** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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**FORM 10-Q**

 
| **ý** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|------------|-----------------------------------------------------------------------------------------------|

 

**For the quarterly period ended March31, 2004**

 

**Commission File Number: 000-25291**

 

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**TUT SYSTEMS, INC.**

(Exact name of registrant as specified in itscharter)

 
| **Delaware**                                                                  |   | **94-2958543**                      |
|-------------------------------------------------------------------------------|--------|-------------------------------------|
| (State or other  jurisdiction ofincorporation or organization)                |   | (I.R.S. EmployerIdentification 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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Indicate by check mark whether the registrant: (1) hasfiled all reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.  Yes  ý  No  o

 

Indicate by check mark whether the registrant is anaccelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes  ý  No  o

 

As of April 30, 2004, 20,375,838 shares of theRegistrant’s common stock, par value $0.001 per share, were issued andoutstanding.

 

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**TUT SYSTEMS, INC.**

 

**FORM 10-Q**

 

**INDEX**

 
| **PART I.**       | **FINANCIAL INFORMATION**                                                                                            |   |
|-------------------|----------------------------------------------------------------------------------------------------------------------|--------|
|              |                                                                                                                 |   |
| Item 1.           | Condensed  Consolidated Financial Statements (unaudited):                                                            |   |
|              |                                                                                                                 |   |
|              | Condensed  Consolidated Balance Sheets as of December 31, 2003 and March 31, 2004                                    |   |
|              |                                                                                                                 |   |
|              | Condensed  Consolidated Statements of Operations for the three months ended March 31,  2003 and  March 31, 2004 |   |
|              |                                                                                                                 |   |
|              | Condensed  Consolidated Statements of Cash Flows for the three months ended March 31,  2003 and March 31, 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 shareamounts)**

 
|                                                                                                                                        |   | **December  31,  2003** |   | **March  31,  2004** |   |
|---------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|--------|----------------------|--------|
|                                                                                                                                        |   |                    |   | **(unaudited)**      |   |
| **ASSETS**                                                                                                                                  |   |                    |   |                 |   |
| Current assets:                                                                                                                             |   |                    |   |                 |   |
| Cash and cash equivalents                                                                                                                   |   | $                       | 14,370 |                 | $      | 12,270 |   |
| Accounts receivable, net of allowance for  doubtful accounts of $47 and $45 in 2003 and 2004, respectively                                  |   | 7,062                   |   | 6,083                |   |
| Insurance settlement receivable                                                                                                             |   | 10,725                  |   | 10,000               |   |
| Inventories, net                                                                                                                            |   | 4,181                   |   | 3,972                |   |
| Prepaid expenses and other                                                                                                                  |   | 1,026                   |   | 1,627                |   |
| Total current assets                                                                                                                        |   | 37,364                  |   | 33,952               |   |
| Property and equipment, net                                                                                                                 |   | 1,722                   |   | 2,078                |   |
| Intangibles and other assets                                                                                                                |   | 3,685                   |   | 3,103                |   |
| Total assets                                                                                                                                |   | $                       | 42,771 |                 | $      | 39,133 |   |
|                                                                                                                                        |   |                    |   |                 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                               |   |                    |   |                 |   |
| Current liabilities:                                                                                                                        |   |                    |   |                 |   |
| Accounts payable                                                                                                                            |   | $                       | 3,055  |                 | $      | 3,732 |   |
| Accrued liabilities                                                                                                                         |   | 1,516                   |   | 2,097                |   |
| Legal settlement liability                                                                                                                  |   | 10,725                  |   | 10,000               |   |
| Deferred revenue                                                                                                                            |   | 253                     |   | 368                  |   |
| Total current liabilities                                                                                                                   |   | 15,549                  |   | 16,197               |   |
| Note payable                                                                                                                                |   | 3,523                   |   | 3,603                |   |
| Other liabilities                                                                                                                           |   | 44                      |   | 31                   |   |
| Total liabilities                                                                                                                           |   | 19,116                  |   | 19,831               |   |
| 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 20,329 shares issued and outstanding in 2003  and 2004, respectively |   | 20                      |   | 20                   |   |
| Additional paid-in capital                                                                                                                  |   | 305,777                 |   | 305,865              |   |
| Accumulated other comprehensive loss                                                                                                        |   | (89                     | )      | (80                  | )      |
| Accumulated deficit                                                                                                                         |   | (282,053                | )      | (286,503             | )      |
| Total stockholders’ equity                                                                                                             |   | 23,655                  |   | 19,302               |   |
| Total liabilities and stockholders’ equity                                                                                             |   | $                       | 42,771 |                 | $      | 39,133 |   |

 

*The accompanying notes are anintegral part of these condensed consolidated financial statements.*

