**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 June 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 itscharter)

 
| **Delaware**                                                                  | ** ** | **94-2958543**                         |
|-------------------------------------------------------------------------------|------------|----------------------------------------|
| (State  or other jurisdiction ofincorporation 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: **(503)  594-1400** |

 

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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  ý  No  o

 

Asof July 26, 2004, 20,431,650 shares of the Registrant’s common stock, par value$0.001 per share, were issued and outstanding.

 

 

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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 June 30, 2004                                     |   |
|              |                                                                                                                 |   |
|              | Condensed  Consolidated Statements of Operations for the three and six months ended June  30, 2003 and June 30, 2004 |   |
|              |                                                                                                                 |   |
|              | Condensed  Consolidated Statements of Cash Flows for the six months ended June 30, 2003  and June 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 2.           | Changes in Securities, Use of Proceeds and  Issuer Purchases of Equity Securities                                    |   |
|              |                                                                                                                 |   |
| Item 3.           | Defaults Upon Senior Securities                                                                                      |   |
|              |                                                                                                                 |   |
| Item  4.          | Submission  of Matters to a Vote of Security Holders                                                                 |   |
|              |                                                                                                                 |   |
| Item 5.           | Other Information                                                                                                    |   |
|              |                                                                                                                 |   |
| 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** | ** ** | **June 30,  2004** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|--------------------|------------|
| ** **                                                                                                                                  | ** ** | ** **             | ** ** | **(unaudited)**    | ** ** |
| **ASSETS**                                                                                                                                  |       |                   |       |               |       |
| Current assets:                                                                                                                             |       |                   |       |               |       |
| Cash and cash equivalents                                                                                                                   |       | $                      | 14,370     |               | $          | 8,756 |   |
| Accounts receivable, net of allowance for  doubtful accounts of $47 and $45 in 2003 and 2004, respectively                                  |       | 7,062                  |       | 4,812              |       |
| Insurance settlement receivable                                                                                                             |       | 10,725                 |       | —             |       |
| Inventories, net                                                                                                                            |       | 4,181                  |       | 4,749              |       |
| Prepaid expenses and other                                                                                                                  |       | 1,026                  |       | 1,869              |       |
| Total current assets                                                                                                                        |       | 37,364                 |       | 20,186             |       |
| Property and equipment, net                                                                                                                 |       | 1,722                  |       | 1,834              |       |
| Intangibles and other assets                                                                                                                |       | 3,685                  |       | 2,712              |       |
| Total assets                                                                                                                                |       | $                      | 42,771     |               | $          | 24,732 |   |
|                                                                                                                                        |       |                   |       |               |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                               |       |                   |       |               |       |
| Current liabilities:                                                                                                                        |       |                   |       |               |       |
| Accounts payable                                                                                                                            |       | $                      | 3,055      |               | $          | 3,109 |   |
| Accrued liabilities                                                                                                                         |       | 1,516                  |       | 1,828              |       |
| Legal settlement liability                                                                                                                  |       | 10,725                 |       | **—**         |       |
| Deferred revenue                                                                                                                            |       | 253                    |       | 232                |       |
| Total current liabilities                                                                                                                   |       | 15,549                 |       | 5,169              |       |
| Note payable                                                                                                                                |       | 3,523                  |       | 3,673              |       |
| Other liabilities                                                                                                                           |       | 44                     |       | 18                 |       |
| Total liabilities                                                                                                                           |       | 19,116                 |       | 8,860              |       |
| Commitments and contingencies (Note 6)                                                                                                      |       |                   |       |               |       |
| 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 20,432 shares issued and outstanding in 2003  and 2004, respectively |       | 20                     |       | 20                 |       |
| Additional paid-in capital                                                                                                                  |       | 305,777                |       | 306,088            |       |
| Accumulated other comprehensive loss                                                                                                        |       | (89                    | )          | (99                | )          |
| Accumulated deficit                                                                                                                         |       | (282,053               | )          | (290,137           | )          |
| Total stockholders’ equity                                                                                                             |       | 23,655                 |       | 15,872             |       |
| Total liabilities and stockholders’ equity                                                                                             |       | $                      | 42,771     |               | $          | 24,732 |   |

 

*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  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                               | ** ** | **2003**                         | ** ** | **2004**                       | ** ** | **2003** | ** ** | **2004** | ** ** |
| Revenues:                                                                |       |                             |       |                           |       |   |   |   |   |
| Product                                                                  |       | $                                | 7,700      |                           | $          | 5,105 |   | $ | 14,101 |   | $ | 11,264 |   |
| License and royalty                                                      |       | 165                              |       | 18                             |       | 365 |   | 35 |   |
| Total revenues                                                           |       | 7,865                            |       | 5,123                          |       | 14,466 |   | 11,299 |   |
| Cost of goods sold                                                       |       | 4,015                            |       | 3,447                          |       | 7,274 |   | 8,576 |   |
| Gross margin                                                             |       | 3,850                            |       | 1,676                          |       | 7,192 |   | 2,723 |   |
| Operating expenses:                                                      |       |                             |       |                           |       |   |   |   |   |
| Sales and marketing                                                      |       | 1,927                            |       | 1,932                          |       | 3,854 |   | 3,836 |   |
| Research and development                                                 |       | 2,248                            |       | 1,860                          |       | 4,334 |   | 3,682 |   |
| General and administrative                                               |       | 1,105                            |       | 1,099                          |       | 2,307 |   | 2,216 |   |
| Impairment of intangible assets                                          |       | 128                              |       | —                         |       | 128 |   | 202 |   |
| Amortization of intangible assets                                        |       | 459                              |       | 376                            |       | 918 |   | 772 |   |
| Total operating expenses                                                 |       | 5,867                            |       | 5,267                          |       | 11,541 |   | 10,708 |   |
|                                                                     |       |                             |       |                           |       |   |   |   |   |
| Loss from operations                                                     |       | (2,017                           | )          | (3,591                         | )          | (4,349 | ) | (7,985 | ) |
| Interest and other (expense) income, net                                 |       | (8                               | )          | (44                            | )          | 93 |   | (99 | ) |
|                                                                     |       |                             |       |                           |       |   |   |   |   |
| Net loss                                                                 |       | $                                | (2,025     | )                              | $          | (3,635 | ) | $ | (4,256 | ) | $ | (8,084 | ) |
|                                                                     |       |                             |       |                           |       |   |   |   |   |
| Net loss per share, basic and diluted (Note 3)                           |       | $                                | (0.10      | )                              | $          | (0.18 | ) | $ | (0.21 | ) | $ | (0.40 | ) |
|                                                                     |       |                             |       |                           |       |   |   |   |   |
| Shares used in computing net loss per share, basic and diluted (Note  3) |       | 19,894                           |       | 20,396                         |       | 19,848 |   | 20,346 |   |

 

*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)**

** **
| ** **                                                                   | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                   | ** ** | **2003**                       | ** ** | **2004** | ** ** |
| Cash flows from operating activities:                                        |       |                           |       |   |   |
| Net loss                                                                     |       | $                              | (4,256     | ) | $ | (8,084 | ) |
| Adjustments to reconcile net loss to net cash used in operating  activities: |       |                           |       |   |   |
| Depreciation                                                                 |       | 488                            |       | 650 |   |
| Provision (recovery) for doubtful accounts                                   |       | 3                              |       | 13 |   |
| Provision for excess and obsolete inventory and abandoned products           |       | 15                             |       | 995 |   |
| Impairment of intangibles                                                    |       | 128                            |       | 202 |   |
| Amortization of intangibles                                                  |       | 918                            |       | 772 |   |
| Deferred interest on note payable                                            |       | 128                            |       | 150 |   |
| Change in operating assets and liabilities, net of businesses  acquired:     |       |                           |       |   |   |
| Accounts receivable                                                          |       | (2,923                         | )          | 2,237 |   |
| Inventories                                                                  |       | 1,277                          |       | (1,563 | ) |
| Prepaid expenses and other assets                                            |       | (372                           | )          | (854 | ) |
| Accounts payable and accrued liabilities                                     |       | (4,231                         | )          | 340 |   |
| Deferred revenue                                                             |       | (559                           | )          | (21 | ) |
| Net cash used in operating activities                                        |       | (9,384                         | )          | (5,163 | ) |
| Cash flows from investing activities:                                        |       |                           |       |   |   |
| Purchase of property and equipment                                           |       | (516                           | )          | (762 | ) |
| Net cash used in investing activities                                        |       | (516                           | )          | (762 | ) |
| Cash flows from financing activities:                                        |       |                           |       |   |   |
| Proceeds from issuances of common stock, net                                 |       | 11                             |       | 311 |   |
| Net cash provided by financing activities                                    |       | 11                             |       | 311 |   |
| Net decrease in cash and cash equivalents                                    |       | (9,889                         | )          | (5,614 | ) |
| Cash and cash equivalents, beginning of period                               |       | 25,571                         |       | 14,370 |   |
| Cash and cash equivalents, end of period                                     |       | $                              | 15,682     |   | $ | 8,756 |   |

 

*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 video processing systemsthat enable private enterprise and government entities to transport videosignals over satellite, fiber, radio, or copper networks for surveillance,distance learning, and TV production applications. The Company also offers broadbandtransport and service management products that enable the provisioning of highspeed Internet access and other broadband data services over existing coppernetworks 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. Video-based products nowrepresent a majority of the Company’s sales.

 

The Company has incurred substantial losses and negative cash flowsfrom operations since inception. For the six months ended June 30, 2004, theCompany incurred a net loss of $8,084 and negative cash flows from operatingactivities of $5,163, and has an accumulated deficit of $290,137 at June 30,2004. Management believes that the cash and cash equivalents as of June 30,2004 are sufficient to fund its operating activities and capital expenditureneeds for the next twelve months. However, in the event that general economic conditions worsen, theCompany may require additional cash to fund its operations. The Company plansto seek additional equity funding to provide working capital, fund potentialacquisitions and potentially redeem the VTC acquisition indebtedness.  The Company cannot assure that such fundingefforts will be successful. Failure to generate positive cash flow in thefuture could have a material impact on the Company’s ability to achieve its intendedbusiness objectives.

 

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

** **

**Basis ofpresentation**

** **

Theaccompanying condensed consolidated financial statements as of December 31,2003 and June 30, 2004 and for the three and six months ended June 30, 2003 and2004 are unaudited. The unaudited interim condensed consolidated financialstatements have been prepared on the same basis as the annual financialstatements and, in the opinion of management, reflect all adjustments, whichinclude only normal recurring adjustments, necessary to present fairly theCompany’s financial position as of December 31, 2003 and June 30, 2004, itsresults of operations for the three and six months ended June 30, 2003 and 2004and its cash flows for the six months ended June 30, 2003 and 2004. Thesecondensed consolidated financial statements and the accompanying notes areunaudited and should be read in conjunction with the Company’s auditedfinancial statements included in the Company’s Annual Report on Form 10-K/A,filed with the Securities and Exchange Commission on June 11, 2004. The balancesheet as of December 31, 2003 was derived from audited financial statements butdoes not include all disclosures required by generally accepted accountingprinciples. The results for the three and six months ended June 30, 2004 arenot necessarily indicative of the expected results for any other interim periodor the year ending December 31, 2004.

