our inventory quantities in anaccurate and timely manner; and

 

2.                                       Our accounts payableprocess failed to adequately reconcile our accounts payable records withsuppliers’ records, considering what the suppliers had shipped to us prior toperiod end.

 

While thesematerial weaknesses had an immaterial effect on our reported results, theynevertheless constituted deficiencies in our disclosure controls. In light ofthese material weaknesses and the requirements enacted by the Sarbanes-OxleyAct of 2002 and the related rules and regulations adopted by the SEC, our ChiefExecutive Officer and Chief Financial Officer concluded that, as ofDecember 31, 2003, our disclosure controls and procedures neededimprovement and were not effective. Despite those deficiencies in ourdisclosure controls, management believed that as of December 31, 2003, and atthe time of filing its Annual Report on Form 10-K for the fiscal year endedDecember 31, 2003, as amended, there were no material inaccuracies, oromissions of material facts necessary to make the statements not misleading inlight of the circumstances under which they were made.

 

At the time ofour acquisition of the VideoTele.com business in November 2002, we had inplace disclosure controls and procedures and processes for our existingbusiness (i.e., our pre-November 2002 business) that our CEO and CFO atthe time believed to be sufficient to record, process, summarize and reportinformation required to be reported within the time periods specified by theSEC. Likewise, we had in place internal controls that our CEO and CFO believedat the time of the VTC acquisition to be sufficient to “provide reasonableassurance regarding the reliability of financial reporting and preparation offinancial statements for external purposes in accordance with generallyaccepted accounting principles.”

 

Since December 31,2002, we have continued to review our disclosure controls and procedures andinternal controls periodically in connection with our Form 10-Q filings.Throughout 2003, our CEO and CFO have continued to believe that our disclosurecontrols and procedures and internal controls have allowed us to provide allmaterial and necessary disclosure in a timely manner, as required by theExchange Act and the applicable rules thereunder.

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InJanuary 2004, during the audit of our financial statements for the fiscalyear ended December 31, 2003, PricewaterhouseCoopers LLP discovered thematerial weaknesses noted above and brought these weaknesses to our attention.Based on discussions with PricewaterhouseCoopers LLP and the audit committee ofour Board of Directors, we worked throughout our year-end 2003 accounting closeand audit to identify the nature, scope and materiality of these weaknesses inour internal controls and their impact on our fiscal year 2003 financialstatements and to determine the extent to which these internal controlweaknesses might adversely affect our disclosure controls and procedures. Basedon further detailed review of our internal controls as they relate to inventoryand accounts payable during the fourth quarter of fiscal 2003, we determinedthat the accounts payable process had failed to record certain liabilitiesassociated with VTC products that we purchased, principally from our contractmanufacturer and certain other suppliers. We quantified this internal controlweakness relating to accounts payable recordation by reconciling our records tothat of our contract manufacturer and reviewing our liabilities with othervendors. We quantified the inventory process control weakness by takingcomplete physical inventories at each VTC inventory location and reconcilingthe results to our records. Upon completion of our analysis and testing, weidentified an additional charge of approximately $34,000 to cost of goods soldrelated to the internal control weaknesses identified above. We recorded thischarge prior to issuing our financial statements for the year endedDecember 31, 2003. In addition to our review of the financial statementsfor the fiscal year ended December 31, 2003, we re-confirmed that ouraccounts payable recordation and inventory controls were effective for the yearended December 31, 2002.

 

During ourreview of these internal controls weaknesses, we identified the cause of theseinternal control weaknesses to be the result of prior VTC accounting staffturnover that occurred during the first quarter of 2003. During this quarter,key accounting staff of VTC left the company without sufficient time totransition all of the internal controls and institutional knowledge to our remainingfinance and accounting staff.

 

In addition toidentifying the above two internal control weaknesses relating to inventory andthe accounts payable process, we also tested our other internal controls todetermine whether there were other such material weaknesses aside from theinventory and accounts payable weaknesses mentioned above that affected ourfinancial statements for the fiscal year ended December 31, 2003. Inparticular, we tested our other internal controls by reviewing processes, analyticalreviews and substantive testing that included other third-party confirmationsand by reviewing activity subsequent to year-end 2003. Based on these tests, wedid not identify any other material weaknesses in internal controls. Therefore,our CEO and CFO believed at the time of the original filing of theForm 10-K on February 2, 2004 that they had reasonable grounds toconclude that the weaknesses in internal controls related solely to those itemsmentioned above and resulted in an immaterial charge of approximately $34,000.

 

Based on theirreview of our internal controls as described above, our CEO and CFO alsoassessed our disclosure controls and procedures for the fiscal year endedDecember 31, 2003. Our CEO and CFO believed at the time of the originalfiling of the Form 10-K that they had reasonable grounds to conclude that,other than the inventory and accounts payable weaknesses thatPricewaterhouseCoopers LLP had identified, there were no other materialweaknesses in our disclosure controls and procedures and that the informationrequired to be reported in the Form 10-K was recorded, processed,summarized and reported within the time periods specified by the applicableExchange Act rules.

 

In order toensure that we have eliminated the two weaknesses in our internal controls forpurposes of future reporting, we have undertaken significant efforts to improveour processes and procedures as they relate to inventory reporting and accountspayable reconciliation. The audit committee is taking an active role in theseefforts, including overseeing management’s implementation of correctivemeasures. With respect to inventory management, since identifying thoseweaknesses in our internal controls, we have performed and will continue toperform physical inventory counts at least at the end of each quarter in 2004.We have implemented improved inventory systems and accounting controls and havehired an additional full-time staff accountant to account for and control ourinventory accounting, given our operations manager company-wide responsibilityfor inventory management, and have reiterated to key operations and accountingpersonnel the importance of proper inventory management and control. We will beexpanding our inventory receiving process to include remote locations, asappropriate and reconciling inventory to each customer order. Regardingaccounts payable reconciliation, we have confirmed and will continue to confirmour key accounts payable balances with our vendors and reconciled theconfirmations to our accounting records on a quarterly basis in 2004.

 

Managementbelieves that the controls and procedures identified above have and willaddress the conditions identified by PricewaterhouseCoopers LLP as materialweaknesses. These changes will become permanent elements of our internalcontrols. We are now confident that we have and are in the process ofimplementing the proper level of controls to correct the material weaknesses.We plan to continue to monitor the effectiveness of our internal controls andprocedures on an ongoing basis and will take further action as appropriate.

 

***Definitionsfor Discussion of Results of Operations***

 

Our discussion of our results of operations focuses on the followingitems from our income statement: Total revenue consists of product sales, andlicense and royalty fees. Product revenue consists of sales of our videoprocessing systems, which includes both digital TV headend and videotransmission systems. Product revenue also consists of revenue from ourbroadband transport and service management products. License and royalty feesconsist of non-refundable license fees and royalties received by us forproducts sold by our licensees. Since our acquisition of VTC, a large part ofour quarterly revenue has been associated with the sale of digital TV headends.Furthermore, each individual headend sale has represented a significant portionof our revenue for each quarter.

 

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If we were to sell even one less system than our forecasted number ofheadend sales per quarter, our quarterly revenue would be materially impacted.As we have not entered into any new license or royalty agreements since 2000,we expect that our license and royalty revenue will be minimal for theforeseeable future. Cost of goods sold, or COGS, consists of costs related toraw materials, contract manufacturing, personnel, overhead, test and qualityassurance for products, and the cost of licensed technology included in ourproducts. Raw materials, contract manufacturing and licensed technology are theprincipal elements of COGS and vary directly with product sales. Sales andmarketing expense consists primarily of selling and marketing personnel costs,including sales commissions, travel, trade shows, promotions and outsideservices. Research and development expense consists primarily of personnel andfacilities costs, contract consultants, outside testing services, and equipmentand supplies associated with enhancing existing products and developing newproducts. General and administrative expense consists primarily of personnelcosts for administrative officers and support personnel, professional servicesand insurance expenses. Amortization of intangible assets consists primarily ofexpenses associated with the amortization of technology and patents related toprior years’ acquisitions.

** **

**Results ofOperations**

 

Thefollowing table sets forth items from our statements of operations as apercentage of total revenue for the periods indicated:

 
| ** **                     | ** ** | **Three Months  Ended September 30,** | ** ** | **Nine Months  Ended September 30,** | ** ** |
|--------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                     | ** ** | **2003**                              | ** ** | **2004**                             | ** ** | **2003** | ** ** | **2004** | ** ** |
| Total revenue                  |       | 100.0                                 | %          | 100.0                                | %          | 100.0 | % | 100.0 | % |
| Total cost of goods sold       |       | 44.0                                  |       | 61.5                                 |       | 48.0 |   | 70.5 |   |
| Gross margin                   |       | 56.0                                  |       | 38.5                                 |       | 52.0 |   | 29.5 |   |
| Operating expenses:            |       |                                  |       |                                 |       |   |   |   |   |
| Sales and marketing            |       | 21.7                                  |       | 30.0                                 |       | 24.8 |   | 32.5 |   |
| Research and development       |       | 22.2                                  |       | 27.6                                 |       | 27.0 |   | 30.7 |   |
| General and administrative     |       | 11.9                                  |       | 15.6                                 |       | 14.5 |   | 18.1 |   |
| Restructuring costs            |       | 3.4                                   |       | —                               |       | 1.3 |   | — |   |
| Impairment of intangibles      |       | —                                |       | —                               |       | 0.6 |   | 1.1 |   |
| Amortization of intangibles    |       | 5.2                                   |       | 5.6                                  |       | 5.9 |   | 6.4 |   |
| Total operating expenses       |       | 64.4                                  |       | 78.9                                 |       | 74.1 |   | 88.9 |   |
| Loss from operations           |       | (8.4                                  | )          | (40.4                                | )          | (22.0 | ) | (59.4 | ) |
| Interest and other income, net |       | (0.3                                  | )          | (0.7                                 | )          | 0.3 |   | (0.8 | ) |
| Net loss                       |       | (8.7                                  | )%         | (41.1                                | )%         | (21.7 | )% | (60.2 | )% |

 

*Three and Nine Months Ended September 30, 2003 and 2004*

 