 

3

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**TUT SYSTEMS, INC.**

 

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS**

**(in thousands, except per shareamounts)**

**(unaudited)**

 
|                                                                     |   | **Three Months Ended********March 31,** |   |
|--------------------------------------------------------------------------|--------|-----------------------------------------|--------|
|                                                                     |   | **2003**                                |   | **2004** |   |
| Revenues:                                                                |   |                                    |   |   |   |
| Product                                                                  |   | $                                       | 6,401  |   | $ | 6,159 |   |
| License and royalty                                                      |   | 200                                     |   | 18 |   |
| Total revenues                                                           |   | 6,601                                   |   | 6,177 |   |
| Cost of goods sold:                                                      |   | 3,259                                   |   | 5,129 |   |
| Gross profit                                                             |   | 3,342                                   |   | 1,048 |   |
| Operating expenses:                                                      |   |                                    |   |   |   |
| Sales and marketing                                                      |   | 1,927                                   |   | 1,905 |   |
| Research and development                                                 |   | 2,086                                   |   | 1,822 |   |
| General and administrative                                               |   | 1,202                                   |   | 1,117 |   |
| Impairment of intangible assets                                          |   | 3⁄4                                  |   | 202 |   |
| Amortization of intangible assets                                        |   | 459                                     |   | 396 |   |
| Total operating expenses                                                 |   | 5,674                                   |   | 5,442 |   |
| Loss from operations                                                     |   | (2,332                                  | )      | (4,394 | ) |
| Interest and other income (expense), net                                 |   | 101                                     |   | (56 | ) |
| Net loss                                                                 |   | $                                       | (2,231 | ) | $ | (4,450 | ) |
| Net loss per share, basic and diluted (Note 3)                           |   | $                                       | (0.11  | ) | $ | (0.22 | ) |
| Shares used in computing net loss per share, basic and diluted (Note  3) |   | 19,801                                  |   | 20,297 |   |

 

*The accompanying notes are an integralpart of these condensed consolidated financial statements.*

 

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**TUT SYSTEMS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFCASH FLOWS**

**(in thousands)**

**(unaudited)**

 
|                                                                         |   | **Three Months Ended********March 31,** |   |
|------------------------------------------------------------------------------|--------|-----------------------------------------|--------|
|                                                                         |   | **2003**                                |   | **2004** |   |
| Cash flows from operating activities:                                        |   |                                    |   |   |   |
| Net loss                                                                     |   | $                                       | (2,231 | ) | $ | (4,450 | ) |
| Adjustments to reconcile net loss to net cash used in operating  activities: |   |                                    |   |   |   |
| Depreciation                                                                 |   | 235                                     |   | 328 |   |
| Noncash interest income                                                      |   | 10                                      |   | — |   |
| Provision for (recovery of) doubtful accounts                                |   | (15                                     | )      | 13 |   |
| Provision for excess and obsolete inventory and abandoned products           |   | —                                  |   | 974 |   |
| Impairment of intangible assets                                              |   | —                                  |   | 202 |   |
| Amortization of intangible assets                                            |   | 459                                     |   | 396 |   |
| Deferred interest on note payable                                            |   | 64                                      |   | 80 |   |
| Change in operating assets and liabilities:                                  |   |                                    |   |   |   |
| Accounts receivable                                                          |   | (185                                    | )      | 966 |   |
| Inventories                                                                  |   | 48                                      |   | (765 | ) |
| Prepaid expenses and other assets                                            |   | (467                                    | )      | (608 | ) |
| Accounts payable and accrued liabilities                                     |   | (2,044                                  | )      | 1,245 |   |
| Deferred revenue                                                             |   | (229                                    | )      | 115 |   |
| Net cash used in operating activities                                        |   | (4,355                                  | )      | (1,504 | ) |
| Cash flows from investing activities:                                        |   |                                    |   |   |   |
| Purchase of property and equipment                                           |   | (267                                    | )      | (684 | ) |
| Net cash used in investing activities                                        |   | (267                                    | )      | (684 | ) |
| Cash flows from financing activities:                                        |   |                                    |   |   |   |
| Proceeds from issuances of common stock, net                                 |   | 11                                      |   | 88 |   |
| Net cash provided by financing activities                                    |   | 11                                      |   | 88 |   |
| Net decrease in cash and cash equivalents                                    |   | (4,611                                  | )      | (2,100 | ) |
| Cash and cash equivalents, beginning of period                               |   | 25,571                                  |   | 14,370 |   |
| Cash and cash equivalents, end of period                                     |   | $                                       | 20,960 |   | $ | 12,270 |   |

* *

*The accompanying notes are anintegral part of these condensed consolidated financial statements.*

 

5

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**TUT SYSTEMS, INC.**

 

**NOTES TO UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

**(in thousands, except per shareamounts)**

 

**NOTE 1—DESCRIPTION OF BUSINESS:**

 

The Company designs, develops,and sells digital video processing systems that enable telephony-based serviceproviders to deliver broadcast quality digital video signals over theirnetworks. The Company also offers video processing systems that enable privateenterprise and government entities to transport video signals over satellite,fiber, radio, or copper networks for surveillance, distance learning, and TVproduction applications. The Company also designs, develops and marketsbroadband transport and service management products that enable theprovisioning of high speed Internet access and other broadband data servicesover existing copper networks within hotels and private campus facilities.