 

**Revenuerecognition**

** **

The Company generates revenue primarily from the sale of hardware products,including third-party products, through professional services, and through thesale of its software products. The Company sells products through direct saleschannels and through distributors. Generally, product revenue is generated fromthe sale of video processing systems and components and the sale of broadbandtransport and service management products. Turnkey solution revenue isprincipally generated by the sale of complete end-to-end video processingsystems that are designed, developed and produced according to a buyer’sspecifications.

 

*Product revenues*

* *

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’s 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 which softwareis more than incidental to the arrangement. SOP 97-2 requires that revenuerecognized from software arrangements be allocated to each element of thearrangement 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 fairvalue does exist or until all elements of the arrangement are delivered,subject to certain 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 bySOP 98-9, *Modification ofSOP 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 objectiveevidence of fair value (as defined by SOP 97-2), revenue from turnkeysolutions is generally recognized using the percentage-of-completion method, asstipulated by SOP 81-1. The percentage-of-completion method reflects theportion of the anticipated contract revenue that has been earned that is equalto the ratio of labor effort expended to date to the anticipated final laboreffort, based on current estimates of total labor effort necessary to completethe project. 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 thecustomer site, with an additional approximately 9% of the contract value billedupon substantial completion of the project and the balance upon customeracceptance. The contractual arrangements relative to turnkey solutions includecustomer acceptance provisions. However, such provisions are generallyconsidered to be incidental to the arrangement in its entirety becausecustomers are fully obligated with respect to approximately 99% of the contractvalue irrespective of 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 the customer,the creditworthiness of the customer, evidence of sell-through to the end user,and current payment terms. Based on the results of the assessment, the Companymay recognize revenue when the products are shipped or defer recognition ofrevenue until evidence of sell-through occurs and cash is received. In order torecognize revenue, the Company must also make a judgment regardingcollectibility of the arrangement fee. Management’s judgment of collectibilityis applied on a customer-by-customer basis pursuant to the Company’s creditreview policy. The Company sells to customers for which there is a history ofsuccessful collection and to new customers for which no similar history mayexist. New customers are subject to a credit review process, which evaluatesthe customers’ financial position and ability to pay. New customers aretypically 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 forproducts sold by its licensees. Currently, the majority of the Company’slicense and royalty revenue is comprised of non-refundable license fees paid inadvance. Such revenue is recognized ratably over the period during whichpost-contract customer support is expected to be provided or upon delivery andtransfer of agreed upon technical specifications in contracts where essentiallyno further support obligations exist. Future license and royalty revenue isexpected to consist primarily of royalties received by the Company for productssold by its licensees.

 

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 six months ended June 30, 2004, the Company determined thatcertain 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 cause theCompany to conclude that impairment indicators exist. Any resulting impairmentloss could have a material adverse impact on the Company’s financial conditionand 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. TheCompany accounts for stock issued to non-employees in accordance with theprovisions of SFAS No. 148 and the Emerging Issues Task Force (“EITF”) IssueNo. 96-18, “Accounting for Equity Instruments that are Issued to other thanEmployees for Acquiring, 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.

 

8

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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  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                                             | ** ** | **2003**                         | ** ** | **2004**                       | ** ** | **2003** | ** ** | **2004** | ** ** |
| Net loss – as reported                                                                                                            |       | $                                | (2,025     | )                              | $          | (3,635 | ) | $ | (4,256 | ) | $ | (8,084 | ) |
| Adjustment:                                                                                                                            |       |                             |       |                           |       |   |   |   |   |
| Total stock-based employee compensation expense determined under a  fair value based method for all grants, net of related tax effects |       | (970                             | )          | (593                           | )          | (2,037 | ) | (1,405 | ) |
| Net loss – pro forma                                                                                                              |       | $                                | (2,995     | )                              | $          | (4,228 | ) | $ | (6,293 | ) | $ | (9,489 | ) |
| Basic and diluted net loss per share – as reported                                                                                |       | $                                | (0.10      | )                              | $          | (0.18 | ) | $ | (0.21 | ) | $ | (0.40 | ) |
| Basic and diluted net loss per share – pro forma                                                                                  |       | $                                | (0.15      | )                              | $          | (0.21 | ) | $ | (0.32 | ) | $ | (0.47 | ) |

 

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,Consolidated Financial Statements,” which was subsequently revised inDecember 2003 with the issuance of FIN46-R. This interpretation requirescertain variable interest entities to be consolidated by the primarybeneficiary of the entity if the equity investors in the entity do not have thecharacteristics of a controlling financial interest or do not have sufficientequity at risk for the entity to finance its activities without additionalsubordinated financial support from other parties. Application of thisInterpretation is required in financial statements for periods ending afterMarch 15, 2004. The adoption of this Interpretation in the six monthsended June 30, 2004 did not have a material impact on the Company’s results ofoperations, financial position or cash 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.

 

9

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The calculation of net loss per share follows:

 
| ** **                                                               | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                               | ** ** | **2003**                         | ** ** | **2004**                       | ** ** | **2003** | ** ** | **2004** | ** ** |
| Net loss per share, basic and diluted:                                   |       |                             |       |                           |       |   |   |   |   |
| Net loss                                                                 |       | $                                | (2,025     | )                              | $          | (3,635 | ) | $ | (4,256 | ) | $ | (8,084 | ) |
| Net loss per share, basic and diluted                                    |       | $                                | (0.10      | )                              | $          | (0.18 | ) | $ | (0.21 | ) | $ | (0.40 | ) |
| Shares used in computing net loss per share, basic and diluted           |       | 19,894                           |       | 20,396                         |       | 19,848 |   | 20,346 |   |
| Antidilutive securities not included in net loss per share  calculations |       | 3,879                            |       | 4,357                          |       | 3,879 |   | 4,357 |   |

** **

** **

**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  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                               | ** ** | **2003**                         | ** ** | **2004**                       | ** ** | **2003** | ** ** | **2004** | ** ** |
| Net loss                                 |       | $                                | (2,025     | )                              | $          | (3,635 | ) | $ | (4,256 | ) | $ | (8,084 | ) |
| Unrealized losses on other assets        |       | —                           |       | (15                            | )          | 12 |   | 2 |   |
| Foreign currency translation adjustments |       | (6                               | )          | (4                             | )          | (12 | ) | (12 | ) |
| Net change in other comprehensive loss   |       | (6                               | )          | (19                            | )          | — |   | (10 | ) |
| Total comprehensive loss                 |       | $                                | (2,031     | )                              | $          | (3,654 | ) | $ | (4,256 | ) | $ | (8,094 | ) |

 

10

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**NOTE5—BALANCE SHEET COMPONENTS:**

 
| ** **                                                        | ** ** | **December 31,  2003** | ** ** | **June 30,  2004** | ** ** |
|-------------------------------------------------------------------|------------|------------------------|------------|--------------------|------------|
| Inventories, net:                                                 |       |                   |       |               |       |
| Finished goods                                                    |       | $                      | 4,015      |               | $          | 5,264 |   |
| Raw materials                                                     |       | 391                    |       | 334                |       |
| Allowance for excess and obsolete inventory and abandoned product |       | (225                   | )          | (849               | )          |
|                                                              |       | $                      | 4,181      |               | $          | 4,749 |   |
| Property and equipment:                                           |       |                   |       |               |       |
| Computers and software                                            |       | $                      | 1,328      |               | $          | 1,577 |   |
| Test equipment                                                    |       | 2,277                  |       | 2,771              |       |
| Office equipment                                                  |       | 41                     |       | 56                 |       |
|                                                              |       | 3,646                  |       | 4,404              |       |
| Less: accumulated depreciation                                    |       | (1,924                 | )          | (2,570             | )          |
|                                                              |       | $                      | 1,722      |               | $          | 1,834 |   |
| Accrued liabilities:                                              |       |                   |       |               |       |
| Professional Services                                             |       | $                      | 494        |               | $          | 892 |   |
| Compensation                                                      |       | 652                    |       | 757                |       |
| Other                                                             |       | 370                    |       | 179                |       |
|                                                              |       | $                      | 1,516      |               | $          | 1,828 |   |

 

The Company recorded aprovision for inventory within cost of goods sold totaling $21 in the threemonths ended June 30, 2004, and $995 in the six months ended June 30, 2004,related to the costs of raw materials and finished goods in excess of what theCompany reasonably expected to sell in the foreseeable future as of the secondquarter of 2004.  The Company alsoreduced 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 |   |

 
| ** **                       | ** ** | **As of June 30, 2004**     | ** ** |
|----------------------------------|------------|-----------------------------|------------|
| ** **                       | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Intangibles** | ** ** |
| Amortized intangible assets:     |       |                        |       |   |   |   |   |
| Completed technology and patents |       | $                           | 7,922      |   | $ | (5,741 | ) | $ | 2,181 |   |
| Contract backlog                 |       | 247                         |       | (247 | ) | — |   |
| Customer list                    |       | 86                          |       | (20 | ) | 66 |   |
| Maintenance contract renewals    |       | 50                          |       | (17 | ) | 33 |   |
| Trademarks                       |       | 315                         |       | (75 | ) | 240 |   |
|                             |       | $                           | 8,620      |   | $ | (6,100 | ) | 2,520 |   |
|                             |       |                        |       |   |   |   |   |
| Other non-current assets         |       |                        |       |   |   | 192 |   |
|                             |       |                        |       |   |   | $ | 2,712 |   |

 

11

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During the sixmonths ended June 30, 2004, the Company determined that certain of thetechnology acquired as part of the purchase of the Viagate Technologies, Inc.assets in September 2001 had become impaired. As a result, the Company incurred a loss of $202 to write-off thetechnology.

 

The aggregate amortizationexpense for the three months ended June 30, 2003 and 2004 was $459 and $376,respectively and $918 and $772 for the six months ended June 30, 2003 and 2004.

 

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

 

| Remainder of 2004 |   | $   | 752    |   |
|-------------------|--------|-----|--------|--------|
| 2005              |   | 875 |   |
| 2006              |   | 424 |   |
| 2007              |   | 363 |   |
| Thereafter        |   | 106 |   |
|              |   | $   | 2,520  |   |

 

**NOTE6—COMMITMENTS AND CONTINGENCIES:**

 

*Lease obligations*

* *

The Company leases equipmentand office, assembly and warehouse space under non-cancelable operating leasesthat expire from 2004 through 2005.

 

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

 

| Remainder of 2004 |   | $      | 435    |   |
|-------------------|--------|--------|--------|--------|
| 2005              |   | 266    |   |
| Thereafter        |   | — |   |
|              |   | $      | 701    |   |

 

*Purchase commitments*

* *

The Company hadnon-cancelable commitments to purchase finished goods inventory totaling $1,009and $447 in aggregate at December 31, 2003 and June 30, 2004, respectively.

 

*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 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 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. 

 

12

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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 the underwriter-defendants.The ultimate 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.

 

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 June 30, 2004, the Company has not accrued a liability forthis matter.