*Total Revenue.* Our total revenue decreased to $6.7 million and $18.0 million for thethree and nine months ended September 30, 2004, respectively, when comparedwith total revenue of $8.5 million and $23.0 million for the same periodsin 2003. For the three months ended September 30, 2004, our product revenuefrom video processing systems declined by 24.4% to $5.0 million from$6.6 million for the three months ended September 30, 2003.  Forthe nine months ended September 30, 2004, our product revenue from videoprocessing systems decreased by $4.5 million, or 27.2%, to $12.3 million from$16.8 million for the same period in 2003.   The decreases in videoprocessing systems product revenue were due primarily to the adverse effect ofseveral digital TV headend sales not closing during the period asexpected.  We continue to experience avariety of factors that are causing prospective customers to delay their purchasedecisions.  Certain prospective  customers have indicated to us that factorscausing these delays include, but are not limited to, their anticipation of theintroduction and general availability of advanced compression technologieslater this year and early next year, customers’ decisions to use more efficientdata transmission technologies (decisions that some of our customers wish tomake before they commit to purchasing headends) and customers’ decisions aboutusing emerging video signal encryption technologies (decisions that some of ourcustomers wish to make before they commit to purchasing headends).  Sales of broadband transport and servicemanagement products decreased from $2.0 million in the third quarter of 2003 to$1.7 million in the third quarter of 2004 and decreased from $6.1 million forthe nine months ended September 30, 2003 to $5.7 million for the nine monthsended September 30, 2004.   The decrease in broadband transport andservice management products revenue was primarily the result of customerschoosing competing products that transmit data via wireless data transmissiontechnologies instead of our products (which transmit data over telephonewires). Accordingly, we expect that revenue from our broadband transport andservice management products will decline slightly for the remainder of 2004,compared to the three months ended September 30, 2004.  For the three months ended September30, 2004, our license and royalty revenue decreased to $4,000 from$0.2 million for the three months ended September 30, 2003 and decreased to$40,000 for the nine months ended September 30, 2004 from $0.6 million for thenine months ended September 30, 2003.  Weexpect that our license and royalty revenue will be minimal for the foreseeablefuture.

 

*Cost of Goods Sold.*  For the three months ended September 30,2004, our cost of goods sold increased by $0.3 million to $4.1 millionfrom $3.8 million for the three months ended September 30, 2003. Thisincrease in costs of goods sold is due to a year over year net increase of $1.1million in inventory reserves and an increase in labor costs of $0.2million.  Partially offsetting theseincreases was a reduction in material costs of $1.0 million   Cost of goods sold increased by $1.7 millionto $12.7 million during the nine months ended September 30, 2004 from $11.0million for the nine months ended September 30, 2003.  This increase in costs of goods sold is dueto a year over year

 

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increase of $2.2 million ininventory reserves.  Also included in thisincrease is $0.5 million in labor costs, $0.2 million in contractors expense,and $0.3 million in freight, travel and other expenses.  Partially offsetting these increases was adecrease in material costs of $1.5 million.

 

*Sales and Marketing.*  For the three months ended September 30,2004, our sales and marketing expenses increased to $2.0 million from $1.8million for the three months ended September 30, 2003.  The increase was due to higher personnelrelated costs.  For the nine months endedSeptember 30, 2004, our sales and marketing expense increased to $5.8 millionfrom $5.7 million for the nine months ended September 30, 2003.  The increase was due to higher expenses foradvertising and trade shows.

 

*Research and Development.*  For the three months ended September 30,2004, our research and development expense remained the same relative to thesame period in 2003. Research and development expense decreased by $0.7 millionto $5.5 million for the nine months ended September 30, 2004 from $6.2 million forthe nine months ended September 30, 2003. The $0.7 million decrease was due to a decrease in personnel relatedcosts.  We expect that our research anddevelopment expenses will increase throughout the remainder of 2004. Ourcapital expenditures for research and development were $27,000 and$45,000 for the three months ended September 30, 2003 and 2004,respectively and $0.3 million and $0.6 million for the nine months endedSeptember 30, 2003 and 2004, respectively. We expect capital expenditures for researchand development in 2004 to remain comparable to capital expenditures in 2003.

 

*General and Administrative.*  For the three and nine months ended September30, 2003 and 2004, our general and administrative expense remained the same at$1.0 million and $3.3 million, respectively.

 

*Impairment of Intangible Assets. *During the firstquarter of 2004, we determined that certain of the technology acquired as partof the purchase of the ViaGate Technology assets had become impaired. As aresult, we recorded an impairment charge of $0.2 million to write off thebook value of the intangible assets associated with this technology. During thesecond quarter of 2003, we recognized a loss of $0.1 million for the impairmentof certain technology acquired as part of the acquisition of the assets ofViaGate.

 

*Amortization of Intangible Assets.*  Amortization of intangible assets iscomprised of intangibles related to the acquisitions of Xstreamis Limited in2000, and VTC in 2002. The remaining intangible assets subject to amortizationfrom these acquisitions consist primarily of completed technology and patents.For the three months ended September 30, 2003 and 2004, amortization ofintangible assets remained consistent at $0.4 million.  Amortization of intangible assets decreasedto $1.1 million for the nine months ended September 30, 2004 from $1.4 millionfor the nine months ended September 30, 2003.

 

*Interest and Other Income, Net.*  Interest and other income, net consistsprimarily of interest income and expense. For the nine months ended September30, 2004, our interest and other income, decreased to a net expense of$0.1 million from a net interest and other income of $0.1 million forthe nine months ended September 30, 2003. The decrease in the nine months endedSeptember 30, 2004 of $0.2 million compared with the nine months endedSeptember 30, 2003 was primarily the result of lower interest rates on loweraverage cash balances and increased interest expense associated with the$3.7 million note issued in connection with our purchase of VTC inNovember 2002.

 

**Liquidity and Capital Resources**

 

Cash and cash equivalents totaled $9.3 million at September 30,2004, compared with cash and cash equivalents of $14.4 million at December31, 2003, reflecting a net reduction in cash and cash equivalents of$5.1 million.

 

Cash used in operating activities was $6.9 million for the ninemonths ended September 30, 2004, compared with $11.6 million for the ninemonths ended September 30, 2003. The reduced cash used in operating activitieswas primarily due to a decrease in accounts receivable due to lower revenue inthe third quarter of 2004 and an increased focus on collections and an increasein accounts payable and accrued liabilities due to an increase in end ofquarter inventory purchases.  We recordeda provision for excess and obsolete inventory within cost of goods soldtotaling $1.4 million in the nine months ended September 30, 2004.

 

Additions to property and equipment were $1.1 million in the ninemonths ended September 30, 2004, compared with $0.7 million in the ninemonths ended September 30, 2003, primarily reflecting an increased investmentin research and development assets. In total we expect capital expenditures for2004 to be comparable to 2003. We expect these capital expenditures to befunded from operations.

 

Cash from financing activities was $2.9 million in the nine monthsended September 30, 2004, compared with $0.7 million for the nine months endedSeptember 30, 2003. The increase in cash was due to borrowings under the creditfacility.

 

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The following table sets forth our contractual obligations as ofSeptember 30, 2004:

 
| ** **                   | ** ** | **Payments due by period (in thousands)** | ** ** |
|------------------------------|------------|-------------------------------------------|------------|
| **Contractual  Obligations** | ** ** | **Total**                                 | ** ** | **Remainder  of 2004** | ** ** | **2005  to  2006** | ** ** | **2007  to  2008** | ** ** | **Thereafter** | ** ** |
| Long-Term Debt Obligations   |       | $                                         | 3,743      |   | $ | — |   | $ | — |   | $ | 3,743 |   | $ | — |   |
| Operating Lease Commitments  |       | 1,043                                     |       | 233 |   | 731 |   | 52 |   | 27 |   |
| Purchase Obligations         |       | 479                                       |       | 479 |   | — |   | — |   | — |   |
| Other Long-Term Liabilities  |       | 4                                         |       | 4 |   | — |   | — |   | — |   |
| Total                        |       | $                                         | 5,269      |   | $ | 716 |   | $ | 731 |   | $ | 3,795 |   | $ | 27 |   |

 

Wedo not have any off balance sheet arrangements.

 

Aspart of our acquisition of VTC from Tektronix in November 2002, we issueda note payable to Tektronix for $3.2 million, with repayment in sixtymonths, or by November 2007. The interest rate on this note is 8% and is compoundedannually. Through January 31, 2006, the accrued interest is added to theprincipal balance of the note. Thereafter, we will pay accrued interest on thisnote commencing on January 31, 2006 and on each April 30,July 31 and October 31 thereafter until the principal balance is paidin full. Principal and accrued interest on the note payable is$3.7 million at September 30, 2004. Accrued interest in the nine months ended September 30, 2004 was $0.2million.

 

Inconnection with the settlements of certain legal matters in December 2003, werecorded a liability and a receivable, each in the amount of$10.7 million, in our December 31, 2003 balance sheet. Thesettlements were formerly approved by the respective courts and the amountswere paid by our insurance carriers during the nine months ended September 30,2004. Therefore, we removed the $10.7 million liability and receivable relatedto the settlements from the balance sheet as of September 30, 2004.

 

Wehave seen a recent increase in orders for our products and therefore believe,to the extent that such demand continues, that our negative cash flows fromoperating activities will decrease to some extent over the next several fiscalquarters. To provide additional assurance of liquidity we entered into arevolving asset based credit facility, or credit facility, with Silicon ValleyBank, or the bank, on September 23, 2004. This facility has a term of two yearsand expires on September 23, 2006. All borrowings under this facility areclassified as current liabilities. Borrowings under the credit facility are formula based and limited tothe lesser of $7.0 million or an amount based on a percentage of eligibleaccounts receivable and eligible inventories.  Based on the maximum percentages of eligible accounts receivable andeligible inventory levels, borrowings under this facility were $2.6 million asof September 30, 2004. The annual interest rate as of September 30, 2004 was5.25%.  The interest rate is equal to thebank’s base rate, or prime rate, currently at 4.75%, plus 0.5%. The rate mayincrease by 1.0% if the Company does not meet certain financial covenants. Thecredit facility is secured by all of our assets, and contains variouscovenants.