 

Historically, the Company derived most of its sales from its broadbandtransport and service management products. In November 2002, the Companyacquired VideoTele.com, or VTC, from Tektronix, Inc. to extend its productofferings to include digital video processing systems. 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 three months ended March 31,2004, the Company incurred a net loss of $4,450 and negative cash flows fromoperating activities of $1,504, and has an accumulated deficit of $286,503 atMarch 31, 2004. Management believes that the cash and cash equivalents asof March 31, 2004 are sufficient to fund its operating activities andcapital expenditure needs for the next twelve months.  However, in the event that general economic conditions worsen,the Company may require additional cash to fund its operations. The Companyplans to seek additional equity funding to provide working capital, fundpotential acquisitions and potentially redeem the VTC acquisitionindebtedness.  The Company cannot assurethat such funding efforts will be successful. Failure to generate positive cashflow in the future could have a material impact on the Company’s ability toachieve its intended business objectives.

 

**NOTE 2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:**

 

**Basis of presentation**

 

The accompanying condensed consolidated financialstatements as of March 31, 2004 and December 31, 2003 and for the three monthsended March 31, 2003 and 2004 are unaudited. The unaudited interim condensedconsolidated financial statements have been prepared on the same basis as theannual financial statements and, in the opinion of management, reflect alladjustments, which include only normal recurring adjustments, necessary topresent fairly the Company’s financial position as of December 31, 2003 andMarch 31, 2004, its results of operations for the three months ended March 31,2003 and 2004 and its cash flows for the three months ended March 31, 2003 and2004. These condensed consolidated financial statements and the accompanyingnotes are unaudited and should be read in conjunction with the Company’saudited financial statements included in the Company’s Annual Report on Form10-K/A, filed with the Securities and Exchange Commission on April 7, 2004. Thebalance sheet as of December 31, 2003 was derived from audited financialstatements but does not include all disclosures required by generally acceptedaccounting principles. The results for the three months ended March 31, 2004are not necessarily indicative of the expected results for any other interimperiod or the year ending December 31, 2004.

 

**Revenue recognition**

 

The Company generates revenue primarily from the sale of hardwareproducts, including third-party products, through professional services, andthrough the sale of its software products. The Company sells products throughdirect sales channels and through distributors. Generally, product revenue is

 

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generated from the sale of video processing systems and components andthe sale of broadband transport and service management products. Turnkeysolution revenue is principally generated by the sale of complete end-to-endvideo processing systems that are designed, developed and produced according toa buyer’s specifications.

 

*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.

 

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 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 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 PCS element, for which theCompany has established vendor specific objective evidence of fair value (asdefined 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 of the arrangement prior to the time of delivery to the customersite, with an additional approximately 9% of the contract value billed uponsubstantial completion of the project and the balance upon customer acceptance.The contractual arrangements relative to turnkey solutions include customeracceptance provisions. However, such provisions are generally considered to beincidental to the arrangement in its entirety because customers are fullyobligated with respect to approximately 99% of the contract value irrespectiveof whether acceptance occurs or not.

 

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

 

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

 

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 and royalty revenue consists of non-refundable up-front licensefees, some of which may offset initial royalty payments, and royalties receivedby the Company for products sold by its licensees. Currently, the majority ofthe Company’s license and royalty revenue is comprised of non-refundablelicense fees paid in advance. Such revenue is recognized ratably over theperiod during which post-contract customer support is expected to be providedor upon delivery and transfer of agreed upon technical specifications incontracts where essentially no further support obligations exist. Futurelicense and royalty revenue is expected to consist primarily of royaltiesreceived by the Company for products sold by its licensees.

 

Should changes in conditions cause us to determine that the criteriafor revenue recognition are not met for certain future transactions, revenuerecognition for any reporting period could be adversely affected.