 

***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 ofinvestors who purchased the Company’s stock during the period betweenJuly 20, 2000 and January 31, 2001, seeking unspecified damages. Thecomplaints allege that the Company and certain of its current and formerofficers and directors made false and misleading statements about the Company’sbusiness during the putative class period. Specifically, the complaints allegeviolations of Section 10(b) and 20(a) of the Securities Exchange Act of 1934,as amended. The complaints were consolidated under the name *In re Tut Systems, Inc. Securities Litigation*,Master File No. C-01-2659-CW (the “Securities Litigation Action”). Leadplaintiffs and lead counsel for plaintiffs were appointed. Plaintiffs filed aconsolidated class action complaint on February 4, 2002. Defendants fileda Motion to Dismiss on March 29, 2002. On August 15, 2002, the Courtgranted in part and denied in part the Motion to Dismiss. On September 23,2002, plaintiffs filed an amended complaint. Defendants filed a Motion toDismiss the amended complaint, and on August 6, 2003 the Court granted inpart that Motion. On September 24, 2003, defendants answered the remainingallegations of the amended complaint. Defendants reached a settlement of theSecurities Litigation Action in December 2003. Subject to preliminary and finalapproval by the Court, the Company’s insurance carriers agreed to pay $10million, on behalf of the Company, to settle the suit. The settlement includesa release of all defendants. The insurance carriers paid the settlement amountto plaintiffs’ escrow agent in January 2004. The Court preliminarily approvedthe settlement on February 24, 2004 and finally approved the settlement onMay 14, 2004. The settlement became final on June 15, 2004, the date when theappeals period ended. Therefore, in the second quarter of 2004, the $10 millionwas removed from the insurance settlement receivable and the legal settlementliability.

 

***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 and expensesto 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 individualdefendants.

 

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.

 

13

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**NOTE7—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. Revenues are attributed to the followingcountries based on the location of customers:

 

 
| ** **          | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **          | ** ** | **2003**                         | ** ** | **2004**                       | ** ** | **2003** | ** ** | **2004** | ** ** |
| United States       |       | $                                | 6,109      |                           | $          | 3,753 |   | $ | 11,840 |   | $ | 9,154 |   |
| International:      |       |                             |       |                           |       |   |   |   |   |
| Canada              |       | 589                              |       | 515                            |       | 708 |   | 815 |   |
| Ireland             |       | 291                              |       | 584                            |       | 545 |   | 730 |   |
| All other countries |       | 876                              |       | 271                            |       | 1,373 |   | 600 |   |
|                |       | $                                | 7,865      |                           | $          | 5,123 |   | $ | 14,466 |   | $ | 11,299 |   |

 

No individual customer accounted for greater than 10% of the Company’srevenue for the three and six months ended June 30, 2003.  One customer, Enterasys Networks Ltd.accounted for 11% of the Company’s revenue for the three months ended June 30,2004.  No individual customer accountedfor greater than 10% of the Company’s revenue for the six months ended June 30,2004.

 

*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 service managementproducts enable the transmission of broadband data over existing hotels andprivate campus networks.

 

Revenuerelating to the broadband transport and service management products was $2,532and $2,016 for the three months ended June 30, 2003 and 2004, respectively and$4,189 and $3,916 for the six months ended June 30, 2003 and 2004,respectively. Revenue related to video processing systems was $5,333 and $3,107for the three months ended June 30, 2003 and 2004, respectively and $10,277 and$7,383 for the six months ended June 30, 2003 and 2004, respectively. 

 

14

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**ITEM 2****.****     ****MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION AND 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 differ materiallyfrom those projected in such statements. Readers are cautioned not to placeundue reliance on these forward-looking statements, which speak only as of thedate hereof. The forward-looking statements contained in this quarterly reportinclude statements about the following: (1)our belief that there is and willcontinue to be growing demand for video services in the future (2) ourbelief that video products will provide most of our growth opportunities forthe foreseeable future, (3) our belief that the number of telco videosubscribers will grow significantly between 2004 and 2007 and that this marketspace will continue to become more competitive,(4) our expectation that we willsee growing demand for our products in the future, (5) our expectation thatwe will compete with larger public companies as we begin to target larger telcocustomers, (6) our expectation that emerging advancements in video compressiontechnology will allow more efficient transport of video streams, (7) ourexpectation that digital subscriber line or DSL technology will continue todominate telco broadband networks for the foreseeable future, (8) ourbelief that new controls and procedures have addressed the conditionsidentified by our auditors as material weaknesses, (9) our expectation thatcapital expenditures for research and development will decrease in 2004, (10)our expectation that our research and development expenses will increasethroughout the remainder of 2004, (11) our expectation that capitalexpenditures in 2004 will be comparable to 2003 and that these capitalexpenditures will be funded from operations,(12) our expectation that we willpay accrued interest on the note issued to Tektronix beginning January 31,2006,(13) our belief that our cash and cash equivalents as of June 30,2004 are sufficient to fund our operating activities and capital expenditureneeds for the next twelve months, (14) our expectation that workingcapital will begin to increase in future periods, (15) our expectationthat we will seek additional equity funding in the third quarter of 2004, (16)our expectation that future license and royalty revenue will decrease in futureperiods, (17) our anticipation that our sales and operating margins willcontinue to fluctuate, (18) our expectation that revenue for the second half of2004 will exceed revenue for the first half of the year, (19) our anticipationthat we will generally continue to invoice foreign sales in U.S. dollars, (20)our intention to continue to evaluate new acquisition candidates, divesture anddiversification strategies, and (21) our expectation that customersoutside of the United States will represent a significant and growing portionof 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 service management products thatenable the provisioning of high speed Internet access and other broadband dataservices over existing copper networks within hotels and private campusfacilities.

 

***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 (OneWorldSystems, Inc. and ViaGate Technologies, Inc.) in order to expand oursales of broadband transport and service management products. However, thesignificant downturn in the world economy in general, and thetelecommunications

 

15

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market in particular, beginningin late 2000 had a severe and sustained adverse effect on our business,financial condition and results of operations. Our sales of broadband transportand service management products decreased substantially beginning in 2001,which required us to take a number of restructuring efforts and incursignificant impairment and other charges in order to realign our cost structurein light of the economic environment. For the period January 1, 2001through December 31, 2002, we incurred an aggregate of $32.6 millionin intangible asset impairment charges and $11.5 million in restructuringcharges. In 2003, sales from our broadband transport and service managementproducts stabilized, as we began to experience an improvement in sales ofbroadband transport and service management products to the hospitalityindustry.

 

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 totalrevenues 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 six months endedJune 30, 2004, international sales represented 26.7% and 19.0%, 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 April 2003, the number of telcovideo subscribers worldwide will increase from 572,000 at the end of 2003 toover 19.0 million by the end of 2007. 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 product linethan 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 higher percentageof 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 two quartersof 2004 our sales cycle generally increased and customers delayed purchasingdecisions.  The deferral of customer orders reduced our revenue in thefirst two quarters of 2004 compared with prior periods and compared with whatwe had expected for those quarters.  Webelieve this lengthening of the decision making process is the result of anincreasing variety of other products that interface with our systems. We havebeen operating at a loss since inception and, based on expected revenues, weanticipate that we will continue to operate at loss during the remainder of2004.  As we announced on July 8, 2004,we expect revenues during the second half of 2004 will exceed revenue for thefirst half of the year.  However, thedeferral of customer orders we experienced during the first half of 2004 maycontinue, which may result in reduced revenues in the future.

 

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

 

Our Chief Executive Officer and Chief Financial Officer carried out anevaluation of the effectiveness of our disclosure controls and procedures (asdefined in Rule 13a-15(e) under the Exchange Act) as of June 30, 2004.This evaluation included various steps that our Chief Executive Officer andChief Financial 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 June 30, 2004, our ChiefExecutive Officer and Chief Financial Officer have concluded that ourdisclosure control and procedures are effective.

 

In January 2004 in connection with the completion of its audit ofour financial 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 and processesrelating to inventory management and reporting that it considers to be materialweaknesses, as defined by Statement on Auditing Standards No. 60,“Communication of Internal Control Related Matters Noted in an Audit.” Thematerial weaknesses that PricewaterhouseCoopers identified related to inventorycontrols and the accounts payable process for the Company’s Videotele.combusiness, which the Company acquired in November 2002. Specifically: 

 

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

 

2.                                       Our accountspayable process failed to adequately reconcile our accounts payable recordswith suppliers’ records, considering what the suppliers had shipped to us priorto period end. 

 

While these material weaknesses had animmaterial effect on our reported results, they nevertheless constituted deficienciesin our disclosure controls. In light of these material weaknesses and therequirements enacted by the Sarbanes-Oxley Act of 2002 and the related rulesand regulations adopted by the SEC, our Chief Executive Officer and ChiefFinancial Officer concluded that, as of December 31, 2003, our disclosurecontrols and procedures needed improvement and were not effective. Despitethose deficiencies in our disclosure controls, management believed that as ofDecember 31, 2003, there were no material inaccuracies, or omissions ofmaterial facts necessary to make the statements not misleading in light of thecircumstances under which they were made.

 

At the 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 timeperiods specified by the SEC. Likewise, we had in place internal controls thatour CEO and CFO believed at the time of the VTC acquisition to be sufficient to“provide reasonable assurance regarding the reliability of financial reportingand preparation of financial statements for external purposes in accordancewith generally accepted accounting principles.” 

 

Since December 31, 2002, we have continued to review ourdisclosure controls and procedures and internal controls periodically inconnection with our Form 10-Q filings. Throughout 2003, our CEO and CFOhave continued to believe that our disclosure controls and procedures andinternal controls have allowed us to provide all material and necessarydisclosure in a timely manner, as required by the Exchange Act and theapplicable rules thereunder. 

 

In January 2004, during the audit of our financial statements forthe fiscal year ended December 31, 2003, PricewaterhouseCoopers LLPdiscovered the material weaknesses noted above and brought these weaknesses toour attention. Based on discussions with PricewaterhouseCoopers LLP and theaudit committee of our Board of Directors, we worked throughout our year-end 2003accounting close and audit to identify the nature, scope and materiality ofthese weaknesses in our internal controls and their impact

 

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on our fiscal year 2003financial statements and to determine the extent to which these internalcontrol weaknesses might adversely affect our disclosure controls andprocedures. Based on further detailed review of our internal controls as theyrelate to inventory and accounts payable during the fourth quarter of fiscal2003, we determined that the accounts payable process had failed to recordcertain liabilities associated with VTC products that we purchased, principallyfrom our contract manufacturer and certain other suppliers. We quantified thisinternal control weakness relating to accounts payable recordation byreconciling our records to that of our contract manufacturer and reviewing ourliabilities with other vendors. We quantified the inventory process controlweakness by taking complete physical inventories at each VTC inventory locationand reconciling the results to our records. Upon completion of our analysis andtesting, we identified an additional charge of approximately $34,000 to cost ofgoods sold related to the internal control weaknesses identified above. Werecorded this charge prior to issuing our financial statements for the yearended December 31, 2003. In addition to our review of the financialstatements for the fiscal year ended December 31, 2003, we re-confirmedthat our accounts payable recordation and inventory controls were effective forthe year ended December 31, 2002. 

 

During our review of these internal controls weaknesses, we identifiedthe cause of these internal control weaknesses to be the result of prior VTCaccounting staff turnover that occurred during the first quarter of 2003.During this quarter, key accounting staff of VTC left the company withoutsufficient time to transition all of the internal controls and institutionalknowledge to our remaining finance and accounting staff. 