 

Whilewe anticipate, based on discussions with the bank, that we will continue to beable to borrow money under the line of credit, the bank enjoys discretion withrespect to whether it will continue to make loans to us under the line ofcredit and there is therefore no guarantee that the bank will necessarilycontinue to loan to us. Furthermore, while the bank has made no intention to doso, under the terms of the credit facility the bank is able to declare an eventof default and accelerate our duty to repay any borrowings based on a widearray of circumstances. These circumstances include, among others, a materialadverse change in our business, operations or condition (financial orotherwise).

 

Subsequentto September 30, 2004, we completed the sale of 4.6 million shares of ourcommon stock at a price of $2.25 per share for gross proceeds of $10.3million.  Net proceeds from the offeringwere approximately $8.7 million.

 

Ifwe are unable to continue to borrow under the credit facility, or if the recentincrease in orders for our products does not continue and our currentexpectations concerning future revenue therefore do not turn out to beaccurate, we might be required to take measures to reduce our operatingexpenses and we might require additional sources of funds in order to continueoperations over the next twelve months. We cannot be assured that such fundingwould be available on commercially reasonable terms or at all.  We believe that our cash and cash equivalentsare sufficient to fund our operating activities and capital expenditure needsfor the next twelve months.

 

**Critical Accounting Policies and Estimates**

 

Ourdiscussion and analysis of our financial condition and results of operationsare based upon our consolidated financial statements, which have been preparedin accordance with generally accepted accounting principles in the UnitedStates. The preparation of these financial statements requires us to makeestimates and assumptions that affect the reported amounts of assets andliabilities, the disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenue and expensesduring the reporting periods. We base our estimates on historical experienceand on various other assumptions that are believed to be reasonable under thecircumstances, the results of which form the basis for making judgments aboutthe carrying values of assets and liabilities that are not readily apparentfrom other sources. Actual results may differ from these estimates underdifferent assumptions or conditions.

 

Wehave identified the policies below as critical to our business operations andthe understanding of our results of operations.

 

*Revenue recognition.*  Wegenerate revenue primarily from the sale of hardware products, includingthird-party products,

 

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throughprofessional services, and through the sale of our software products. We sellproducts through direct sales channels and through distributors. Generally,product revenue is generated from the sale of video processing systems andcomponents and the sale of broadband transport and service management products.Turnkey solution revenue is principally generated by the sale of completeend-to-end video processing systems that are designed, developed and producedaccording to a buyer’s specifications.

 

Productrevenue is generated primarily from the sale of complete end-to-end videoprocessing systems generally referred to as turnkey solutions. Turnkeysolutions are multi-element arrangements, which consist of hardware products,software products, professional services and post-contract support. Sales ofturnkey solutions are classified as product revenue in the statement ofoperations.

 

Productrevenue is also generated from the sale of video processing component productsand the sale of broadband transport and service management products. We sellthese products through our own direct sales channels and also throughdistributors. Our revenue recognition policies for turnkey solutions are inaccordance with SOP 97-2, *SoftwareRevenue Recognition,* as amended, which is the authoritative guidancefor recognizing revenue on software transactions and transactions in whichsoftware is more than incidental to the arrangement. SOP 97-2 requiresthat revenue recognized from software arrangements be allocated to each elementof the arrangement based on the relative fair values of the elements, such ashardware, software products, maintenance services, installation, training orother elements. Under SOP 97-2, the determination of fair value is basedon objective evidence that is specific to the vendor. If such evidence of fairvalue for any undelivered element of the arrangement does not exist, allrevenue from the arrangement is deferred until such time that evidence of fair valuedoes exist or until all elements of the arrangement are delivered, subject tocertain limited exceptions set forth in SOP 97-2, as amended.SOP 97-2 was amended in February 1998 by SOP 98-4, *Deferral of the Effective Date of a Provision ofSOP 97-2* and was amended again in December 1998 by SOP 98-9, *Modification of SOP 97-2, Software RevenueRecognition, with Respect to Certain Transactions*.       Those amendments deferred and thenclarified, respectively, the specification of what was considered vendor specificobjective evidence of fair value for the various elements in a multiple elementarrangement.

 

Inthe case of software arrangements that require significant production,modification or customization of software, which encompasses all of our turnkeyarrangements, SOP 97-2 refers to the guidance in SOP 81-1, *Accounting for Performance of Construction-Type andCertain Production-Type Contracts.* We recognize revenue for allturnkey arrangements in accordance with SOP 97-2 and SOP 81-1.Excluding the PCS element of the multi-element arrangement, for which we haveestablished vendor specific objective evidence of fair value (as defined bySOP 97-2), revenue from turnkey solutions is generally recognized usingthe percentage-of-completion method, as stipulated by SOP 81-1. Thepercentage-of-completion method reflects the portion of the anticipatedcontract revenue that has been earned that is equal to the ratio of laboreffort expended to date to the anticipated final labor effort, based on currentestimates of total labor effort necessary to complete the project. Revenue fromthe PCS element of the arrangement is deferred at the point of sale andrecognized over the term of the PCS period. Generally, the terms of the turnkeysolution sales provide for billing of approximately 90% of the contract valueprior to the time of delivery to the customer site, with an additionalapproximately 9% of the contract value billed upon substantial completion ofthe project and the balance upon customer acceptance.  The contractual arrangements relative toturnkey solutions include customer acceptance provisions. However, suchprovisions are generally considered to be incidental to the arrangement in itsentirety because customers are fully obligated with respect to approximately99% of the contract value irrespective of whether acceptance occurs or not.

 

Fordirect sales of video processing systems component products not included aspart of turnkey solutions and the direct sale of broadband transport andservice management products, we recognize revenue when persuasive evidence ofan arrangement exists, delivery has occurred, the fee is fixed or determinable,and collection is reasonably assured.

 

Significantmanagement judgments and estimates must be made in connection with the measurementof revenue in a given period. We follow specific and detailed guidelines fordetermining the timing of revenue recognition. At the time of the transaction,we assess a number of factors, including specific contract and purchase orderterms, completion and timing of delivery to the common-carrier, pasttransaction history with the customer, the creditworthiness of the customer,evidence of sell-through to the end user, and current payment terms. Based onthe results of the assessment, we may recognize revenue when the products areshipped or defer recognition of revenue until evidence of sell-through occursand cash is received. In order to recognize revenue, we must also make ajudgment regarding collectibility of the arrangement fee.  Management’s judgment of collectibility isapplied on a customer-by-customer basis pursuant to our credit reviewpolicy.  We sell to customers for whichthere is a history of successful collection and to new customers for which suchhistory may not exist.  New customers aresubject to a credit review process, which evaluates the customers’ financialposition and ability to pay. New customers are typically assigned a creditlimit based on a review of their financial position.  Such credit limits are only increased after asuccessful collection history with the customer has been established.  If it is determined from the outset of anarrangement that collectibility is not probable based upon our credit reviewprocess, no credit is extended and revenue is recognized on a cash-collectedbasis after shipment has occurred or the revenue has been earned under thepercentage-of-completion method.

 

Wealso maintain accruals and allowances for all cooperative marketing and otherprograms, as necessary. Estimated sales returns and warranty costs are based onhistorical experience and are recorded at the time revenue is recognized, asnecessary. Our products generally carry a one year warranty from the date ofpurchase. To date, warranty costs have been insignificant to the overallfinancial statements taken as a whole.

 

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Licenseand royalty revenue consists of non-refundable up-front license fees, some ofwhich may offset initial royalty payments, and royalties received by us for productssold by our licensees. Currently, the majority of our license and royaltyrevenue is comprised of non-refundable license fees paid in advance. Suchrevenue is recognized ratably over the period during which post-contractcustomer support is expected to be provided or upon delivery and transfer ofagreed upon technical specifications in contracts where essentially no furthersupport obligations exist. Future license and royalty revenue is expected toconsist primarily of royalties received by us for products sold by ourlicensees. We expect that such license and royalty revenue will not constitutea substantial portion of our revenue in future periods.

 

*Inventories.*  Inventories are stated at thelower of cost or market. Cost is computed using standard cost, whichapproximates actual cost on a first-in, first-out basis. We record provisionsto write down our inventory and related purchase commitments for estimatedobsolescence or unmarketable inventory equal to the difference between the costof the inventory and the estimated market value based upon assumptions aboutthe future demand and market conditions. If actual future demand or marketconditions are less favorable than we estimate, additional inventory provisionsmay be required.

 

*Allowance for doubtful accounts.*  Wemaintain allowances for doubtful accounts for estimated losses resulting fromthe inability of our customers to make payments. These estimated allowances areperiodically reviewed, analyzing the customers’ payment history and informationregarding the customers’ creditworthiness known to us. If the financialcondition of any of our customers were to deteriorate, resulting in theirinability to make payments, an additional allowance would be required.

 

*Accounting for long-lived assets.*  Weare required to periodically assess the impairment of long-lived assets. Animpairment review is performed whenever events or changes in circumstancesindicate that the carrying value may not be recoverable.

 

Factorsconsidered important which could trigger an impairment review include, but arenot limited to, significant underperformance relative to expected historical orprojected future operating results, significant changes in the manner of use ofthe acquired assets or the strategy for the overall business, significantnegative industry or economic trends, a significant decline in the stock pricefor a sustained period, and our market capitalization relative to net bookvalue.

 

Whenour management determines that the carrying value may not be recoverable basedupon the existence of one or more of the above indicators of impairment, anyimpairment measured is based on a projected discounted cash flow method using adiscount rate commensurate with the risk inherent in our current businessmodel.

 

Duringthe nine months ended September 30, 2003, we determined that certain intangiblelong-lived assets were impaired and recorded a loss of $0.1 million under SFASNo. 144   During the nine month endedSeptember 30, 2004, we determined that certain intangible long-lived assetswere impaired and recorded a loss of $0.2 million under SFAS No. 144.Future events could cause us to conclude that impairment indicators once againexist. Any resulting impairment loss could have a material adverse impact onour financial condition and results of operations.