 

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** **

**Inventories**

 

Inventories are stated at the lower of cost or market. Cost is computedusing standard cost which approximates actual cost on a first-in, first-outbasis. The Company records provisions to write down its inventory and relatedpurchase commitments for estimated obsolescence or unmarketable inventory equalto the difference between the cost of the inventory and the estimated marketvalue based upon assumptions about the future demand and market conditions. Ifactual future demand or market conditions are less favorable than thoseestimated by the Company, additional inventory provisions may be required.

 

**Allowance for doubtful accounts**

 

The Company maintains an allowance for doubtfulaccounts for estimated losses resulting from the inability of its customers tomake payments. These estimated allowances are periodically reviewed and takeinto account customers’ payment history and information regarding customers’creditworthiness that is known to the Company. If the financial condition of anyof its customers were to deteriorate, resulting in their inability to makepayments, an additional allowance would be required.

 

**Accounting for 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 three months ended March 31, 2004, theCompany determined that certain of the technology acquired as part of thepurchase of the Viagate Technologies, Inc. assets in September 2001 had becomeimpaired. As a result, the Company incurred a loss of $202 to write-off thetechnology.

 

Future events could cause the Company to conclude thatimpairment indicators exist. Any resulting impairment loss could have amaterial adverse impact on the Company’s financial condition and results ofoperations.

 

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** **

**Accounting for stock based compensation**

 

The Company accounts for stock-based employeecompensation arrangements in accordance with the provisions of AccountingPrinciples Board Opinion No. 25 (“APB No. 25”), “Accounting for Stock Issued toEmployees,” Financial Accounting Standard Board Interpretation No. 44 (“FIN44”), “Accounting for Certain Transactions Involving Stock Compensation—anInterpretation of APB 25,” and complies with the disclosure provisions ofStatement of Financial Accounting Standard No. 148 (“SFAS No. 148”),“Accounting for Stock-Based Compensation, Transition and Disclosure.” Under APBNo. 25, compensation expense is based on the difference, if any, on the date ofthe grant, between the fair market value of the Company’s stock and theexercise price. The Company accounts for stock issued to non-employees inaccordance with the provisions of SFAS No. 148 and the Emerging Issues TaskForce (“EITF”) Issue No. 96-18, “Accounting for Equity Instruments that areIssued to other than Employees for Acquiring, or in Conjunction with SellingGoods or Services.”

 

The Company amortizes stock-based compensation usingthe straight-line method over the remaining vesting periods of the relatedoptions, which is generally four years. Pro forma information regarding netloss and earnings per share is presented and has been determined as if theCompany had accounted for employee stock options under the fair value method ofSFAS No. 123, as amended by SFAS No. 148.

 

The following table illustrates the effect on net lossand earnings per share if the Company had applied the fair value recognitionprovisions of SFAS No. 123, as amended by SFAS No. 148, to stock-based employeecompensation:

 
|                                                                                                                                   |   | **Three Months Ended********March 31,** |   |
|----------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------|--------|
|                                                                                                                                   |   | **2003**                                |   | **2004** |   |
| Net loss – as reported                                                                                                            |   | $                                       | (2,231 | ) | $ | (4,450 | ) |
| Total stock-based employee compensation expense determined under a  fair value based method for all grants, net of related tax effects |   | (1,067                                  | )      | (812 | ) |
| Net loss – pro forma                                                                                                              |   | $                                       | (3,298 | ) | $ | (5,262 | ) |
| Basic and diluted net loss per share – as reported                                                                                |   | $                                       | (0.11  | ) | $ | (0.22 | ) |
| Basic and diluted net loss per share – pro forma                                                                                  |   | $                                       | (0.17  | ) | $ | (0.26 | ) |

 

The fair value of options and shares issued pursuantto the option plans and at the grant date were estimated using theBlack-Scholes model. The Black-Scholes option-pricing model was developed foruse in estimating the fair value of traded options that have no vestingrestrictions and are fully transferable. Option-pricing models require theinput of highly subjective assumptions including the expected stock pricevolatility. The Company uses projected volatility rates, which are based uponhistorical volatility rates trended into future years. Because employee stockoptions have characteristics significantly different from those of tradedoptions, and because changes in the subjective input assumptions can materiallyaffect the

 

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fairvalue estimate, in management’s opinion, the existing models do not necessarilyprovide a reliable single measure of the fair value of options.

 

The effects of applying pro forma disclosures of netloss and net loss per share are not likely to be representative of the proforma effects on net loss/income and net loss/earnings per share in the futureyears, as the number of future shares to be issued under these plans is notknown and the assumptions used to determine the fair value can varysignificantly.

 

**Recent accounting 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 period endedMarch 31, 2004 did not have a material impact on the Company’s results ofoperations, financial position or cash flows.

 

**Reclassifications**

 

Certain reclassifications have been made to priorperiod balances in order to conform to the current period presentation.

 

**NOTE 3—NET LOSS PER SHARE:**

 

Basic and diluted netloss per 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.