 

In addition to identifying the above two internal control weaknessesrelating to inventory and the accounts payable process, we also tested ourother internal controls to determine whether there were other such materialweaknesses aside from the inventory and accounts payable weaknesses mentionedabove that affected our financial statements for the fiscal year endedDecember 31, 2003. In particular, we tested our other internal controls byreviewing processes, analytical reviews and substantive testing that includedother third-party confirmations and by reviewing activity subsequent toyear-end 2003. Based on these tests, we did not identify any other materialweaknesses in internal controls. Therefore, our CEO and CFO believed at thetime of the original filing of the Form 10-K on February 2, 2004 thatthey had reasonable grounds to conclude that the weaknesses in internalcontrols related solely to those items mentioned above and resulted in animmaterial charge of approximately $34,000. 

 

Based on their review of our internal controls as described above, ourCEO and CFO also assessed our disclosure controls and procedures for the fiscalyear ended December 31, 2003. Our CEO and CFO believed at the time of theoriginal filing of the Form 10-K that they had reasonable grounds toconclude 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 information requiredto be reported in the Form 10-K was recorded, processed, summarized andreported within the time periods specified by the applicable Exchange Actrules. 

 

In order to ensure that we have eliminated the two weaknesses in ourinternal controls for purposes of future reporting, we have undertakensignificant efforts to improve our processes and procedures as they relate toinventory reporting and accounts payable reconciliation. The audit committee istaking an active role in these efforts, including overseeing management’simplementation of corrective measures. With respect to inventory management, wehave performed 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, have reiterated to key operations andaccounting personnel the importance of proper inventory management and control.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 our key accountspayable balances with our vendors and reconciled the confirmations to ouraccounting records on a quarterly basis in 2004.

 

Management believes that the controls and procedures identified abovehave and will address the conditions identified by PricewaterhouseCoopers LLPas material weaknesses. These changes will become permanent elements of ourinternal controls. 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 revenues 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. If we were to sell even one less system thanour forecasted number of headend sales per quarter, our quarterly revenue wouldbe materially impacted. As we have not entered into any new license or royaltyagreements since 2000, we expect that our license and

 

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royalty revenue will decreasein the foreseeable future. Cost of goods sold, or COGS, consists of costsrelated to raw materials, contract manufacturing, personnel, overhead, test andquality assurance for products, and the cost of licensed technology included inour products. Raw materials, contract manufacturing and licensed technology arethe principal 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 revenues for the periods indicated: 

 
| ** **                     | ** ** | **Three Months  Ended June 30,** | ** ** | **Six Months  Ended June 30,** | ** ** |
|--------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                     | ** ** | **2003**                         | ** ** | **2004**                       | ** ** | **2003** | ** ** | **2004** | ** ** |
| Total revenues                 |       | 100.0                            | %          | 100.0                          | %          | 100.0 | % | 100.0 | % |
| Total cost of goods sold       |       | 51.1                             |       | 67.3                           |       | 50.3 |   | 75.9 |   |
| Gross margin                   |       | 48.9                             |       | 32.7                           |       | 49.7 |   | 24.1 |   |
| Operating expenses:            |       |                             |       |                           |       |   |   |   |   |
| Sales and marketing            |       | 24.5                             |       | 37.7                           |       | 26.6 |   | 34.0 |   |
| Research and development       |       | 28.6                             |       | 36.3                           |       | 30.0 |   | 32.6 |   |
| General and administrative     |       | 14.1                             |       | 21.5                           |       | 16.0 |   | 19.6 |   |
| Impairment of intangibles      |       | 1.6                              |       | —                         |       | 0.9 |   | 1.8 |   |
| Amortization of intangibles    |       | 5.8                              |       | 7.3                            |       | 6.3 |   | 6.8 |   |
| Total operating expenses       |       | 74.6                             |       | 102.8                          |       | 79.8 |   | 94.8 |   |
| Loss from operations           |       | (25.7                            | )          | (70.1                          | )          | (30.1 | ) | (70.7 | ) |
| Interest and other income, net |       | (0.1                             | )          | (0.9                           | )          | 0.6 |   | (0.9 | ) |
| Net loss                       |       | (25.8                            | )%         | (71.0                          | )%         | (29.5 | )% | (71.6 | )% |

 

*Three and Six Months Ended June 30, 2003 and 2004*

* *

*Total Revenues.*  Our total revenues decreased to $5.1 millionand $11.3 million for the three and six months ended June 30, 2004,respectively, when compared with total revenues of $7.9 million and $14.5million for the same periods in 2003. For the three months ended June 30, 2004,our product revenue from video processing systems declined by 41.5% to$3.1 million from $5.3 million for the three months ended June 30,2003.  For the six months ended June 30, 2004, ourproduct revenue from video processing systems decreased by $2.9 million, or28.2%, to $7.4 million from $10.3 million for the same period in 2003.    The decreases in video processing systemsproduct revenue were due primarily to the adverse effect of several digital TVheadend sales not closing during the period as expected.  While we believe the market for digital TVheadend sales continues to expand, we are seeing an increase in a variety offactors that are causing many prospective customers to delay their purchasedecisions.  Sales of broadband transportand service management products decreased from $2.5 million in the secondquarter of 2003 to $2.0 million in the second quarter of 2004 and decreasedfrom $4.2 million for the six months ended June 30, 2003 to $3.9 million forthe six months ended June 30, 2004.  Included in sales of broadband transport and service management productswere sales to one customer, Enterasys Networks Ltd. which accounted for 11% ofour total revenue for the three months ended June 30, 2004.  For the three months ended June 30, 2004, ourlicense and royalty revenue decreased to $18,000 from $0.2 million for thethree months ended June 30, 2003 and decreased to $35,000 for the six monthsended June 30, 2004 from $0.4 million for the six months ended June 30,2003.  We expect that our license androyalty revenue will continue to decrease in the foreseeable future. 

 

*Cost of Goods Sold.*  For the three months ended June 30, 2004, ourcost of goods sold decreased by $0.6 million to $3.4 million from$4.0 million for the three months ended June 30, 2003. The decrease incost of goods sold was due to a $0.9 million decrease in material costsrelating to lower sales volume, partially offset by an increase in labor costsof  $0.2 million and an increase inoverhead costs of $0.1 million.   Cost ofgoods sold increased by $1.3 million to $8.6 million during the six monthsended June 30,

 

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2004 from $7.3 million for thesix months ended June 30, 2003.  Thisincrease in costs of goods sold includes an increase of $1.0 million ininventory reserves recorded during the first quarter of 2004.  The remaining increase in costs of goods soldof $0.3 million includes an increase in labor costs of $0.3 million and anincrease in overhead costs of $0.5 million, partially offset by a decrease inmaterial costs of $0.5 million. 

 

*Sales and Marketing.*  For the three and six months ended June 30,2004 and 2003, our sales and marketing expenses remained consistent at $1.9million and $3.8 million respectively.

 

*Research and Development.*  For the three months ended June 30, 2004, ourresearch and development expense decreased by 17.3% to $1.9 million from$2.2 million for the three months ended June 30, 2003. The$0.3 million decrease in our research and development expense for thesecond quarter of 2004 when compared with the same period in 2003 was due to adecrease of $0.3 million in personnel related costs. We expect that ourresearch and development expenses will increase throughout the remainder of2004. Research and development expense decreased by $0.6 million to $3.7million for the six months ended June 30, 2004 from $4.3 million for the sixmonths ended June 30, 2003.  The $0.6million decrease was due to a decrease of $0.6 million in personnel relatedcosts.  Our capital expenditures forresearch and development were $0.1 million and $19,000 for the threemonths ended June 30, 2003 and 2004, respectively and $0.1 million and $0.3million for the six months ended June 30, 2003 and 2004, respectively. Weexpect capital expenditures for research and development to decrease in 2004.

 

*General and Administrative.*  For the three months ended June 30, 2004 and2003, our general and administrative expense remained consistent at $1.1million.  For the six months ended June30, 2004, general and administrative expense decreased to $2.2 million from$2.3 million for the six months ended June 30, 2003.  The $0.1 million decrease was due to a $0.2million decrease in personnel related costs and a $0.2 million decrease ininsurance costs offset by a $0.3 million increase in outside services.

 

*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 June 30, 2004, amortization of intangible assetsdecreased by 18.1% to $0.4 million from $0.5 million for the threemonths ended June 30, 2003.  Amortizationof intangible assets decreased by $15.9% to $0.8 million for the six monthsended June 30, 2004 from $0.9 million for the six months ended June 30, 2003. 

 

*Interest and Other Income, Net.*  Interest and other income, net consistsprimarily of interest income and expense and foreign currency exchange gainsand losses. For the six months ended June 30, 2004, our interest and otherincome, decreased to a net expense of $0.1 million from a net interest andother income of $0.1 million for the six months ended June 30, 2003. Thedecrease in the six months ended June 30, 2004 of $0.2 million comparedwith the six months ended June 30, 2003 was primarily the result of lowerinterest rates on lower average cash balances and increased interest expenseassociated with the $3.2 million note issued in connection with ourpurchase of VTC in November 2002.

 

**Liquidity and Capital Resources**

** **

Cash and cash equivalents totaled $8.8 million at June 30, 2004,compared with cash and cash equivalents of $14.4 million at December 31,2003, reflecting a net reduction in cash and cash equivalents of$5.6 million.

 

Cash used in operating activities was $5.2 million for the sixmonths ended June 30, 2004, compared with $9.4 million for the six monthsended June 30, 2003. The reduced cash used in operating activities wasprimarily due to a decrease in accounts receivable due to lower revenue in thesecond quarter of 2004 and an increase in accounts payable and accruedliabilities due to an increase in end of quarter inventory purchases.  We recorded a provision for excess andobsolete inventory within cost of goods sold totaling $1.0 million in the sixmonths ended June 30, 2004.  

 

Additions to property and equipment were $0.8 million in the sixmonths ended June 30, 2004, compared with $0.5 million in the six monthsended June 30, 2003, primarily reflecting an increased investment in researchand development assets. In total we expect capital expenditures for 2004 to becomparable to 2003. We expect these capital expenditures to be funded fromoperations.

 

Cash from financing activities were $0.3 million in the six monthsended June 30, 2004, compared with $11,000 for the six months ended June 30,2003 from increased exercises of stock options.

 

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The following table sets forth our contractual obligations as of June30, 2004:

 
| ** **                   | ** ** | **Payments due by period** | ** ** |
|------------------------------|------------|----------------------------|------------|
| **Contractual  Obligations** | ** ** | **Total**                  | ** ** | **Remainder  of 2004** | ** ** | **2005  to  2006** | ** ** | **2007  to  2008** | ** ** | **Thereafter** | ** ** |
| Long-Term Debt Obligations   |       | $                          | 3,673      |   | $ | — |   | $ | — |   | $ | 3,673 |   | $ | — |   |
| Operating Lease Commitments  |       | 701                        |       | 435 |   | 266 |   | — |   | — |   |
| Purchase Obligations         |       | 447                        |       | 447 |   | — |   | — |   | — |   |
| Other Long-Term Liabilities  |       | 18                         |       | — |   | 18 |   | — |   | — |   |
| Total                        |       | $                          | 4,839      |   | $ | 882 |   | $ | 284 |   | $ | 3,673 |   | $ | — |   |

 

We do not have any off balance sheet arrangements.