 

*Legal contingencies. *We are currently involved in certain legalproceedings as discussed in our consolidated financial statements. Because ofuncertainties related to the potential amount and range of loss from thepending litigation, management is unable to make a reasonable estimate of theliability that could result if there is an unfavorable outcome in these legalproceedings. We recorded a liability for the In re Tut Systems, Inc. SecuritiesLitigation and the Lefkowitz matters, as well as an equal and correspondingreceivable (which we subsequently removed from the balance sheet as of June 30,2004). We have not recorded a liability for the Whalen matter as a consequenceof several uncertainties. As additional information becomes available, we willassess the potential liability related to these pending litigation matters andmay revise our estimates accordingly. Revisions of our estimates of suchpotential liability could materially impact our results of operations,financial condition or cashflows.

 

**RecentAccounting Pronouncements**

 

In January 2003, theFinancial Accounting Standards Board, the (“FASB”) issued FASB InterpretationNo. 46 (FIN 46), “Consolidation of Variable Interest Entities, anInterpretation of ARB No. 51, Consolidated Financial Statements,” andsubsequently revised in December 2003 with the issuance of FIN 46-R. Thisinterpretation requires certain variable interest entities to be consolidatedby the primary beneficiary of the entity if the equity investors in the entitydo not have the characteristics of a controlling financial interest or do nothave sufficient equity at risk for the entity to finance its activities withoutadditional subordinated financial support from other parties. Application ofthis Interpretation is required in financial statements for periods endingafter March 15, 2004.  The adoptionof this Interpretation in the nine months ended September 30, 2004 did not havea material impact on our results of operations, financial position or cashflows.

 

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**ADDITIONALRISK FACTORS THAT COULD AFFECT OUR OPERATING RESULTS AND THE MARKET PRICE OFOUR STOCK**

 

**We have a history of significant losses, and we may neverachieve profitability.**

 

Wehave incurred substantial net losses and experienced negative cash flow foreach quarter since our inception. As of September 30, 2004, we had anaccumulated deficit of $292.9 million. We expect to incur losses in thenear future. Moreover, we may never achieve profitability and, if we do so, wemay not be able to maintain profitability. We may not be able to generate asufficient level of revenue to offset our current level of expenditures.Moreover, because our expenditures for sales and marketing, research anddevelopment, and general and administrative functions are relatively fixed inthe short term, we may be unable to adjust our spending in a timely manner torespond to any unanticipated decline in revenue. If we fail to achieveprofitability within the timeframe expected by securities analysts orinvestors, then the market price of our common stock will likely decline.

 

**Each saleof our headend systems represents a significant portion of our revenue for anygiven quarter. Our failure to meet our quarterly forecast of sales of headendsystems in any given quarter could have a material adverse impact on ourfinancial results for a given quarter.**

 

Sincewe acquired VTC in November 2002, a large part of our quarterly revenue isassociated with the sale of headend systems. Each sale represents a significantportion of our revenue for each quarter. We base our operating forecast on ourhistorical sales. Because of the high cost per unit of our headend systems, ifwe were to sell even one less system than our forecasted number of headendsales per quarter, such a decrease in sales would have a material and adverseimpact on our revenue for that quarter, and we may fail to meet investorexpectations.

 

**We operate in an intensely competitive marketplace, and manyof our competitors have better resources than we do.**

 

Ourprimary competitors in the digital TV headend market are small privatecompanies that are focused on a more narrow product line than ours, therebyallowing these competitors to devote substantially more targeted resources todeveloping and marketing new products than we can. As we begin to target largertelco customers for our video content processing systems, we expect morecompetition from large public companies like Harmonic, Inc., Tandberg TelevisionASA, and Motorola, Inc., all of which have substantially greaterfinancial, technical and other resources than we do. These competitors haveachieved success in providing headend components for cable multiple systemoperators and satellite TV providers and, we expect these competitors to marketsome of their products for use in TV over DSL applications. For example, in thepast, Harmonic provided video content processing systems to SaskTel, a largeCanadian telephone service provider. Harmonic also recently announced that itwill provide video content processing systems to Video Networks Limited, avideo-over-DSL provider in the United Kingdom.

 

Ourcompetition in the market for video transmission processing products primarilycomes from small private companies such as SkyStream Networks and publiccompanies such as Optibase Inc. and Tandberg Television that togetheroffer a wide array of products with special features and functions. Ourbroadband transport and service management business tends to compete againstpublic, private and foreign network equipment companies.

 

Tothe extent that any of these current or potential future competitors enter orexpand further into our markets, develop superior technology and products oroffer superior prices or performance features relative to our products, suchcompetition could result in lost sales and severe downward pressure on ourpricing, either of which would adversely affect our revenue and profitability.

 

**Commercial acceptance of any technological solution thatcompetes with technology based on communication over copper telephone wirecould materially and adversely impact demand for our products, our revenue andgrowth strategy.**

 

Themarkets for video content processing, transmission and high-speed data accesssystems and services are characterized by several competing communicationtechnologies, including fiber optic cables, coaxial cables, satellites andother wireless facilities. Many of our products are based on communication overcopper telephone wire. Because there are physical limits to the speed anddistance over which data can be transmitted over copper wire, our products maynot be a viable solution for customers requiring service at performance levelsbeyond the current limits of copper telephone wire. Our customer base isconcentrated on telephone service providers that have a large investment incopper wire technology. If these customers lose market share to theircompetitors who use competing technologies that are not as constrained by physicallimitations as copper telephone wire, and that are able to provide fasteraccess, greater reliability, increased cost-effectiveness or other advantages,demand for our products will decrease. Moreover, to the extent that ourcustomers choose to install fiber optic cable or other transmission media aspart of their infrastructure, or to the extent that homes and businessesinstall other transmission media within buildings, demand for our products maydecline. The occurrence of any one or more of these events would harm demandfor our products, which would thereby adversely affect our revenue and growthstrategy.

 

**If the projected growth in demand for video services fromtelephone service providers does not materialize or if our customers findalternative methods of delivering video services, future sales of our videocontent processing systems will suffer.**

 

Wemanufacture video content processing systems that enable telephone serviceproviders to offer video services to their customers. Our customers, the telephoneservice providers, face competition from cable companies, satellite serviceproviders and

 

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wirelesscompanies. For some users, these competing solutions provide fast access, highreliability and cost-effective solutions for delivering data, including videoservices. Telephone service providers hope to maintain their market share intheir core business of voice telephony as well as increase their revenue percustomer by offering their customers more services, including video servicesand high-speed data services. However, if the telephone service providers findalternative ways of maintaining and growing their market share in their corebusiness that do not require that they offer video services, demand for ourproducts will decrease substantially. Moreover, if technological advancementsare developed that allow our customers to provide video services withoutupgrading their current system infrastructure, or that offer our customers amore cost-effective method of delivering video services, sales of our videocontent processing systems will suffer. Alternatively, even if the telephoneservice providers choose our video content processing systems, the serviceproviders may not be successful in marketing video services to their customers,in which case our sales would decrease substantially.

 

**Ouroperating results fluctuate significantly from quarter to quarter, and this maycause the price of our stock to decline.**

 

Overthe last 12 quarters, our sales per quarter have fluctuated between$9.2 million and $2.0 million. Over the same periods, our loss fromoperations as a percentage of revenue has fluctuated between approximately 5.2%and 1,274% of revenue. We anticipate that our sales and operating margins willcontinue to fluctuate. We expect this fluctuation to continue for a variety ofreasons, including:

 

**•**                                          the timing of customers’ purchase decisions,acceptance of our new products and possible cancellations;

 

**•**                                          competitive pressures, including pricing pressuresfrom our partners and competitors;

 

**•**                                          delays or problems in the introduction of ournew products;

 

**•**                                          announcements of new products, services ortechnological innovations by us or our competitors; and

 

**•**                                          management of inventory levels.

 

**The sales cycle for video content processing systems is longand unpredictable, which requires us to incur high sales and marketing expenseswith no assurance that a sale will result.**

 

Thesales cycle for our headend systems can be as long as 12-18 months.Additionally, with respect to the sale of our products to U.S. and foreigngovernment organizations, we may experience long sales cycles as a result ofgovernment procurement processes. As a result, while we continue to incur costsassociated with a particular sale prior to payment from the customer, we maynot recognize revenue from efforts to sell particular products for extendedperiods of time.

 

Asa result, our quarter-to-quarter comparisons of our revenue and operatingresults may not be meaningful and may not provide an accurate indicator of ourfuture performance. Our operating results in one or more future quarters mayfail to meet the expectations of investment research analysts or investors,which could cause an immediate and significant decline in the trading price ofour common stock.

 

**If we fail to accurately forecast demand for our products,revenue, profitability and reputation could be harmed.**

 

Werely on contract manufacturers and third-party equipment manufacturers, orOEMs, to manufacture, assemble, test and package our products. We also dependon third-party suppliers for the materials and parts that constitute ourproducts. Our reliance on contract manufacturers, OEMs and third-partysuppliers requires us to accurately forecast the demand for our products andcoordinate our efforts with those of our contract manufacturers, OEMs andsuppliers. We often make significant up-front financial commitments with ourcontract manufacturers, OEMs and suppliers in order to procure the rawmaterials and begin manufacturing and assembly of the products. If we fail toaccurately forecast demand or coordinate our efforts with our suppliers, OEMsand contract manufacturers, we may face supply, manufacturing or testingcapacity constraints. These constraints could result in delays in the deliveryof our products, which could lead to the loss of existing or potentialcustomers and could thereby result in lost sales and damage to our reputation,which would adversely affect our revenue and profitability. Further, we outsourcethe manufacturing of our products based on forecasts of sales. If orders forour products exceed our forecasts, we may have difficulty meeting customers’orders in a timely manner, which could damage our reputation or result in lostsales. Conversely, if our forecasts exceed the orders we actually receive andwe are unable to cancel future purchase and manufacturing commitments in atimely manner, our inventory levels would increase. This could expose us tolosses related to slow moving and obsolete inventory, which would have amaterial adverse effect on our profitability.

 

**If we fail to develop and introduce new products in responseto the rapid technological changes in the markets in which we compete, we willnot remain competitive.**

 

Themarkets for video content processing, transmission and high-speed data accesssystems are characterized by rapid technological developments, frequentenhancements to existing products and new product introductions, changes inend-user requirements and evolving industry standards. To remain competitive,we must continually improve the performance, features and reliability of ourproducts. For example, advancements in compression technology are leading thevideo content processing industry to

 

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beginthe transition to next generation compression standards. These advances willallow for further reductions in the bandwidth required to deliver standarddefinition video channels and introduce the possibility of delivering high-definitiontelevision over asymmetric digital subscriber lines, or ADSL, for the firsttime. ADSL is a new technology that allows more data to be transmitted overcopper telephone lines than standard DSL. Further advances in compressiontechnology, or the emergence of new industry standards would require that wefurther redesign our products to incorporate, and remain compatible with,emerging technologies and industry standards.