 

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The calculation of netloss per share follows:

 
|                                                                     |   | **Three Months Ended  March 31,** |   |
|--------------------------------------------------------------------------|--------|-----------------------------------|--------|
|                                                                     |   | **2003**                          |   | **2004** |   |
| Net loss per share, basic and diluted:                                   |   |                              |   |   |   |
| Net loss                                                                 |   | $                                 | (2,231 | ) | $ | (4,450 | ) |
| Net loss per share, basic and diluted                                    |   | $                                 | (0.11  | ) | $ | (0.22 | ) |
| Shares used in computing net loss per share, basic and diluted           |   | 19,801                            |   | 20,297 |   |
| Antidilutive securities not included in net loss per share  calculations |   | 4,096                             |   | 4,446 |   |

** **

**NOTE 4—COMPREHENSIVE LOSS:**

 

Comprehensive lossincludes net loss, unrealized gains and losses on investments, and foreigncurrency translation adjustments that have been previously excluded from netloss and reflected instead in stockholders’ equity. The following table setsforth the calculation of comprehensive loss:

 
|                                     |   | **Three Months Ended********March 31,** |   |
|------------------------------------------|--------|-----------------------------------------|--------|
|                                     |   | **2003**                                |   | **2004** |   |
| Net loss                                 |   | $                                       | (2,231 | ) | $ | (4,450 | ) |
| Unrealized gains on investments          |   | 12                                      |   | 16 |   |
| Foreign currency translation adjustments |   | (5                                      | )      | (7 | ) |
| Net change in other comprehensive loss   |   | 7                                       |   | 9 |   |
| Total comprehensive loss                 |   | $                                       | (2,224 | ) | $ | (4,441 | ) |

 

12

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**NOTE 5—BALANCE SHEET COMPONENTS:**

 
|                                                              |   | **December 31,  2003** |   | **March 31,********2004** |   |
|-------------------------------------------------------------------|--------|------------------------|--------|---------------------------|--------|
| Inventories, net:                                                 |   |                   |   |                      |   |
| Finished goods                                                    |   | $                      | 4,015  |                      | $      | 4,762 |   |
| Raw materials                                                     |   | 391                    |   | 100                       |   |
| Allowance for excess and obsolete inventory and abandoned product |   | (225                   | )      | (890                      | )      |
|                                                              |   | $                      | 4,181  |                      | $      | 3,972 |   |
| Property and equipment:                                           |   |                   |   |                      |   |
| Computers and software                                            |   | $                      | 1,328  |                      | $      | 1,527 |   |
| Test equipment                                                    |   | 2,277                  |   | 2,760                     |   |
| Office equipment                                                  |   | 41                     |   | 41                        |   |
|                                                              |   | 3,646                  |   | 4,328                     |   |
| Less: accumulated depreciation                                    |   | (1,924                 | )      | (2,250                    | )      |
|                                                              |   | $                      | 1,722  |                      | $      | 2,078 |   |
| Accrued liabilities:                                              |   |                   |   |                      |   |
| Professional Services                                             |   | 494                    |   | 947                       |   |
| Compensation                                                      |   | 652                    |   | 800                       |   |
| Other                                                             |   | 370                    |   | 350                       |   |
|                                                              |   | $                      | 1,516  |                      | $      | 2,097 |   |

 

TheCompany recorded a provision for inventory within cost of goods sold totalling$974 in the three months ended March 31, 2004, related to the costs of rawmaterials and finished goods in excess of what the Company reasonably expectedto sell in the foreseeable future as of the first quarter of 2004.  The Company also reduced inventory costs tomarket value.

 

Intangibleand 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 |   |

 

13

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|                             |   | **As  of March 31, 2004**   |   |
|----------------------------------|--------|-----------------------------|--------|
|                             |   | **Gross  Carrying  Amount** |   | **Accumulated  Amortization** |   | **Net  Intangibles** |   |
| Amortized intangible assets:     |   |                        |   |   |   |   |   |
| Completed technology and patents |   | $                           | 7,922  |   | $ | (5,382 | ) | $ | 2,540 |   |
| Contract backlog                 |   | 247                         |   | (247 | ) | — |   |
| Customer list                    |   | 86                          |   | (17 | ) | 69 |   |
| Maintenance contract renewals    |   | 50                          |   | (14 | ) | 36 |   |
| Trademarks                       |   | 315                         |   | (64 | ) | 251 |   |
|                             |   | $                           | 8,620  |   | $ | (5,724 | ) | 2,896 |   |
|                             |   |                        |   |   |   |   |   |
| Other non-current assets         |   |                        |   |   |   | 207 |   |
|                             |   |                        |   |   |   | $ | 3,103 |   |

 

Duringthe three months ended March 31, 2004, the Company determined that certain ofthe technology 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 aggregateamortization expense for the three months ended March 31, 2003 and 2004 was$459 and $396, respectively.