 

As part of our acquisition of VTC from Tektronix in November 2002,we issued a note payable to Tektronix for $3.2 million, with repayment insixty months, or by November 2007. The interest rate on this note is 8%and is compounded annually. Through January 31, 2006, the accrued interestis added to the principal balance of the note. Thereafter, we will pay accruedinterest on this note commencing on January 31, 2006 and on eachApril 30, July 31 and October 31 thereafter until the principalbalance is paid in full. Principal and accrued interest on the note payable is$3.7 million at June 30, 2004. Accrued interest in the six months ended June 30, 2004 was $0.1 million.

 

In connection with the settlements of certain legal matters in December2003, we recorded 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 during the sixmonths ended June 30, 2004. These amounts were paid by our insurance carriersduring the six months ended June 30, 2004. The settlements were formallyapproved by the respective courts during the six months ended June 30, 2004 andtherefore, we removed the $10.7 million liability and receivable related to thesettlements from the balance sheet as of June 30, 2004.

 

We have incurred substantial losses and negative cash flows fromoperations since inception. For the six months ended June 30, 2004, we incurreda net loss of $8.1 million, negative cash flows from operating activitiesof $5.2 million, and have an accumulated deficit of $290.1 million.

 

We believe that the cash and cash equivalents as of June 30, 2004 aresufficient to fund our operating activities and capital expenditure needs forthe next twelve months. However, in the event that general economic conditionsworsen, we may require additional cash to fund our operations. We plan to seekadditional equity funding to provide working capital, fund potentialacquisitions and potentially redeem the VTC acquisition indebtedness. We cannotbe assured that such funding efforts will be successful. Failure to generatepositive cash flow in the future could have a material adverse effect on ourability to achieve our intended business objectives.

 

**Critical Accounting Policies and Estimates**

** **

Our discussion and analysis of our financial condition and results ofoperations are based upon our consolidated financial statements, which havebeen prepared in accordance with generally accepted accounting principles inthe United States. The preparation of these financial statements requires us tomake estimates 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 expenses duringthe reporting periods. We base our estimates on historical experience and onvarious 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.

 

We have identified the policies below as critical to our businessoperations and the understanding of our results of operations.

 

*Revenue recognition.*  We generate revenue primarily from the saleof hardware products, including third-party products, through professionalservices, and through the sale of our software products. We sell 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 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. We sell these products through our own direct sales channels and alsothrough distributors.

 

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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 fairvalue does exist or until all elements of the arrangement are delivered,subject to certain 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 amendmentsdeferred and then clarified, respectively, the specification of what wasconsidered vendor specific objective evidence of fair value for the variouselements in a multiple element arrangement.

 

In the case of software arrangements that require significantproduction, modification or customization of software, which encompasses all ofour turnkey arrangements, SOP 97-2 refers to the guidance inSOP 81-1, *Accounting for Performance ofConstruction-Type and Certain Production-Type Contracts.* Werecognize revenue for all turnkey arrangements in accordance with SOP 97-2and SOP 81-1. Excluding the PCS element of the multi-element arrangement,for which we have established vendor specific objective evidence of fair value(as defined by SOP 97-2), revenue from turnkey solutions is generallyrecognized using the percentage-of-completion method, as stipulated bySOP 81-1. The percentage-of-completion method reflects the portion of theanticipated contract revenue that has been earned that is equal to the ratio oflabor effort expended to date to the anticipated final labor effort, based oncurrent estimates of total labor effort necessary to complete the project.Revenue from the PCS element of the arrangement is deferred at the point ofsale and recognized over the term of the PCS period. Generally, the terms ofthe turnkey solution sales provide for billing of approximately 90% of thecontract value prior to the time of delivery to the customer site, with anadditional approximately 9% of the contract value billed upon substantialcompletion of the 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.

 

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, we recognize revenue when persuasiveevidence of an arrangement exists, delivery has occurred, the fee is fixed ordeterminable, and collection is reasonably assured.

 

Significant management judgments and estimates must be made inconnection with the measurement of revenue in a given period. We followspecific and detailed guidelines for determining the timing of revenuerecognition. At the time of the transaction, we assess a number of factors,including specific contract and purchase order terms, completion and timing ofdelivery to the common-carrier, past transaction history with the customer, thecreditworthiness of the customer, evidence of sell-through to the end user, andcurrent payment terms. Based on the results of the assessment, we may recognizerevenue when the products are shipped or defer recognition of revenue untilevidence of sell-through occurs and cash is received. In order to recognizerevenue, we must also make a judgment regarding collectibility of thearrangement fee.  Management’s judgmentof collectibility is applied on a customer-by-customer basis pursuant to our creditreview policy.  We sell to customers forwhich there is a history of successful collection and to new customers forwhich such history may not exist.  Newcustomers are subject to a credit review process, which evaluates thecustomers’ financial position and ability to pay. New customers are typicallyassigned a credit limit 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 the percentage-of-completionmethod.

 

We also maintain accruals and allowances for all cooperative marketingand other programs, as necessary. Estimated sales returns and warranty costsare based on historical experience and are recorded at the time revenue isrecognized, as necessary. Our products generally carry a one year warranty fromthe date of purchase. To date, warranty costs have been insignificant to theoverall financial statements taken as a whole.

 

License and royalty revenue consists of non-refundable up-front licensefees, some of which may offset initial royalty payments, and royalties receivedby us for products sold by our licensees. Currently, the majority of ourlicense and royalty revenue is comprised of non-refundable license fees paid inadvance. Such revenue is recognized ratably over the period during whichpost-contract customer support is expected to be provided or upon delivery andtransfer of agreed upon technical specifications in contracts where essentiallyno further support obligations exist. Future license and royalty revenue isexpected to consist primarily of royalties received by us for products sold byour licensees. We expect that such license and royalty revenue will notconstitute a substantial portion of our revenue in future periods.

 

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*Inventories.*  Inventories are stated at the lower of costor market. Cost is computed using standard cost, which approximates actual coston a first-in, first-out basis. We record provisions to write down ourinventory and related purchase commitments for estimated obsolescence orunmarketable inventory equal to the difference between the cost of theinventory and the estimated market value based upon assumptions about thefuture 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.*  We maintain allowances for doubtful accountsfor estimated losses resulting from the inability of our customers to makepayments. These estimated allowances are periodically reviewed, analyzing thecustomers’ payment history and information regarding the customers’creditworthiness known to us. If the financial condition of any of ourcustomers were to deteriorate, resulting in their inability to make payments,an additional allowance would be required.

 

*Accounting for long-lived assets.*  We are required to periodically assess theimpairment of long-lived assets. An impairment review is performed wheneverevents or changes in circumstances indicate that the carrying value may not berecoverable. 

 

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 our marketcapitalization relative to net book value. 

 

When our 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 ourcurrent business model. 

 

During the six months ended June 30, 2003, we determined that certainintangible long-lived assets were impaired and recorded a loss of $0.1 millionunder SFAS No. 144   During the six monthended June 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 note 6. Because of uncertainties related to boththe potential amount and range of loss from the pending litigation, managementis unable to make a reasonable estimate of the liability that could result ifthere is an unfavorable outcome in certain of these legal proceedings. We havenot recorded a liability for the *Whalen*matteras a consequence of several uncertainties. As additional information becomesavailable, we will assess the potential liability related to these litigationmatters and may revise our estimates accordingly. Revisions of our estimates ofsuch potential liability could materially impact our results of operations,financial condition or cashflows.

 

**RecentAccounting Pronouncements**

** **

InJanuary 2003, the Financial Accounting Standards Board, the (“FASB”)issued FASB Interpretation No. 46 (FIN 46), “Consolidation of VariableInterest Entities, an Interpretation of ARB No. 51, Consolidated FinancialStatements,” and subsequently revised in December 2003 with the issuanceof FIN 46-R. This interpretation requires certain variable interest entities tobe consolidated by the primary beneficiary of the entity if the equityinvestors in the entity do not have the characteristics of a controllingfinancial interest or do not have sufficient equity at risk for the entity tofinance its activities without additional subordinated financial support fromother parties. Application of this Interpretation is required in financialstatements for periods ending after March 15, 2004.  The adoption of this Interpretation in thesix months ended June 30, 2004 did not have a material impact on our results ofoperations, financial position or cash flows. 

 

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

 

**We have a history of significant losses, andwe may never achieve profitability.**

** **

We have incurred substantial net losses and experienced negative cashflow for each quarter since our inception. As of June 30, 2004, we had an accumulateddeficit of $290.1 million. We expect to incur losses in the near future.Moreover, we may never achieve profitability and, if we do so, we may not beable to maintain profitability. We may not be able to generate a sufficientlevel of revenue to offset our current level of expenditures. Moreover, becauseour expenditures for sales and marketing, research and development, and generaland administrative functions are relatively fixed in the short term, we may beunable to adjust our spending in a timely manner to respond to anyunanticipated decline in revenue. If we fail to achieve profitability withinthe timeframe expected by securities analysts or investors, then the marketprice of our common stock will likely decline. 

 

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**Each sale of our headend systems represents asignificant portion of our revenue for any given quarter. Our failure to meetour quarterly forecast of sales of headend systems in any given quarter couldhave a material adverse impact on our financial results for a given quarter.**

** **

Since we acquired VTC in November 2002, a large part of ourquarterly revenue is associated with the sale of headend systems. Each salerepresents a significant portion of our revenue for each quarter. We base ouroperating forecast on our historical sales. Because of the high cost per unitof our headend systems, if we were to sell even one less system than ourforecasted number of headend sales per quarter, such a decrease in sales wouldhave a material and adverse impact on our revenue for that quarter, and we mayfail to meet investor expectations. 

 

**We operate in an intensely competitivemarketplace, and many of our competitors have better resources than we do.**

** **

Our primary competitors in the digital TV headend market are smallprivate companies that are focused on a more narrow product line than ours,thereby allowing these competitors to devote substantially more targetedresources to developing and marketing new products than we can. As we begin to targetlarger telco customers for our video content processing systems, we expect morecompetition from large public companies like Harmonic, Inc., TandbergTelevision ASA, and Motorola, Inc., all of which have substantiallygreater financial, technical and other resources than we do. These competitorshave achieved 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. 

 

Our competition in the market for video transmission processingproducts primarily comes from small private companies such as SkyStreamNetworks and public companies such as Optibase Inc. and Tandberg Televisionthat together offer a wide array of products with special features andfunctions. Our broadband transport and service management business tends tocompete against public, private and foreign network equipment companies. 

 

To the extent that any of these current or potential future competitorsenter or expand further into our markets, develop superior technology andproducts or offer superior prices or performance features relative to ourproducts, such competition could result in lost sales and severe downwardpressure on our pricing, either of which would adversely affect our revenue andprofitability. 