 

Wecannot assure you that we will be able to respond quickly and effectively totechnological change. We may have only limited time to enter certain markets,and we cannot assure you that we will be successful in achieving widespreadacceptance of our products before competitors can offer products and servicessimilar or superior to our products. If we fail to introduce new products thataddress technological changes or if we experience delays in our productintroductions, our ability to compete would be adversely affected, therebyharming our revenue, profitability and growth strategy.

 

**We depend on international sales for a significant portion ofour revenue, which subjects our business to a number of risks. If we are unableto generate significant international sales, our revenue, profitability andshare price could be materially and adversely affected.**

 

Salesto customers outside of the United States accounted for approximately 56.3%,43.0% and 18.4% of revenue for the years ended December 31, 2001, 2002 and2003, respectively and 18.0% and 21.4% for the nine months ended September 30,2003 and 2004, respectively. Sales and operating activities outside of theUnited States are subject to inherent risks, including fluctuations in thevalue of the United States dollar relative to foreign currencies; tariffs,quotas, taxes and other market barriers; political and economic instability;restrictions on the export or import of technology; potentially limitedintellectual property protection; difficulties in staffing and managinginternational operations and potentially adverse tax consequences. Any of thesefactors may have a material adverse effect on our ability to grow or maintaininternational revenue.

 

Weexpect sales to customers outside of the United States to represent asignificant and growing portion of our revenue. However, we cannot assure youthat foreign markets for our products will develop at the rate or to the extentthat we anticipate. If we fail to generate significant international sales, ourrevenue, profitability and share price could be materially and adversely affected.

 

**Fluctuations in interest and currency exchange rates maydecrease demand for our products.**

 

Substantiallyall of our foreign sales are invoiced in U.S. dollars. As a result,fluctuations in currency exchange rates could cause our products to becomerelatively more expensive for international customers, thereby reducing demandfor our products. We anticipate that we will generally continue to invoiceforeign sales in U.S. dollars. We do not currently engage in foreign currencyhedging transactions. However, as we expand our current internationaloperations, we may allow payment in foreign currencies and, as a result, ourexposure to foreign currency transaction losses may increase. To reduce thisexposure, we may purchase forward foreign exchange contracts or use otherhedging strategies. However, we cannot assure you that any currency hedgingstrategy would be successful in avoiding exchange-related losses. Any suchlosses would adversely impact our profitability.

 

**If our contract manufacturers, third-party OEMs andthird-party suppliers fail to produce quality products or parts in a timelymanner, we may not be able to meet our customers’ demands.**

 

Wedo not manufacture our products. We rely on contract manufacturers and OEMs tomanufacture, assemble, package and test substantially all of our products andto purchase most of the raw materials and components used in our products.Additionally, we depend on third-party suppliers to provide quality parts andmaterials to our contract manufacturers and OEMs, and we obtain some of the keycomponents and sub-assemblies used in our products from a single supplier or alimited group of suppliers. Neither we nor our contract manufacturers or OEMshave any guaranteed supply arrangements with the suppliers. If our suppliersfail to provide a sufficient supply of key components, we could experiencedifficulties in obtaining alternative sources at reasonable prices, if at all,or in altering product designs to use alternative components. Moreover, if ourcontract manufacturers or OEMs fail to deliver quality products in a timelymanner, such failure would harm our ability to meet our scheduled productdeliveries to customers. Delays and reductions in product shipments couldincrease our production costs, damage customer relationships and harm ourrevenue and profitability. In addition, if our contract manufacturers and OEMsfail to perform adequate quality control and testing of our products, we wouldexperience increased production costs for product repair and replacement, andour profitability would be harmed. Moreover, defects in products that are notdiscovered in the quality assurance process could damage customer relationshipsand result in product returns or product liability claims, each of which couldharm our revenue, profitability and reputation.

 

**Design defects in our products could harm our reputation andour revenue, profitability and reputation.**

 

Anydefect or deficiency in our products could reduce the functionality,effectiveness or marketability of our products. These defects or deficienciescould cause customers to cancel or delay their orders for our products,reducing revenue or profitability. In any of these events, we would be requiredto devote substantial financial and other resources for a significant period oftime to develop new product designs. We cannot assure you that we would besuccessful in addressing any design defects in our products or in developingnew product designs in a timely manner, if at all. Any of these events,individually or in the aggregate, could harm our

 

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revenue,profitability and reputation.

 

**Our business depends on the integrity of our intellectualproperty rights. If we fail to adequately protect our intellectual property,our revenue, profitability, reputation and growth strategy could be adverselyaffected.**

 

We attempt to protect ourintellectual property and proprietary technology through patents, trademarksand copyrights, by generally entering into confidentiality or licenseagreements with our employees, consultants, vendors, strategic partners andcustomers as needed, and by generally limiting access to and distribution ofour trade secret technology and proprietary information. However, any of ourpending or future patent or trademark applications may not ultimately be issuedas patents or trademarks of the scope that we sought, if at all, and any of ourpatents, trademarks or copyrights may be invalidated, deemed unenforceable, orotherwise challenged. In addition, other parties may circumvent or designaround our patents and other intellectual property rights, may misappropriateour proprietary technology, or may otherwise develop similar, duplicate orsuperior products. Further, the intellectual property laws and our agreementsmay not adequately protect our intellectual property rights and effectiveintellectual property protection may be unavailable or limited in certainforeign countries in which we do business or may do business in the future.

 

Thetelecommunications and data communications industries are characterized by theexistence of extensive patent portfolios and frequent intellectual propertylitigation. From time to time, we have received, and may in the future receive,claims that we are infringing third parties’ intellectual property rights. Anypresent or future claims, with or without merit, could be time-consuming,result in costly litigation, divert management time and attention and otherresources, cause product shipment delays or require us to enter into royalty orlicensing agreements. Such royalty or licensing agreements, if required, maynot be available on terms acceptable to us. In addition, any such litigationcould force us to cease selling or using certain products or services, or to redesignsuch products or services. Further, we may in the future initiate claims orlitigation against third-parties for infringement of our intellectual propertyrights or to determine the scope and validity of our intellectual propertyrights or those of competitors. Such litigation could result in substantialcosts and diversion of resources. Any of the foregoing could have an adverseeffect upon our revenue, profitability, reputation and growth strategy.

 

**If we fail to provide our customers with adequate and timelycustomer support, our relationships with our customers could be damaged, whichwould harm our revenue and profitability.**

 

Ourability to achieve our planned sales growth and retain customers will depend inpart on the quality of our customer support operations. Our customers generallyrequire significant support and training with respect to our products,particularly in the initial deployment and implementation stage. As our systemsand products become more complex, we believe our ability to provide adequatecustomer support will be increasingly important to our success. We have limitedexperience with widespread deployment of our products to a diverse customerbase, and we cannot assure you that we will have adequate personnel to providethe levels of support that our customers may require during initial productdeployment or on an ongoing basis. Our failure to provide sufficient support toour customers could delay or prevent the successful deployment of our products.Failure to provide adequate support could also have an adverse impact on ourreputation and relationship with our customers, could thereby prevent us fromgaining new customers and could harm our revenue and profitability.

 

**If we fail to manage our expanding operations, our ability toincrease our revenue and improve our results of operations could be harmed.**

 

Weanticipate that, in the future, we may need to expand certain areas of ourbusiness to grow our customer base and exploit market opportunities. Inparticular, we expect to face numerous challenges in the implementation of ourbusiness strategy to focus on selling our products to the larger, moreestablished service providers. To manage our operations, we must, among otherthings, continue to implement and improve our operational, financial andmanagement information systems, hire and train additional qualified personnel,continue to expand and upgrade core technologies and effectively managemultiple relationships with various customers, suppliers and otherthird-parties. We cannot assure you that our systems, procedures or controlswill be adequate to support our operations or that our management will be ableto achieve the rapid execution necessary to exploit fully the market for ourproducts or systems. If we are unable to manage our operations effectively, ourrevenue, operations and share price could be harmed.

 

**If we are unable to address the material weaknesses in ourinternal controls that our independent registered public accounting firmidentified in the fourth quarter of fiscal 2003, such weaknesses couldmaterially and adversely affect our ability to provide the public with timelyand accurate material information about our company, which could harm ourreputation and share price.**

 

InJanuary 2004, our independent registered public accounting firm identifieddeficiencies in our internal controls that they considered to be materialweaknesses. Based on these weaknesses, our CEO and CFO determined that, as ofDecember 31, 2003, our disclosure controls and procedures were notsufficient to record, process, summarize and report information required to bereported within the time periods specified by the SEC and accumulated andcommunicated to our management, including our CEO and CFO, to allow timelydiscussions regarding required disclosure. These material weaknesses related toour inventory and our accounts payable processes, both of which affect ourbalance sheet and may also affect our income statement reporting. We haveworked to fully address these issues. In order for investors and the equityanalyst community to make informed investment decisions and recommendationsabout our securities, it is important that we provide them with accurate andtimely information in accordance with the Securities Exchange Act of 1934, as amended(the “Exchange Act”) and the rules promulgated thereunder. If we cannot do so,

 

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investorswill sell our shares and industry analysts will either make incorrectrecommendations about our company or else end coverage of our companyaltogether, any of which results could harm our reputation and adversely impactour share price.

 

**We are currently engaged in a securities class actionlawsuit, which, if it were to result in an unfavorable resolution, couldadversely affect our reputation, profitability and share price.**

 

Weare currently engaged as a defendant in a lawsuit (i.e., *Whalen v. Tut Systems, Inc. et al.*)that alleges securities law violations against us and certain of our currentand former officers and directors under Section 11 of the Securities Actof 1933, as amended, and Section 10(b) and Rule 10b-5 of theSecurities Exchange Act of 1934, as amended. While we have reached a settlementwith the plaintiffs in this lawsuit, the settlement is subject to certaincontingencies, including court approval of the terms of settlement. If thecourt does not approve this settlement, or any other applicable contingenciesare not resolved or otherwise addressed, we would be required to resumelitigation in this matter. If we were to resume litigation in these matters,there is no assurance that we would prevail and, if the outcome of suchlitigation were unfavorable to us, our reputation, profitability and shareprice could be adversely affected.