 

Minimum futureamortization expense as of March 31, 2004 is as follows:

 
| Remainder of 2004 |   | $   | 1,129  |   |
|-------------------|--------|-----|--------|--------|
| 2005              |   | 875 |   |
| 2006              |   | 424 |   |
| 2007              |   | 363 |   |
| Thereafter        |   | 105 |   |
|              |   | $   | 2,896  |   |

 

14

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**NOTE 6—COMMITMENTS AND CONTINGENCIES:**

 

*Lease obligations*

 

The Company leasesequipment and office, assembly and warehouse space under non-cancelableoperating leases that expire from 2004 through 2005.

 

Minimum future leasepayments under operating leases as of March 31, 2004 are as follows:

 
| Remainder of 2004 |   | $      | 694    |   |
|-------------------|--------|--------|--------|--------|
| 2005              |   | 266    |   |
| Thereafter        |   | — |   |
|              |   | $      | 960    |   |

 

*Purchase commitments*

 

The Company hadnon-cancelable commitments to purchase finished goods inventory totaling $1,009and $364 in aggregate at December 31, 2003 and March 31, 2004, respectively.

 

*Contingencies*

 

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

*** ***

On October 30, 2001, the Company andcertain of its current and former officers and directors were named asdefendants in *Whalen v. Tut Systems, Inc. etal.*, Case No. 01-CV-9563, a purported securities class actionlawsuit filed in the United States District Court for the Southern District ofNew York. An amended complaint was filed on December 5, 2001. Aconsolidated amended complaint was filed on April 19, 2002. Theconsolidated amended complaint asserts that the prospectuses from the Company’sJanuary 29, 1999 initial public offering and its March 23, 2000secondary offering failed to disclose certain alleged actions by theunderwriters for the offerings. The complaint alleges claims against theCompany and certain of its current and former officers and directors underSection 11 of the Securities Act of 1933, as amended, and underSection 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934,as amended, and alleges claims against certain of its current and formerofficers and directors under Sections 15 and 20(a) of the Securities Act.The complaint also names as defendants the underwriters for the Company’sinitial public offering and secondary offering. Similar suits were filed in theSouthern District of New York challenging over 300 other initial publicofferings and secondary offerings conducted in 1999 and 2000. Therefore, forpretrial 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*. The individual defendants inthe *Whalen* action, namely, NelsonCaldwell, Salvatore D’Auria and Matthew Taylor, were dismissed withoutprejudice by an October 9, 2002 Order of the Court, approving the parties’October 1, 2002 Stipulation of Dismissal. On February 19, 2003, theCourt issued an Opinion and Order denying the Company’s motion to dismiss.

 

In June and July 2003, nearly all of the issuers named as defendants inthe *In Re Initial Public Offering SecuritiesLitigation* (collectively, the “issuer-defendants”), including theCompany, approved a tentative settlement proposal that is reflected in amemorandum of understanding. The Company’s Board of Directors approved thememorandum of understanding in June 2003 on certain conditions, including thenumber of issuers participating in the settlement. The memorandum ofunderstanding is not a legally

 

15

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binding agreement. Further, any final settlement agreement would besubject to a number of conditions, most of which would be outside of theCompany’s control, including approval by the Court. The underwriter-defendantsin the *In Re Initial Public OfferingSecurities Litigation* (collectively, the “underwriter-defendants”),including the underwriters in the *Whalen*suit, are not parties to the memorandum of understanding.

 

The memorandum of understanding provides that, in exchange for arelease of claims against the settling issuer-defendants, the insurers of allof the settling issuer-defendants will provide a surety undertaking toguarantee plaintiffs a $1 billion recovery from the non-settling defendants,including the underwriter-defendants. The ultimate amount, if any, that may bepaid on behalf of the Company will therefore depend on the final terms of thesettlement agreement, including the number of issuer-defendants that ultimatelyapprove the final settlement agreement, and the amounts, if any, recovered bythe plaintiffs from the underwriter-defendants and other non-settlingdefendants. In the event that all or substantially all of the issuer-defendantsapprove the final settlement agreement, the amount that the Company would berequired to pay to the plaintiffs could range from zero to approximately $3.5million, depending on plaintiffs’ recovery from the underwriter-defendants andfrom other non-settling parties. If the plaintiffs recover at least $1 billionfrom the underwriter-defendants, the Company would have no liability forsettlement payments under the proposed terms of the settlement. If theplaintiffs recover less than $1 billion, the Company believes that itsinsurance will likely cover some or all of its share of any payments towardssatisfying plaintiffs’ $1 billion recovery deficit. Management estimatesthat its range of loss relative to this matter is zero to $3.5 million.Presently there is no more likely point estimate of loss within this range. Asa consequence of the uncertainties described above regarding the amount the Companywill ultimately be required to pay, if any, as of March 31, 2004, the Companyhas not accrued a liability for this matter.