 

**Commercial acceptance of any technologicalsolution that competes with technology based on communication over coppertelephone wire could materially and adversely impact demand for our products,our revenue and growth strategy.**

** **

The markets for video content processing, transmission and high-speeddata access systems and services are characterized by several competingcommunication technologies, including fiber optic cables, coaxial cables,satellites and other wireless facilities. Many of our products are based oncommunication over copper telephone wire. Because there are physical limits tothe speed and distance over which data can be transmitted over copper wire, ourproducts may not be a viable solution for customers requiring service atperformance levels beyond the current limits of copper telephone wire. Ourcustomer base is concentrated on telephone service providers that have a largeinvestment in copper wire technology. If these customers lose market share totheir competitors who use competing technologies that are not as constrained byphysical limitations as copper telephone wire, and that are able to providefaster access, greater reliability, increased cost-effectiveness or otheradvantages, demand for our products will decrease. Moreover, to the extent thatour customers choose to install fiber optic cable or other transmission mediaas part 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 videoservices from telephone service providers does not materialize or if ourcustomers find alternative methods of delivering video services, future salesof our video content processing systems will suffer.**

** **

We manufacture video content processing systems that enable telephoneservice providers to offer video services to their customers. Our customers,the telephone service providers, face competition from cable companies,satellite service providers and wireless companies. For some users, thesecompeting solutions provide fast access, high reliability and cost-effectivesolutions for delivering data, including video services. Telephone serviceproviders hope to maintain their market share in their core business of voicetelephony as well as increase their revenue per customer by offering theircustomers more services, including video services and high-speed data services.However, if the telephone service providers find alternative ways ofmaintaining and growing their market share in their core business that do notrequire that they offer video services, demand for our products will decreasesubstantially. Moreover, if technological advancements are developed that allowour customers to provide video services without upgrading their current systeminfrastructure, or that offer our customers a more cost-effective method ofdelivering video services, sales of our video content processing systems willsuffer. Alternatively, even if the telephone service providers choose our videocontent processing systems, the service providers may not be successful inmarketing video services to their customers, in which case our sales woulddecrease substantially. 

 

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**Our operating results fluctuate significantlyfrom quarter to quarter, and this may cause the price of our stock to decline.**

** **

Over the last 12 quarters, our sales per quarter have fluctuatedbetween $9.2 million and $2.0 million. Over the same periods, ourloss from operations as a percentage of revenue has fluctuated betweenapproximately 5.2% and 1,274% of revenue. We anticipate that our sales andoperating margins will continue to fluctuate. We expect this fluctuation tocontinue for a variety of reasons, including: 

 

•                                          thetiming of customers’ purchase decisions, acceptance of our new products andpossible cancellations; 

 

•                                          competitivepressures, including pricing pressures from our partners and competitors; 

 

•                                          delaysor problems in the introduction of our new products; 

 

•                                          announcementsof new products, services or technological innovations by us or ourcompetitors; and 

 

•                                          managementof inventory levels. 

 

**The sales cycle for video content processingsystems is long and unpredictable, which requires us to incur high sales andmarketing expenses with no assurance that a sale will result.**

** **

The sales cycle for our headend systems can be as long as12-18 months. Additionally, with respect to the sale of our products toU.S. and foreign government organizations, we may experience long sales cyclesas a result of government procurement processes. As a result, while we continueto incur costs associated with a particular sale prior to payment from thecustomer, we may not recognize revenue from efforts to sell particular productsfor extended periods of time. 

 

As a result, our quarter-to-quarter comparisons of our revenue andoperating results may not be meaningful and may not provide an accurateindicator of our future performance. Our operating results in one or morefuture quarters may fail to meet the expectations of investment researchanalysts or investors, which could cause an immediate and significant declinein the trading price of our common stock. 

 

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

** **

We rely on contract manufacturers and third-party equipmentmanufacturers, or OEMs, to manufacture, assemble, test and package ourproducts. We also depend on third-party suppliers for the materials and partsthat constitute our products. Our reliance on contract manufacturers, OEMs andthird-party suppliers requires us to accurately forecast the demand for ourproducts and coordinate our efforts with those of our contract manufacturers,OEMs and suppliers. We often make significant up-front financial commitmentswith our contract 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, weoutsource the manufacturing of our products based on forecasts of sales. Iforders for our products exceed our forecasts, we may have difficulty meetingcustomers’ orders in a timely manner, which could damage our reputation orresult in lost sales. Conversely, if our forecasts exceed the orders weactually receive and we are unable to cancel future purchase and manufacturingcommitments in a timely manner, our inventory levels would increase. This couldexpose us to losses related to slow moving and obsolete inventory, which wouldhave a material adverse effect on our profitability. 

 

**If we fail to develop and introduce newproducts in response to the rapid technological changes in the markets in whichwe compete, we will not remain competitive.**

** **

The markets for video content processing, transmission and high-speeddata access systems are characterized by rapid technological developments,frequent enhancements to existing products and new product introductions,changes in end-user requirements and evolving industry standards. To remaincompetitive, we must continually improve the performance, features andreliability of our products. For example, advancements in compressiontechnology are leading the video content processing industry to begin thetransition to next generation compression standards. These advances will allowfor further reductions in the bandwidth required to deliver standard definitionvideo 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, emergingtechnologies and industry standards. 

 

We cannot assure you that we will be able to respond quickly andeffectively to technological change. We may have only limited

 

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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 asignificant portion of our revenue, which subjects our business to a number ofrisks. If we are unable to generate significant international sales, ourrevenue, profitability and share price could be materially and adverselyaffected.**

** **

Sales to customers outside of the United States accounted forapproximately 56.3%, 43.0% and 18.4% of revenue for the years endedDecember 31, 2001, 2002 and 2003, respectively and 18.2% and 19.0% for thesix months ended June 30, 2003 and 2004, respectively. Sales and operatingactivities outside of the United States are subject to inherent risks,including fluctuations in the value of the United States dollar relative toforeign currencies; tariffs, quotas, taxes and other market barriers; politicaland economic instability; restrictions on the export or import of technology;potentially limited intellectual property protection; difficulties in staffingand managing international operations and potentially adverse tax consequences.Any of these factors may have a material adverse effect on our ability to growor maintain international revenue. 

 

We expect sales to customers outside of the United States to representa significant 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 adverselyaffected. 

 

**Fluctuations in interest and currencyexchange rates may decrease demand for our products.**

** **

Substantially all of our foreign sales are invoiced in U.S. dollars. Asa result, fluctuations in currency exchange rates could cause our products tobecome relatively more expensive for international customers, thereby reducingdemand for our products. We anticipate that we will generally continue toinvoice foreign sales in U.S. dollars. We do not currently engage in foreigncurrency hedging 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-partyOEMs and third-party suppliers fail to produce quality products or parts in atimely manner, we may not be able to meet our customers’ demands.**

** **

We do not manufacture our products. We rely on contract manufacturersand OEMs to manufacture, assemble, package and test substantially all of ourproducts and to purchase most of the raw materials and components used in ourproducts. Additionally, we depend on third-party suppliers to provide qualityparts and materials to our contract manufacturers and OEMs, and we obtain someof the key components and sub-assemblies used in our products from a singlesupplier or a limited group of suppliers. Neither we nor our contractmanufacturers or OEMs have any guaranteed supply arrangements with thesuppliers. If our suppliers fail to provide a sufficient supply of keycomponents, we could experience difficulties in obtaining alternative sourcesat reasonable prices, if at all, or in altering product designs to usealternative components. Moreover, if our contract manufacturers or OEMs fail todeliver quality products in a timely manner, such failure would harm ourability to meet our scheduled product deliveries to customers. Delays andreductions in product shipments could increase our production costs, damagecustomer relationships and harm our revenue and profitability. In addition, ifour contract manufacturers and OEMs fail to perform adequate quality controland testing of our products, we would experience increased production costs forproduct repair and replacement, and our profitability would be harmed.Moreover, defects in products that are not discovered in the quality assuranceprocess could damage customer relationships and result in product returns orproduct liability claims, each of which could harm our revenue, profitabilityand reputation. 

 

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

 

Any defect or deficiency in our products could reduce thefunctionality, effectiveness or marketability of our products. These defects ordeficiencies could cause customers to cancel or delay their orders for ourproducts, reduce revenue or render our product designs obsolete. In any ofthese events, we would be required to devote substantial financial and otherresources for a significant period of time to develop new product designs. Wecannot assure you that we would be successful in addressing any design defectsin our products or in developing new product designs in a timely manner, if atall. Any of these events, individually or in the aggregate, could harm ourrevenue, profitability and reputation.

 

**Our business depends on the integrity of ourintellectual property rights. If we fail to adequately protect our intellectualproperty, our revenue, profitability, reputation or growth strategy could beadversely affected.**

 

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We attempt to protect our intellectual property and proprietarytechnology through patents, trademarks and copyrights, by generally enteringinto confidentiality or license agreements with our employees, consultants,vendors, strategic partners and customers as needed, and by generally limitingaccess to and distribution of our trade secret technology and proprietaryinformation. However, any of our pending or future patent or trademarkapplications may not ultimately be issued as patents or trademarks of the scopethat we sought, if at all, and any of our patents, trademarks or copyrights maybe invalidated, deemed unenforceable, or otherwise challenged. In addition,other parties may circumvent or design around our patents and otherintellectual property rights, may misappropriate our proprietary technology, ormay otherwise develop similar, duplicate or superior products. Further, theintellectual property laws and our agreements may not adequately protect ourintellectual property rights and effective intellectual property protection maybe unavailable or limited in certain foreign countries in which we do businessor may do business in the future. 

 

The telecommunications and data communications industries arecharacterized by the existence of extensive patent portfolios and frequentintellectual property litigation. From time to time, we have received, and mayin the future receive, claims that we are infringing third parties’intellectual property rights. Any present or future claims, with or withoutmerit, could be time-consuming, result in costly litigation, divert managementtime and attention and other resources, cause product shipment delays orrequire us to enter into royalty or licensing agreements. Such royalty or licensingagreements, if required, may not be available on terms acceptable to us. Inaddition, any such litigation could force us to cease selling or using certainproducts or services, or to redesign such products or services. Further, we mayin the future initiate claims or litigation against third-parties forinfringement of our intellectual property rights or to determine the scope andvalidity of our intellectual property rights or those of competitors. Suchlitigation could result in substantial costs and diversion of resources. Any ofthe foregoing could have an adverse effect upon our revenue, profitability,reputation or growth strategy. 

 

**If we fail to provide our customers withadequate and timely customer support, our relationships with our customerscould be damaged, which would harm our revenue and profitability.**

** **

Our ability to achieve our planned sales growth and retain customerswill depend in part on the quality of our customer support operations. Ourcustomers generally require significant support and training with respect toour products, particularly in the initial deployment and implementation stage.As our systems and products become more complex, we believe our ability toprovide adequate customer support will be increasingly important to oursuccess. We have limited experience with widespread deployment of our productsto a diverse customer base, and we cannot assure you that we will have adequatepersonnel to provide the levels of support that our customers may requireduring initial product deployment or on an ongoing basis. Our failure toprovide sufficient support to our customers could delay or prevent thesuccessful deployment of our products. Failure to provide adequate supportcould also have an adverse impact on our reputation and relationship with ourcustomers, could thereby prevent us from gaining new customers and could harmour revenue and profitability. 