 

**If our products do not comply with complex governmentregulations, our product sales will suffer.**

 

Weand our customers are subject to varying degrees of federal, state and local aswell as foreign governmental regulation. Our products must comply with variousregulations and standards defined by the Federal Communications Commission, orFCC. The FCC has issued regulations that set installation and equipmentstandards for communications systems. Our products are also required to meetcertain safety requirements. For example, Underwriters Laboratories mustcertify certain of our products in order to meet federal safety requirementsrelating to electrical appliances to be used inside the home. In addition,certain products must be Network Equipment Building Standard certified beforecertain of our customers may deploy them. Any delay in or failure to obtainthese approvals could harm our business, financial condition or results ofoperations. Outside of the United States, our products are subject to theregulatory requirements of each country in which our products are manufacturedor sold. These requirements are likely to vary widely. If we do not obtaintimely domestic or foreign regulatory approvals or certificates, we would notbe able to sell our products where these regulations apply, which could preventus from maintaining or growing our revenue or achieving profitability.

 

Inaddition, regulation of our customers may adversely impact our business,operating results and financial condition. For example, FCC regulatory policiesaffecting the availability of data and Internet services and other terms onwhich telecommunications companies conduct their business may impede our entryinto certain markets. In addition, the increasing demand for communicationssystems has exerted pressure on regulatory bodies worldwide to adopt newstandards, generally following extensive investigation of competingtechnologies. The delays inherent in this governmental approval process maycause the cancellation, postponement or rescheduling of the installation ofcommunications systems by our customers, which in turn may harm our sale ofproducts to these customers.

 

**If we lose key personnel or are unable to hire additionalqualified personnel as necessary, we may not be able to manage our businesssuccessfully, which could materially and adversely affect our growth strategy,reputation and share price.**

 

Wedepend on the performance of Salvatore D’Auria, our President, Chief ExecutiveOfficer and Chairman of the Board, and on other senior management and technicalpersonnel with experience in the video and data communications,telecommunications and high-speed data access industries. The loss of any oneof them could harm our ability to execute our business strategy, which couldadversely affect our reputation and share price. Additionally, we do not haveemployment contracts with any of our executive officers. We believe that ourfuture success will depend in large part on our continued ability to identify,hire, retain and motivate highly skilled employees who are in great demand. Wecannot assure you that we will be able to do so.

 

**We routinely evaluate acquisition candidates and otherdiversification strategies.**

 

Wehave completed a number of acquisitions as part of our efforts to expand and diversifyour business. For example, we acquired our video content processing and videotransmission businesses from Tektronix in November 2002 when we purchasedits subsidiary, VTC. We intend to continue to evaluate new acquisitioncandidates, divestiture and diversification strategies, and if we fail tomanage the integration of acquired companies, it could adversely affect ouroperations and growth strategy. Any acquisition involves numerous risks,including difficulties in the assimilation of the acquired company’s employees,operations and products, uncertainties associated with operating in new marketsand working with new customers, and the potential loss of the acquired company’skey employees. Additionally, we may incur unanticipated expenses, difficultiesand other adverse consequences relating to the integration of technologies,research and development, and administrative and other functions. Any futureacquisitions may also result in potentially dilutive issuances of our equitysecurities, acquisition or divestiture related write-offs and the assumption ofdebt and contingent liabilities. Any of the above factors could adverselyaffect our revenue, profitability, operations or growth strategy.

 

**Our stock price is volatile, and, if you invest in ourcompany, you may suffer a loss of some or all of your investment.**

 

Themarket price and trading volume of our common stock has been subject tosignificant volatility, and this trend may continue. In particular, tradingvolume historically has been low and the market price of our common stock hasincreased dramatically in recent months. Since the announcement of ouracquisition of VTC, the closing price of our common stock, as traded on theNasdaq

 

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NationalMarket, has fluctuated from a low of $0.58 to a high of $7.49 per share. Thevalue of our common stock may decline regardless of our operating performanceor prospects. Factors affecting our market price include:

 

•                                          our perceived prospects;

 

•                                          variations in our operating results andwhether we have achieved our key business targets;

 

•                                          the limited number of shares of our commonstock available for purchase or sale in the public markets;

 

•                                          differences between our reported results andthose expected by investors and securities analysts;

 

•                                          announcements of new contracts, products ortechnological innovations by us or our competitors; and

 

•                                          market reaction to any acquisitions, jointventures or strategic investments announced by us or our competitors.

 

Recentevents have caused stock prices for many companies, including ours, tofluctuate in ways unrelated or disproportionate to their operating performance.The general economic, political and stock market conditions that may affect themarket price of our common stock are beyond our control. The market price ofour common stock at any particular time may not remain the market price in thefuture. In the past, securities class action litigation has been institutedagainst companies following periods of volatility in the market price of theirsecurities. Any such litigation, if instituted against us, could result insubstantial costs and a diversion of management’s attention and resources.

 

**Future sales of shares of our common stock could cause ourstock price to decline.**

 

Substantiallyall of our common stock may be sold without restriction in the public markets,subject only in the case of shares held by our officers and directors andaffiliates to volume and manner of sale restrictions (other than as describedin the following sentence). The approximately 3.3 million shares of commonstock that we issued to Tektronix in connection with our November 2002acquisition of VTC are restricted securities, as that term is defined inRule 144 under the Securities Act, and therefore subject to certainrestrictions. However, we are contractually obligated to file and keepeffective a registration statement in order to allow Tektronix to sell theseshares to the public. Likewise, Tektronix has the right (subject to certain exceptions)to include these shares in certain registration statements pursuant to which wemay sell shares of our common stock.

 

Salesof a substantial number of shares of common stock in the public market, or theperception that these sales could occur could materially and adversely affectour stock price and make it more difficult for us to sell equity securities inthe future at a time and price we deem appropriate.

 

**Our charter, bylaws, retention and change of control plansand Delaware law contain provisions that could delay or prevent a change incontrol.**

 

Certainprovisions of our charter and bylaws and our retention and change of controlplans, the “Plans,” may have the effect of making it more difficult for athird-party to acquire, or of discouraging a third-party from attempting toacquire, control of us. The provisions of the charter and bylaws and the Planscould limit the price that certain investors may be willing to pay in thefuture for shares of our common stock. Our charter and bylaws provide for aclassified board of directors, eliminate cumulative voting in the election ofdirectors, restrict our stockholders from acting by written consent and callingspecial meetings, and provide for procedures for advance notification ofstockholder nominations and proposals. In addition, our Board has the authorityto issue up to 5,000,000 shares of preferred stock and to determine the price,rights, preferences, privileges and restrictions, including voting rights, ofthose shares without any further vote or action by the stockholders. Theissuance of preferred stock, while providing flexibility in connection withpossible financings or acquisitions or other corporate purposes, could have theeffect of making it more difficult for a third-party to acquire a majority ofour outstanding voting stock. The Plans provide for severance payments andaccelerated stock option vesting in the event of termination of employmentfollowing a change of control. The provisions of the charter and bylaws, andthe Plans, as well as Section 203 of the Delaware General Corporation Law,to which we are subject, could discourage potential acquisition proposals,delay or prevent a change of control and prevent changes in our management.

 

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**ITEM 3.**                                                   ***QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK***

 

Weare exposed to changes in interest rates primarily from our investments incertain cash equivalents. Under our current policies, we do not use interestrate derivative instruments to manage exposure to interest rate changes. Ahypothetical 100 basis point adverse move in interest rates along the entireinterest rate yield curve would not materially affect the fair value of ourinterest-sensitive financial instruments at September 30, 2004.

 

Wehave no investments, nor are any significant sales, expenses, or otherfinancial items denominated in foreign country currencies. All of ourinternational sales are denominated in U.S. dollars. An increase in the valueof the U.S. dollar relative to foreign currencies could make our products moreexpensive and, therefore, reduce the demand for our products.

 

**ITEM 4.**                                                   ***CONTROLSAND PROCEDURES***

 

(a)                                  Our Chief Executive Officer and ChiefFinancial Officer carried out an evaluation of the effectiveness of ourdisclosure controls and procedures (as defined in Rule 13a-15(e) under theExchange Act) as of September 30, 2004. This evaluation included various stepsthat our Chief Executive Officer and Chief Financial Officer undertook in aneffort to ensure that our disclosure controls and procedures are designed toensure that information required to be disclosed in our SEC reports isrecorded, processed, summarized and reported within the time periods specifiedby the SEC and accumulated and communicated to our management, including ourChief Executive Officer and Chief Financial Officer, to allow timelydiscussions regarding required disclosure. This evaluation also includedconsideration of our internal controls and procedures for the preparation of ourfinancial statements. As of September 30, 2004, our Chief Executive Officer andChief Financial Officer have concluded that our disclosure control andprocedures are effective.

 

InJanuary 2004 in connection with the completion of its audit of our financialstatements for the year ended December 31, 2003, PricewaterhouseCoopersLLP, the Company’s independent registered public accounting firm, advisedmanagement and the audit committee of the Board of Directors that it hadidentified deficiencies in our internal controls and processes relating toinventory management and reporting that it considers to be material weaknesses,as defined by Statement on Auditing Standards No. 60, “Communication ofInternal Control Related Matters Noted in an Audit.” The material weaknessesthat PricewaterhouseCoopers LLP identified related to inventory controls andthe accounts payable process for the Company’s VideoTele.com business, whichthe Company acquired in November 2002. Specifically:

 

1.                                       Our internal controls are inadequate toproperly record our inventory quantities in an accurate and timely manner; and

 

2.                                       Our accounts payable process failed toadequately reconcile our accounts payable records with suppliers’ records,considering what the suppliers had shipped to us prior to period end.