 

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

** **

Beginning July 12,2001, nine putative stockholder class action lawsuits were filed in the UnitedStates District Court for the Northern District of California against theCompany and certain of its current and former officers and directors. Thecomplaints were filed on behalf of a purported class of investors who purchasedthe Company’s stock during the period between July 20, 2000 andJanuary 31, 2001, seeking unspecified damages. The complaints allege thatthe Company and certain of its current and former officers and directors madefalse and misleading statements about the Company’s business during theputative class period. Specifically, the complaints allege violations ofSection 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended. Thecomplaints were consolidated under the name *Inre Tut Systems, Inc. Securities Litigation*, Master File No.C-01-2659-CW (the “Securities Litigation Action”). Lead plaintiffs and leadcounsel for plaintiffs were appointed. Plaintiffs filed a consolidated classaction complaint on February 4, 2002. Defendants filed a Motion to Dismisson March 29, 2002. On August 15, 2002, the Court granted in part anddenied in part the Motion to Dismiss. On September 23, 2002, plaintiffsfiled an amended complaint. Defendants filed a Motion to Dismiss the amendedcomplaint, and on August 6, 2003 the Court granted in part that Motion. OnSeptember 24, 2003, defendants answered the remaining allegations of theamended complaint. Defendants reached a settlement of the Securities LitigationAction in December 2003. Subject to preliminary and final approval by theCourt, the Company’s insurance carriers agreed to pay $10 million, on behalf ofthe Company, to settle the suit. The settlement includes a release of alldefendants. The Company has recorded a liability in its financial statementsfor the proposed amount of the settlement. In addition, because the insurancecarriers agreed to pay the entire $10 million settlement amount and, therefore,recovery from the insurance carriers was probable, a receivable was alsorecorded for the same amount. Accordingly, there is no impact to the statementof operations because the amounts of the settlement and the insurance recoveryfully offset each other. The insurance carriers paid the settlement amount to plaintiffs’escrow agent in January 2004. The Court preliminarily approved the settlementon February 24, 2004. The settlement amount will be paid out of escrow ifand when the Court finally approves the settlement. A hearing before the Courtto consider final approval of the terms of

 

16

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settlement is currently scheduled for May 14, 2004. Because thesettlement is subject to Court approval, there is no guarantee the settlementwill become final.

 

***Lefkowitzv. D’Auria, et al***

*** ***

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

 

**NOTE 7—SEGMENT INFORMATION:**

 

The Company currently targets its sales and marketing efforts to bothpublic and private service providers and users across two related markets. TheCompany currently operates in a single business segment as there is only onemeasurement of profitability for its operations. Revenues are attributed to thefollowing countries based on the location of customers:

 

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|                |   | **Three Months Ended********March 31,** |   |
|---------------------|--------|---------------------------------------------------|--------|
|                |   | **2003**                                          |   | **2004** |   |
| United States       |   | $                                                 | 5,731  |   | $ | 5,488 |   |
| International:      |   |                                              |   |   |   |
| Canada              |   | 120                                               |   | 299 |   |
| Ireland             |   | 253                                               |   | 145 |   |
| Japan               |   | 164                                               |   | 123 |   |
| All other countries |   | 333                                               |   | 122 |   |
|                |   | $                                                 | 6,601  |   | $ | 6,177 |   |

 

Two customers, Atlantic Telephone MembershipCorporation and Home Telephone Company accounted for 12% and 11%, respectivelyof the Company’s revenue for the three months ended March 31, 2003.  One customer, Pioneer Long Distance Inc.,accounted for 10% of the Company’s revenue for the three months ended March 31,2004.

 

*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 servicemanagement products enable the transmission of broadband data over existinghotels and private campus networks.

 

Revenue relating to thebroadband transport and service management products was $1,658 and $1,936 forthe three months ended March 31, 2003 and 2004, respectively. Revenue relatedto video processing systems was $4,943 and $4,241 for the three months endedMarch 31, 2003 and 2004, respectively. 