 

**If we fail to manage our expandingoperations, our ability to increase our revenues and improve our results ofoperations could be harmed.**

** **

We anticipate that, in the future, we may need to expand certain areasof our business 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 controls willbe adequate to support our operations or that our management will be able toachieve 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 materialweaknesses in our internal controls that our independent registered publicaccounting firm identified in the fourth quarter of fiscal 2003, suchweaknesses could materially and adversely affect our ability to provide thepublic with timely and accurate material information about our company, whichcould harm our reputation and share price.**

** **

In January 2004, our independent registered public accounting firmidentified deficiencies in our internal controls that they considered to bematerial weaknesses. Based on these weaknesses, our CEO and CFO determinedthat, as of December 31, 2003, our disclosure controls and procedures werenot sufficient to record, process, summarize and report information required tobe reported 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, asamended (the “Exchange Act”) and the rules promulgated thereunder. If we cannotdo so, investors will sell our shares and industry analysts will either makeincorrect recommendations about our company or else end coverage of our companyaltogether, any of

 

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which results could harm ourreputation and adversely impact our share price. 

 

**We are currently engaged in a securitiesclass action lawsuit, which, if it were to result in an unfavorable resolution,could adversely affect our reputation, profitability and share price.**

** **

We are 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 complexgovernment regulations, our product sales will suffer.**

** **

We and our customers are subject to varying degrees of federal, stateand local as well as foreign governmental regulation. Our products must complywith various regulations and standards defined by the Federal CommunicationsCommission, or FCC. The FCC has issued regulations that set installation andequipment standards for communications systems. Our products are also requiredto meet certain safety requirements. For example, Underwriters Laboratoriesmust certify certain of our products in order to meet federal safetyrequirements relating to electrical appliances to be used inside the home. Inaddition, certain products must be Network Equipment Building Standardcertified before certain of our customers may deploy them. Any delay in orfailure to obtain these approvals could harm our business, financial conditionor results of operations. Outside of the United States, our products aresubject to the regulatory requirements of each country in which our productsare manufactured or sold. These requirements are likely to vary widely. If wedo not obtain timely domestic or foreign regulatory approvals or certificates,we would not be able to sell our products where these regulations apply, whichcould prevent us from maintaining or growing our revenue or achievingprofitability. 

 

In addition, regulation of our customers may adversely impact ourbusiness, operating results and financial condition. For example, FCCregulatory policies affecting the availability of data and Internet servicesand other terms on which telecommunications companies conduct their businessmay impede our entry into certain markets. In addition, the increasing demandfor communications systems has exerted pressure on regulatory bodies worldwideto adopt new standards, generally following extensive investigation ofcompeting technologies. The delays inherent in this governmental approvalprocess may cause the cancellation, postponement or rescheduling of theinstallation of communications systems by our customers, which in turn may harmour sale of products to these customers. 

 

**If we lose key personnel or are unable tohire additional qualified personnel as necessary, we may not be able to manageour business successfully, which could materially and adversely affect ourgrowth strategy, reputation and share price.**

** **

We depend on the performance of Salvatore D’Auria, our President, ChiefExecutive Officer and Chairman of the Board, and on other senior management andtechnical personnel 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 candidatesand other diversification strategies.**

** **

We have completed a number of acquisitions as part of our efforts toexpand and diversify our business. For example, we acquired our video contentprocessing and video transmission businesses from Tektronix inNovember 2002 when we purchased its subsidiary, VTC. We intend to continueto evaluate new acquisition candidates, divestiture and diversificationstrategies, and if we fail to manage the integration of acquired companies, itcould adversely affect our operations and growth strategy. Any acquisitioninvolves numerous risks, including difficulties in the assimilation of theacquired company’s employees, operations and products, uncertainties associatedwith operating in new markets and working with new customers, and the potentialloss of the acquired company’s key employees. Additionally, we may incurunanticipated expenses, difficulties and other adverse consequences relating tothe integration of technologies, research and development, and administrativeand other functions. Any future acquisitions may also result in potentiallydilutive issuances of our equity securities, acquisition or divestiture relatedwrite-offs and the assumption of debt and contingent liabilities. Any of theabove factors could adversely affect our revenue, profitability, operations orgrowth strategy. 

 

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

** **

The market price and trading volume of our common stock has beensubject to significant volatility, and this trend may

 

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continue. In particular,trading volume historically has been low and the market price of our commonstock has increased dramatically in recent months. Since the announcement ofour acquisition of VTC, the closing price of our common stock, as traded on theNasdaq National Market, has fluctuated from a low of $1.22 to a high of $7.49per share. The value of our common stock may decline regardless of ouroperating performance or prospects. Factors affecting our market price include:

 

•                                          ourperceived prospects; 

 

•                                          variationsin our operating results and whether we have achieved our key business targets;

 

•                                          thelimited number of shares of our common stock available for purchase or sale inthe public markets; 

 

•                                          differencesbetween our reported results and those expected by investors and securitiesanalysts; 

 

•                                          announcementsof new contracts, products or technological innovations by us or ourcompetitors; and 

 

•                                          marketreaction to any acquisitions, joint ventures or strategic investments announcedby us or our competitors. 

 

Recent events have caused stock prices for many companies, includingours, to fluctuate in ways unrelated or disproportionate to their operatingperformance. The general economic, political and stock market conditions thatmay affect the market price of our common stock are beyond our control. The marketprice of our common stock at any particular time may not remain the marketprice in the future. In the past, securities class action litigation has beeninstituted against companies following periods of volatility in the marketprice of their securities. Any such litigation, if instituted against us, couldresult in substantial costs and a diversion of management’s attention andresources. 

 

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

** **

Substantially all of our common stock may be sold without restrictionin the public markets, subject only in the case of shares held by our officersand directors and affiliates to volume and manner of sale restrictions (otherthan as described in the following sentence). The approximately3.3 million shares of common stock that we issued to Tektronix inconnection with our November 2002 acquisition of VTC are restrictedsecurities, as that term is defined in Rule 144 under the Securities Act,and therefore subject to certain restrictions. However, we are contractuallyobligated to file and keep effective a registration statement in order to allowTektronix to sell these shares to the public. Likewise, Tektronix has the right(subject to certain exceptions) to include these shares in certain registrationstatements pursuant to which we may sell shares of our common stock. 

 

Sales of a substantial number of shares of common stock in the publicmarket, or the perception that these sales could occur could materially andadversely affect our stock price and make it more difficult for us to sellequity securities in the future at a time and price we deem appropriate. 

 

**Our charter, bylaws, retention and change ofcontrol plans and Delaware law contain provisions that could delay or prevent achange in control.**

** **

Certain provisions of our charter and bylaws and our retention andchange of control plans, the “Plans,” may have the effect of making it moredifficult for a third-party to acquire, or of discouraging a third-party fromattempting to acquire, control of us. The provisions of the charter and bylawsand the Plans could limit the price that certain investors may be willing topay in the future for shares of our common stock. Our charter and bylawsprovide for a classified board of directors, eliminate cumulative voting in theelection of directors, restrict our stockholders from acting by written consentand calling special meetings, and provide for procedures for advancenotification of stockholder nominations and proposals. In addition, our Boardhas the authority to issue up to 5,000,000 shares of preferred stock and todetermine the price, rights, preferences, privileges and restrictions,including voting rights, of those shares without any further vote or action bythe stockholders. The issuance of preferred stock, while providing flexibilityin connection with possible financings or acquisitions or other corporatepurposes, could have the effect of making it more difficult for a third-partyto acquire a majority of our outstanding voting stock. The Plans provide forseverance payments and accelerated stock option vesting in the event oftermination of employment following a change of control. The provisions of thecharter and bylaws, and the Plans, as well as Section 203 of the DelawareGeneral Corporation Law, to which we are subject, could discourage potentialacquisition proposals, delay or prevent a change of control and prevent changesin 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 June 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)                                  OurChief Executive Officer and Chief Financial Officer carried out an evaluationof the effectiveness of our disclosure controls and procedures (as defined inRule 13a-15(e) under the Exchange Act) as of June 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 June 30, 2004, our ChiefExecutive Officer and Chief Financial Officer have concluded that ourdisclosure control and procedures are effective.

 

In January 2004 in connection with the completion of its audit ofour financial 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 identified relatedto inventory controls and the accounts payable process for the Company’sVideotele.com business, which the Company acquired in November 2002.Specifically: 

 

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

 

2.                                       Our accountspayable process failed to adequately reconcile our accounts payable recordswith suppliers’ records, considering what the suppliers had shipped to us priorto period end. 

 

While these material weaknesses had an immaterial effect on ourreported results, they nevertheless constituted deficiencies in our disclosurecontrols. In light of these material weaknesses and the requirements enacted bythe Sarbanes-Oxley Act of 2002 and the related rules and regulations adopted bythe SEC, our Chief Executive Officer and Chief Financial Officer concludedthat, as of December 31, 2003, our disclosure controls and proceduresneeded improvement and were not effective. Despite those deficiencies in ourdisclosure controls, management believed that as of December 31, 2003, therewere no material inaccuracies, or omissions of material facts necessary to makethe statements not misleading in light of the circumstances under which theywere made.

 

At the 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 timeperiods specified by the SEC. Likewise, we had in place internal controls thatour CEO and CFO believed at the time of the VTC acquisition to be sufficient to“provide reasonable assurance regarding the reliability of financial reportingand preparation of financial statements for external purposes in accordancewith generally accepted accounting principles.” 

 

Since December 31, 2002, we have continued to review ourdisclosure controls and procedures and internal controls periodically inconnection with our Form 10-Q filings. Throughout 2003, our CEO and CFOhave continued to believe that our disclosure controls and procedures andinternal controls have allowed us to provide all material and necessarydisclosure in a timely manner, as required by the Exchange Act and theapplicable rules thereunder. 

 

In January 2004, during the audit of our financial statements forthe fiscal year ended December 31, 2003, PricewaterhouseCoopers LLPdiscovered the material weaknesses noted above and brought these weaknesses toour attention. Based on discussions with PricewaterhouseCoopers LLP and theaudit committee of our Board of Directors, we worked throughout our year-end2003 accounting close and audit to identify the nature, scope and materialityof these weaknesses in our internal controls and their impact on our fiscalyear 2003 financial statements and to determine the extent to which theseinternal control weaknesses might adversely affect our disclosure controls andprocedures. Based on further detailed review of our internal controls as theyrelate to inventory and accounts payable during the fourth quarter of fiscal2003, we determined that the accounts payable process had failed to recordcertain liabilities

 

30

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associated with VTC productsthat we purchased, principally from our contract manufacturer and certain othersuppliers. We quantified this internal control weakness relating to accountspayable recordation by reconciling our records to that of our contractmanufacturer and reviewing our liabilities with other vendors. We quantifiedthe inventory process control weakness by taking complete physical inventoriesat each VTC inventory location and reconciling the results to our records. Uponcompletion of our analysis and testing, we identified an additional charge ofapproximately $34,000 to cost of goods sold related to the internal controlweaknesses identified above. We recorded this charge prior to issuing ourfinancial statements for the year ended December 31, 2003. In addition toour review of the financial statements for the fiscal year endedDecember 31, 2003, we re-confirmed that our accounts payable recordationand inventory controls were effective for the year ended December 31,2002. 