 

While these materialweaknesses had an immaterial effect on our reported results, they neverthelessconstituted deficiencies in our disclosure controls. In light of these materialweaknesses and the requirements enacted by the Sarbanes-Oxley Act of 2002 andthe related rules and regulations adopted by the SEC, our Chief ExecutiveOfficer and Chief Financial Officer concluded that, as of December 31,2003, our disclosure controls and procedures needed improvement and were not effective.Despite those deficiencies in our disclosure controls, management believed thatas of December 31, 2003, and at the time of filing its Annual Report on Form10-K for the fiscal year ended December 31, 2003, as amended, there were nomaterial inaccuracies, or omissions of material facts necessary to make thestatements not misleading in light of the circumstances under which they weremade.

 

Atthe time of our acquisition of the VideoTele.com business inNovember 2002, we had in place disclosure controls and procedures andprocesses for our existing business (i.e., our pre-November 2002 business)that our CEO and CFO at the time believed to be sufficient to record, process,summarize and report information required to be reported within the time periodsspecified by the SEC. Likewise, we had in place internal controls that our CEOand CFO believed at the time of the VTC acquisition to be sufficient to “providereasonable assurance regarding the reliability of financial reporting andpreparation of financial statements for external purposes in accordance withgenerally accepted accounting principles.”

 

SinceDecember 31, 2002, we have continued to review our disclosure controls andprocedures and internal controls periodically in connection with ourForm 10-Q filings. Throughout 2003, our CEO and CFO have continued tobelieve that our disclosure controls and procedures and internal controls haveallowed us to provide all material and necessary disclosure in a timely manner,as required by the Exchange Act and the applicable rules thereunder.

 

InJanuary 2004, during the audit of our financial statements for the fiscalyear ended December 31, 2003, PricewaterhouseCoopers LLP discovered thematerial weaknesses noted above and brought these weaknesses to our attention.Based on discussions with PricewaterhouseCoopers LLP and the audit committee ofour Board of Directors, we worked throughout our year-end 2003 accounting closeand audit to identify the nature, scope and materiality of these weaknesses inour internal controls and their impact on our fiscal year 2003 financialstatements and to determine the extent to which these internal controlweaknesses might adversely affect our disclosure controls and procedures. Basedon further detailed review of our internal controls as they relate to inventoryand accounts payable during the fourth quarter of fiscal 2003, we determinedthat the accounts payable process had failed to record certain liabilitiesassociated with VTC products that we purchased, principally from our contractmanufacturer and certain other suppliers. We quantified this internal controlweakness relating to accounts payable recordation by reconciling our records tothat of our contract manufacturer and reviewing our liabilities with othervendors. We quantified the inventory process control weakness by

 

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takingcomplete physical inventories at each VTC inventory location and reconcilingthe results to our records. Upon completion of our analysis and testing, weidentified an additional charge of approximately $34,000 to cost of goods soldrelated to the internal control weaknesses identified above. We recorded thischarge prior to issuing our financial statements for the year endedDecember 31, 2003. In addition to our review of the financial statementsfor the fiscal year ended December 31, 2003, we re-confirmed that ouraccounts payable recordation and inventory controls were effective for the yearended December 31, 2002.

 

Duringour review of these internal controls weaknesses, we identified the cause ofthese internal control weaknesses to be the result of prior VTC accountingstaff turnover that occurred during the first quarter of 2003. During thisquarter, key accounting staff of VTC left the company without sufficient timeto transition all of the internal controls and institutional knowledge to ourremaining finance and accounting staff.

 

Inaddition to identifying the above two internal control weaknesses relating toinventory and the accounts payable process, we also tested our other internalcontrols to determine whether there were other such material weaknesses asidefrom the inventory and accounts payable weaknesses mentioned above thataffected our financial statements for the fiscal year ended December 31,2003. In particular, we tested our other internal controls by reviewingprocesses, analytical reviews and substantive testing that included otherthird-party confirmations and by reviewing activity subsequent to year-end2003. Based on these tests, we did not identify any other material weaknessesin internal controls. Therefore, our CEO and CFO believed at the time of theoriginal filing of the Form 10-K on February 2, 2004 that they hadreasonable grounds to conclude that the weaknesses in internal controls relatedsolely to those items mentioned above and resulted in an immaterial charge ofapproximately $34,000.

 

Basedon their review of our internal controls as described above, our CEO and CFOalso assessed our disclosure controls and procedures for the fiscal year endedDecember 31, 2003. Our CEO and CFO believed at the time of the originalfiling of the Form 10-K that they had reasonable grounds to conclude that,other than the inventory and accounts payable weaknesses that PricewaterhouseCoopersLLP had identified, there were no other material weaknesses in our disclosurecontrols and procedures and that the information required to be reported in theForm 10-K was recorded, processed, summarized and reported within the timeperiods specified by the applicable Exchange Act rules.

 

Inorder to ensure that we have eliminated the two weaknesses in our internalcontrols for purposes of future reporting, we have undertaken significantefforts to improve our processes and procedures as they relate to inventoryreporting and accounts payable reconciliation. The audit committee is taking anactive role in these efforts, including overseeing management’s implementationof corrective measures. With respect to inventory management, since identifyingthose weaknesses in our internal controls, we have performed and will continueto perform physical inventory counts at least at the end of each quarter in2004. We have implemented improved inventory systems and accounting controlsand have hired an additional full-time staff accountant to account for andcontrol our inventory accounting, given our operations manager company-wideresponsibility for inventory management, and have reiterated to key operationsand accounting personnel the importance of proper inventory management andcontrol. We will be expanding our inventory receiving process to include remotelocations, as appropriate and reconciling inventory to each customer order.Regarding accounts payable reconciliation, we have confirmed and will continueto confirm our key accounts payable balances with our vendors and reconciledthe confirmations to our accounting records on a quarterly basis in 2004.

 

Managementbelieves that the controls and procedures identified above have and willaddress the conditions identified by PricewaterhouseCoopers LLP as materialweaknesses. These changes will become permanent elements of our internalcontrols. We are now confident that we have and are in the process ofimplementing the proper level of controls to correct the material weaknesses.We plan to continue to monitor the effectiveness of our internal controls andprocedures on an ongoing basis and will take further action as appropriate.

 

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**PART II.OTHER INFORMATION**

 

**ITEM 1.**                                                   ***LEGALPROCEEDINGS***

 

***Whalen v. TutSystems, Inc. et al***

 

On October 30, 2001, theCompany and certain of its current and former officers and directors were namedas defendants in *Whalen v. Tut Systems, Inc.et al.,*Case No. 01-CV-9563, a purported securities class actionlawsuit filed in the United States District Court for the Southern District ofNew York. An amended complaint was filed on December 5, 2001. A consolidatedamended complaint was filed on April 19, 2002. The consolidated amended complaintasserts that the prospectuses from the Company’s January 29, 1999 initialpublic offering and its March 23, 2000 secondary offering failed to disclosecertain alleged actions by the underwriters for the offerings. The complaintalleges claims against the Company and certain of its current and formerofficers and directors under Section 11 of the Securities Act of 1933, asamended, and under Section 10(b) and Rule 10b-5 of the Securities Exchange Actof 1934, as amended, and alleges claims against certain of its current andformer officers and directors under Sections 15 and 20(a) of the SecuritiesAct. The complaint also names as defendants the underwriters for the Company’sinitial public offering and secondary offering. Similar suits were filed in the Southern District of New Yorkchallenging over 300 other initial public offerings and secondary offeringsconducted in 1999 and 2000.  Therefore,for pretrial purposes, the *Whalen*action is being coordinated with the approximately 300 other suits beforeUnited States District Court Judge Shira Scheindlin of the Southern District ofNew York under the matter *In Re InitialPublic Offering Securities Litigation. *Theindividual defendants in the *Whalen*action, namely, Nelson Caldwell, Salvatore D ‘Auria and Matthew Taylor, weredismissed without prejudice by an October 9, 2002 Order of the Court, approvingthe parties’ October 1, 2002 Stipulation of Dismissal.  On February 19, 2003, the Court issued anOpinion and Order denying the Company’s motion to dismiss.

 

A stipulation of settlementfor the claims against the issuer-defendants, including the Company, has beensubmitted to the Court on June 14, 2004, in the *In Re Initial Public Offering Securities Litigation*.  The settlement is subject to a number of conditions,most of which are outside of the Company’s control, including approval by theCourt.  The underwriters named asdefendants in the *In Re Initial PublicOffering Securities Litigation* (collectively, the “underwriter-defendants”),including the underwriters named in the *Whalen*suit, are not parties to the stipulation of settlement.

 

The stipulation ofsettlement provides that, in exchange for a release of claims against thesettling issuer-defendants, the insurers of all of the settling issuer-defendantswill provide a surety undertaking to guarantee plaintiffs a $1 billion recoveryfrom the non-settling defendants, including the underwriter-defendants. Theultimate amount, if any, that may be paid on behalf of the Company willtherefore depend on the final terms of the settlement, including the number ofissuer-defendants that ultimately participate in the final settlement, and theamounts, if any, recovered by the plaintiffs from the underwriter-defendantsand other non-settling defendants.

 

Inthe event that all or substantially all of the issuer-defendants participate inthe final settlement, the amount that may be paid to the plaintiffs on behalfof the Company could range from zero to approximately $3.5 million, dependingon plaintiffs’ recovery from the underwriter-defendants and from othernon-settling parties.  If the plaintiffsrecover at least $1 billion from the underwriter-defendants, no settlementpayments would be made on behalf of the Company under the proposed terms of thesettlement.  If the plaintiffs recoverless than $1 billion,  we believe thatour insurance will likely cover some or all of our share of any paymentstowards satisfying plaintiffs’ $1 billion recovery deficit. Managementestimates that its range of loss relative to this matter is zero to$3.5 million. Presently there is no more likely point estimate of losswithin this range. As a consequence of the uncertainties described aboveregarding the amount we will ultimately be required to pay, if any, as ofSeptember 30, 2004, we have not accrued a liability for this matter.