 

During our review of these internal controls weaknesses, we identifiedthe cause of these internal control weaknesses to be the result of prior VTCaccounting staff turnover that occurred during the first quarter of 2003.During this quarter, key accounting staff of VTC left the company withoutsufficient time to transition all of the internal controls and institutionalknowledge to our remaining finance and accounting staff. 

 

In addition to identifying the above two internal control weaknessesrelating to inventory and the accounts payable process, we also tested ourother internal controls to determine whether there were other such materialweaknesses aside from the inventory and accounts payable weaknesses mentionedabove that affected our financial statements for the fiscal year endedDecember 31, 2003. In particular, we tested our other internal controls byreviewing processes, analytical reviews and substantive testing that includedother third-party confirmations and by reviewing activity subsequent toyear-end 2003. Based on these tests, we did not identify any other materialweaknesses in internal controls. Therefore, our CEO and CFO believed at thetime of the original filing of the Form 10-K on February 2, 2004 thatthey had reasonable grounds to conclude that the weaknesses in internalcontrols related solely to those items mentioned above and resulted in animmaterial charge of approximately $34,000. 

 

Based on their review of our internal controls as described above, ourCEO and CFO also assessed our disclosure controls and procedures for the fiscalyear ended December 31, 2003. Our CEO and CFO believed at the time of theoriginal filing of the Form 10-K that they had reasonable grounds toconclude 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 to ensure that we have eliminated the two weaknesses in ourinternal controls for purposes of future reporting, we have undertakensignificant efforts to improve our processes and procedures as they relate toinventory reporting and accounts payable reconciliation. The audit committee istaking an active role in these efforts, including overseeing management’simplementation of corrective measures. With respect to inventory management, wehave performed 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 our key accountspayable balances with our vendors and reconciled the confirmations to ouraccounting records on a quarterly basis in 2004.

 

Management believes that the controls and procedures identified abovehave and will address the conditions identified by PricewaterhouseCoopers LLPas material weaknesses. These changes will become permanent elements of ourinternal controls. 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. 

 

31

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**PART II****. OTHER INFORMATION**

 

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

 

***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 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 stipulationof settlement for the claims against the issuer-defendants, including theCompany, has been 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, we believe that our insurance will likely cover some or all of our shareof any payments towards satisfying plaintiffs’ $1 billion recoverydeficit. Management estimates that its range of loss relative to this matter iszero to $3.5 million. Presently there is no more likely point estimate ofloss within this range. As a consequence of the uncertainties described aboveregarding the amount we will ultimately be required to pay, if any, as of June30, 2004, we have not accrued a liability for this matter. 

 

***In re TutSystems, Inc. Securities Litigation*, Civil ActionNo. C-01-2659-JCS (the “Securities Litigation Action”).**

** **

Beginning July 12, 2001, nine putative stockholder class actionlawsuits were filed in the United States District Court for the NorthernDistrict of California against us and certain of our current and formerofficers and directors. The complaints were filed on behalf of a purportedclass of investors who purchased our stock during the period between July 20,2000 and January 31, 2001, seeking unspecified damages. The complaintsallege that we and certain of our current and former officers and directorsmade false and misleading statements about our business during the putativeclass period. Specifically, the complaints allege violations of Section 10(b)and 20(a) of the Securities Exchange Act of 1934, as amended. The complaintswere consolidated under the name *In re TutSystems, 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, our insurance carriers agreed to pay $10 million, on our behalf, tosettle the suit. The settlement

 

32

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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.The settlement became final on June 15, 2004, the date when the appeals periodended. 

 

**ITEM 2.**     ***CHANGES IN******SECURITIES, USE OF PROCEEDS******AND ISSUERPURCHASES OF EQUITY SECURITIES***

* *

None

 

**ITEM 3.**     ***DEFAULTS UPON******SENIORSECURITIES***

 

None

 

## ***ITEM 4.***     SUBMISSION OFMATTERS TO A VOTE OF SECURITY HOLDERS 

## *** ***

The Company’s Annual Meeting of Shareholders was held on May 19, 2004(the “Annual Meeting”).  At the AnnualMeeting, stockholders voted on two matters: (i) the election of two Class III directors for a term of three yearsexpiring in 2007, and (ii) the ratification of the appointment ofPricewaterhouseCoopers LLP as the Company’s registered public accountingfirm.  The stockholders electedmanagement’s nominees as the Class III directors in an uncontested election andratified the appointment of the registered public accounting firm by thefollowing votes, respectively:

 

(i)                                     Electionof the Class III directors for a terms expiring in 2007:

 
| ** **             | ** ** | **Votes For** | ** ** | **Votes Against** | ** ** | **Votes Abstained** | ** ** | **Broker Non Votes** | ** ** |
|------------------------|------------|---------------|------------|-------------------|------------|---------------------|------------|----------------------|------------|
| Salvatore D’Auria |       | 15,730,298    |       | 217,478           |       |                |       |                 |       |
| Roger Moore            |       | 15,730,298    |       | 217,478           |       |                |       |                 |       |

 

The Company’s Board of Directors is currently comprised of five memberswho are divided into three classes with overlapping three year terms.

 

(ii)                                  Ratificationof appointment of PricewaterhouseCoopers LLP as independent auditors:

 
| **Votes For** | ** ** | **Votes Against** | ** ** | **Votes Abstained** | ** ** | **Broker Non Votes** | ** ** |
|---------------|------------|-------------------|------------|---------------------|------------|----------------------|------------|
| 15,884,123    |       | 62,281            |       | 1,372               |       |                 |       |

 

33

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## ***ITEM 5.***     OTHERINFORMATION

## *** ***

None

 

**ITEM 6.****     *EXHIBITS ANDREPORTS 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.(1) |
|                |       |            |   |
| 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) |
|                |       |            |   |
| 10.7                |       |            | Agreement and General Release between the Company and And Yet, Inc.  dated July 31, 1998.(1) |
|                |       |            |   |
| 10.8                |       |            | Home Phoneline Promoters Agreement by and between the Company and IBM  Corporation, Hewlett-Packard Company, Compaq Computer Corporation, Advanced  Micro Devices, Inc., Intel Corporation, Epigram, Inc., AT&T Wireless  Services Inc., 3Com Corporation, Rockwell Semiconductor Systems, Inc. and  Lucent Technologies Inc. dated June 1, 1998.(1) |
|                |       |            |   |
| 10.9                |       |            | Master Agreement between the Company and Compaq Computer Corporation  dated April 21, 1998 including supplements thereto.(1) |
|                |       |            |   |
| 10.10               |       |            | Extension Agreement among the Company, And Yet, Inc. and Marty Graham  dated December 21, 1998.(1) |
|                |       |            |   |
| 10.11               |       |            | Commercial Office Lease between Las Positas LLC and the Company,  dated March 8, 2000.(4) |
|                |       |            |   |
| 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) |

 

34

----

 
| **Exhibit  Number** | ** ** | **Description** |
|---------------------|------------|-----------------|
|                |       |            |
| 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. |

 

----

(1)                                  Incorporated byreference to our Registration Statement on Form S-1 (File No. 333-60419)as declared effective by the Securities and Exchange Commission onJanuary 28, 1999. 

 

(2)                                  Incorporated byreference to our Quarterly Report on Form 10-Q for the quarter endedMarch 31, 1999. 

 

(3)                                  Incorporated byreference to our Annual Report on Form 10-K for the year endedDecember 31, 1999. 

 

(4)                                  Incorporated byreference to our Registration Statement on Form S-1 (File No. 333-31446)as declared effective by the Securities and Exchange Commission onMarch 23, 2000. 

 

(5)                                  Incorporated byreference to our Current Report on Form 8-K dated May 26, 2000 as filedJune 9, 2000. 

 

(6)                                  Incorporated byreference to our Quarterly Report on Form 10-Q for the quarter endedJune 30, 2000. 

 

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

 

(8)                                  Incorporated byreference to our Current Report on Form 8-K dated October 29, 2002. 

 

(9)                                  Incorporated byreference to our Annual Report on Form 10-K for the year endedDecember 31, 2002. 

 

(10)                            Incorporated by referenceto our Quarterly Report on Form 10-Q for the quarter ended March 31,2004.

 

*                                         Indicatesmanagement contracts or compensatory plans and arrangements.

 

(b)Reports on Form 8-K. 

 

TheCompany filed the following Current Reports on Forms 8-K during the quarterended June 30, 2004: 

 

OnApril 27, 2004, the Company furnished a Current Report on Form 8-K regardingthe Company’s issuance of a press release announcing its earnings for the firstquarter ended March 31, 2004.

 

35

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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: July  28, 2004 |              |   |

 

36

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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.(1) |
|                |       |            |   |
| 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) |
|                |       |            |   |
| 10.7                |       |            | Agreement and General Release between the Company and And Yet, Inc.  dated July 31, 1998.(1) |
|                |       |            |   |
| 10.8                |       |            | Home Phoneline Promoters Agreement by and between the Company and IBM  Corporation, Hewlett-Packard Company, Compaq Computer Corporation, Advanced  Micro Devices, Inc., Intel Corporation, Epigram, Inc., AT&T Wireless  Services Inc., 3Com Corporation, Rockwell Semiconductor Systems, Inc. and  Lucent Technologies Inc. dated June 1, 1998.(1) |
|                |       |            |   |
| 10.9                |       |            | Master Agreement between the Company and Compaq Computer Corporation  dated April 21, 1998 including supplements thereto.(1) |
|                |       |            |   |
| 10.10               |       |            | Extension Agreement among the Company, And Yet, Inc. and Marty Graham  dated December 21, 1998.(1) |
|                |       |            |   |
| 10.11               |       |            | Commercial Office Lease between Las Positas LLC and the Company,  dated March 8, 2000.(4) |
|                |       |            |   |
| 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) |

 

37

----

 
| **Exhibit  Number** | ** ** | **Description** |
|---------------------|------------|-----------------|
|                |       |            |
| 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. |

 

----

(1)                                  Incorporated byreference to our Registration Statement on Form S-1 (File No. 333-60419)as declared effective by the Securities and Exchange Commission onJanuary 28, 1999. 

 

(2)                                  Incorporated byreference to our Quarterly Report on Form 10-Q for the quarter endedMarch 31, 1999. 

 

(3)                                  Incorporated byreference to our Annual Report on Form 10-K for the year endedDecember 31, 1999. 

 

(4)                                  Incorporated byreference to our Registration Statement on Form S-1 (File No. 333-31446)as declared effective by the Securities and Exchange Commission onMarch 23, 2000. 

 

(5)                                  Incorporated byreference to our Current Report on Form 8-K dated May 26, 2000 as filedJune 9, 2000. 

 

(6)                                  Incorporated byreference to our Quarterly Report on Form 10-Q for the quarter endedJune 30, 2000. 

 

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

 

(8)                                  Incorporated byreference to our Current Report on Form 8-K dated October 29, 2002. 

 

(9)                                  Incorporated byreference to our Annual Report on Form 10-K for the year endedDecember 31, 2002. 

 

(10)                            Incorporated by referenceto our Quarterly Report on Form 10-Q for the quarter ended March 31,2004.

 

*                                         Indicatesmanagement contracts or compensatory plans and arrangements.

 

38

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