 

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**ITEM 6.**                                                   ***EXHIBITSAND REPORTS ON FORM 8-K***

 

(a)Exhibits 

 
| **Exhibit  Number** | ** ** | **Description** |
|---------------------|------------|-----------------|
| ** **          | ** ** | ** **      |
| 2.1                 |       |            | Agreement  and Plan of Merger by and among Tut Systems, Inc., Tiger Acquisition  Corporation, Tektronix, Inc. and VideoTele.com, Inc. dated as of  October 28, 2002.(8) |
|                |       |            |   |
| 3.1                 |       |            | Second  Amended and Restated Certificate of Incorporation of the Company. |
|                |       |            |   |
| 3.2                 |       |            | Bylaws  of the Company, as currently in effect.(10) |
|                |       |            |   |
| 4.1                 |       |            | Specimen  Common Stock Certificate.(1) |
|                |       |            |   |
| 10.1*               |       |            | 1992  Stock Plan, as amended, and form of Stock Option Agreement thereunder.(1) |
|                |       |            |   |
| 10.2*               |       |            | 1998  Stock Plan and forms of Stock Option Agreement and Stock Purchase Agreement  thereunder.(1) |
|                |       |            |   |
| 10.3*               |       |            | 1998  Employee Stock Purchase Plan, as amended.(2) |
|                |       |            |   |
| 10.4*               |       |            | 1998  Stock Plan Inland Revenue Approved Rules for UK Employees.(3) |
|                |       |            |   |
| 10.5                |       |            | American  Capital Marketing, Inc. 401(k) Plan.(1) |
|                |       |            |   |
| 10.6                |       |            | Form  of Indemnification Agreement entered into between the Company and each  director and officer.(1) |
|                |       |            |   |
| 10.12*              |       |            | Executive  Retention and Change of Control Plan.(6) |
|                |       |            |   |
| 10.13*              |       |            | Non-Executive  Retention and Change of Control Plan and Summary Plan Description.(6) |
|                |       |            |   |
| 10.14*              |       |            | Non-Qualified  Stock Option Agreement issued to Mark Carpenter on March 3, 2000.(6) |
|                |       |            |   |
| 10.15*              |       |            | 1999  Non-Statutory Stock Option Plan(7) |
|                |       |            |   |
| 10.16               |       |            | Office  Lease Agreement between Kruse Way Office Associates Limited Partnership and  VideoTele.com dated April 28, 2000.(9) |
|                |       |            |   |
| 10.17               |       |            | Office  Lease Agreement between The Richard Oppenheimer Living Trust, The Maurice  Oppenheimer Living Trust, The Helene Oppenheimer Living Trust, and Tut  Systems Inc. dated November 2002.(9) |
|                |       |            |   |
| 10.18               |       |            | Agreement  for the sale and purchase of the entire share capital of Xstreamis plc, by  and among the Company, the shareholders of Xstreamis plc and Philip  Corbishley.(5) |
|                |       |            |   |
| 10.19               |       |            | Loan  and Security Agreement |
|                |       |            |   |
| 11.1                |       |            | Calculation  of net loss per share (contained in Note 3 of Notes to Unaudited  Condensed Consolidated Financial Statements). |
|                |       |            |   |
| 31.1                |       |            | Certification  of Chief Executive Officer Pursuant to Section 302(a) of the Sarbanes-Oxley  Act of 2002. |
|                |       |            |   |
| 31.2                |       |            | Certification  of Chief Financial Officer Pursuant to Section 302(a) of the Sarbanes-Oxley  Act of 2002. |
|                |       |            |   |
| 32.1                |       |            | Certification  of Chief Executive Officer Pursuant to 18 U.S.C. 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002. |
|                |       |            |   |
| 32.2                |       |            | Certification  of Chief Financial Officer Pursuant to 18 U.S.C. 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002. |

 

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(1)                                  Incorporated by reference to our RegistrationStatement on Form S-1 (File No. 333-60419) as declared effective by theSecurities and Exchange Commission on January 28, 1999.

 

(2)                                  Incorporated by reference to our QuarterlyReport on Form 10-Q for the quarter ended March 31, 1999.

 

(3)                                  Incorporated by reference to our AnnualReport on Form 10-K for the year ended December 31, 1999.

 

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(5)                                  Incorporated by reference to our CurrentReport on Form 8-K dated May 26, 2000 as filed September 9, 2000.

 

(6)                                  Incorporated by reference to our QuarterlyReport on Form 10-Q for the quarter ended September 30, 2000.

 

(7)                                  Incorporated by reference to our Schedule TO(File No. 005-58093) filed May 11, 2001.

 

(8)                                  Incorporated by reference to our CurrentReport on Form 8-K dated October 29, 2002.

 

(9)                                  Incorporated by reference to our AnnualReport on Form 10-K for the year ended December 31, 2002.

 

(10)                            Incorporated by reference to our Quarterly Report on Form 10-Q forthe quarter ended March 31, 2004.

 

*                                         Indicates management contracts orcompensatory plans and arrangements.

 

(b)Reports on Form 8-K.

 

**The Company filed the following Current Reports on Forms 8-Kduring the quarter ended September 30, 2004:**

 

•                  CurrentReport on Form 8-K, filed on September 28, 2004;

 

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**SIGNATURE**

 

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

 
|                   | TUT SYSTEMS, INC. |
|------------------------|-------------------|
|                   |              |
|                   |              |
|                   | By:               | /s/    RANDALL  K. GAUSMAN |   |
| ** **             | ** **        | **Randall K. Gausman  Vice-President, Finance and****Administration, Chief Financial  Officer and Secretary  (Principal Financial and Accounting****Officer and Duly Authorized****Officer)** |   |
| ** **             | ** **        | ** ** |
| Date: October 28, 2004 |              |   |

 

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**INDEX TO EXHIBITS**

 
| **Exhibit  Number** | ** ** | **Description** |
|---------------------|------------|-----------------|
| ** **          | ** ** | ** **      |
| 2.1                 |       |            | Agreement  and Plan of Merger by and among Tut Systems, Inc., Tiger Acquisition  Corporation, Tektronix, Inc. and VideoTele.com, Inc. dated as of  October 28, 2002.(8) |
|                |       |            |   |
| 3.1                 |       |            | Second  Amended and Restated Certificate of Incorporation of the Company. |
|                |       |            |   |
| 3.2                 |       |            | Bylaws  of the Company, as currently in effect.(10) |
|                |       |            |   |
| 4.1                 |       |            | Specimen  Common Stock Certificate.(1) |
|                |       |            |   |
| 10.1*               |       |            | 1992  Stock Plan, as amended, and form of Stock Option Agreement thereunder.(1) |
|                |       |            |   |
| 10.2*               |       |            | 1998  Stock Plan and forms of Stock Option Agreement and Stock Purchase Agreement  thereunder.(1) |
|                |       |            |   |
| 10.3*               |       |            | 1998  Employee Stock Purchase Plan, as amended.(2) |
|                |       |            |   |
| 10.4*               |       |            | 1998  Stock Plan Inland Revenue Approved Rules for UK Employees.(3) |
|                |       |            |   |
| 10.5                |       |            | American  Capital Marketing, Inc. 401(k) Plan.(1) |
|                |       |            |   |
| 10.6                |       |            | Form  of Indemnification Agreement entered into between the Company and each  director and officer.(1) |
|                |       |            |   |
| 10.12*              |       |            | Executive  Retention and Change of Control Plan.(6) |
|                |       |            |   |
| 10.13*              |       |            | Non-Executive  Retention and Change of Control Plan and Summary Plan Description.(6) |
|                |       |            |   |
| 10.14*              |       |            | Non-Qualified  Stock Option Agreement issued to Mark Carpenter on March 3, 2000.(6) |
|                |       |            |   |
| 10.15*              |       |            | 1999  Non-Statutory Stock Option Plan(7) |
|                |       |            |   |
| 10.16               |       |            | Office  Lease Agreement between Kruse Way Office Associates Limited Partnership and  VideoTele.com dated April 28, 2000.(9) |
|                |       |            |   |
| 10.17               |       |            | Office  Lease Agreement between The Richard Oppenheimer Living Trust, The Maurice  Oppenheimer Living Trust, The Helene Oppenheimer Living Trust, and Tut  Systems Inc. dated November 2002.(9) |
|                |       |            |   |
| 10.18               |       |            | Agreement  for the sale and purchase of the entire share capital of Xstreamis plc, by  and among the Company, the shareholders of Xstreamis plc and Philip  Corbishley.(5) |
|                |       |            |   |
| 10.19               |       |            | Loan  and Security Agreement |
|                |       |            |   |
| 11.1                |       |            | Calculation  of net loss per share (contained in Note 3 of Notes to Unaudited  Condensed Consolidated Financial Statements). |
|                |       |            |   |
| 31.1                |       |            | Certification  of Chief Executive Officer Pursuant to Section 302(a) of the Sarbanes-Oxley  Act of 2002. |
|                |       |            |   |
| 31.2                |       |            | Certification  of Chief Financial Officer Pursuant to Section 302(a) of the Sarbanes-Oxley  Act of 2002. |
|                |       |            |   |
| 32.1                |       |            | Certification  of Chief Executive Officer Pursuant to 18 U.S.C. 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002. |
|                |       |            |   |
| 32.2                |       |            | Certification  of Chief Financial Officer Pursuant to 18 U.S.C. 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002. |
|                     |            |                 |  |  |

 

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(1)                                  Incorporated by reference to our RegistrationStatement on Form S-1 (File No. 333-60419) as declared effective by theSecurities and Exchange Commission on January 28, 1999.

 

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(2)                                  Incorporated by reference to our QuarterlyReport on Form 10-Q for the quarter ended March 31, 1999.

 

(3)                                  Incorporated by reference to our AnnualReport on Form 10-K for the year ended December 31, 1999.

 

(5)                                  Incorporated by reference to our CurrentReport on Form 8-K dated May 26, 2000 as filed September 9, 2000.

 

(6)                                  Incorporated by reference to our QuarterlyReport on Form 10-Q for the quarter ended September 30, 2000.

 

(7)                                  Incorporated by reference to our Schedule TO(File No. 005-58093) filed May 11, 2001.

 

(8)                                  Incorporated by reference to our CurrentReport on Form 8-K dated October 29, 2002.

 

(9)                                  Incorporated by reference to our AnnualReport on Form 10-K for the year ended December 31, 2002.

 

(10)                            Incorporated by reference to our Quarterly Report on Form 10-Q forthe quarter ended March 31, 2004.

 

*                                         Indicates management contracts orcompensatory plans and arrangements.

 

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