 

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**ITEM 2****.****     ****MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

*The section entitled “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” setforth below contains “forward-looking statements” within the meaning ofSection 27A of the Securities Act of 1933, as amended, andSection 21E of the Securities Exchange Act of 1934, as amended. When usedherein, the words “anticipates,” “believes,” “continue,” “could,” “estimates,”“expects,” “intends,” “may,” “plans,” “seeks,” “should,” “will” or the negativeof these terms or similar expressions are generally intended to identifyforward-looking statements. We have based these forward-looking statements onour current expectations and projections about future events. Suchforward-looking statements are subject to various risks and uncertainties thatcould cause actual results to differ materially from those projected in suchstatements. Readers are cautioned not to place undue reliance on theseforward-looking statements, which speak only as of the date hereof. Theforward-looking statements contained in this quarterly report includestatements about the following: (1) our belief that video products willprovide most of our growth opportunities for the foreseeable future,(2) our belief that the number of telco video subscribers will growsignificantly between 2004 and 2007 and that this market space will continue tobecome more competitive, (3) our expectation that we will compete withlarger public companies as we begin to target larger telco customers,(4) our expectation that digital subscriber line or DSL technology willcontinue to dominate telco broadband networks for the foreseeable future,(5) our belief that new controls and procedures have addressed theconditions identified by our auditors as material weaknesses, (6)  ourexpectation that sales related to VTC products will continue to increase in2004 and sales relating to our broadband transport and service managementproducts will also increase in 2004, but at a lower rate of increase, (7) ourexpectation that capital expenditures for research and development willdecrease in 2004, (8) our expectation that capital expenditures in 2004 will becomparable to 2003 and that these capital expenditures will be funded fromoperations, (9) our belief that our cash and cash equivalents as ofMarch 31, 2004 are sufficient to fund our operating activities and capitalexpenditure needs for the next twelve months, (10) our expectation thatworking capital will begin to increase in future periods, (11) our expectationthat the amount of cash used to fund our operations will decrease in 2004,(12) our expectation that we will seek additional equity funding in thesecond quarter of 2004, (13) our expectation that future license and royaltyrevenue will consist primarily of royalties received by us for products sold byour licensees and that such license and royalty revenue will not constitute asubstantial portion of our revenue in future periods, (14) our expectation thatwe will incur losses in the near future, (15) our expectation that somecompetitors will market some of their products for use in TV over DSLapplications, (16) our anticipation that our sales and operating margins willcontinue to fluctuate, (17) our anticipation that we will generally continue toinvoice foreign sales in U.S. dollars, (18) our intention to continue toevaluate new acquisition candidates, divesture and diversification strategies,and (19) our expectation that customers outside of the United States willrepresent a significant and growing portion of our revenue.*

* *

*Thecautionary 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, performanceor achievements expressed or implied by such forward-looking statements.*

 

*Although we believe that theexpectations reflected in such forward-looking statements are based uponreasonable assumptions, no assurance can be given that such expectations willbe attained or that any deviations will not be material. We disclaim anyobligation or undertaking to disseminate any updates or revision to anyforward-looking statement contained herein or reflect any change in ourexpectations with regard thereto or any change in events, conditions orcircumstances on which any such statement is based.*

 

19

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**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 market in particular, beginning in late 2000 had a severeand sustained adverse effect on our business, financial condition and resultsof operations. Our sales of broadband transport and service management productsdecreased substantially beginning in 2001, which required us to take a numberof restructuring efforts and incur significant impairment and other charges inorder to realign our cost structure in light of the economic environment. Forthe period January 1, 2001 through December 31, 2002, we incurred anaggregate of $32.6 million in intangible asset impairment charges and$11.5 million in restructuring charges. In 2003, sales from our broadbandtransport and service management products stabilized, as we began to experiencean improvement in sales of broadband transport and service management productsto the hospitality industry.

 

With our November 2002 acquisition of Tektronix’s subsidiary VTC,we extended our product offerings to add video processing systems for digitalTV headends and for the transmission of video signals over private andgovernment networks. The acquisition of VTC resulted in significant changes inour business, including: (1) changes in our organizational structure andemployee staffing; (2) relocation of our administrative offices, executiveoffices (as of January 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 months ended March 31,2004, international sales represented 11.2% 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

 

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their customer base. According to a report released by InStat/MDR inApril 2003, the number of telco video subscribers worldwide will increase from572,000 at the end of 2003 to over 19.0 million by the end of 2007. Whilethis growing market presents opportunities to serve a larger customer base, weare also seeing the emergence of intense competition as more companies competeto sell digital TV headend products. We expect this market space will continueto become more competitive in the future. As we begin to target larger telcocustomers, we expect to compete with larger public companies, includingHarmonic, Motorola and Tandberg Television. Our immediate competitors in thedigital TV headend markets are primarily small private companies that arefocused on a more narrow product line than ours and thereby may be able todevote substantially more targeted resources to developing, marketing andselling new products than we are able to. In addition, these companies maybecome targets for acquisition by larger companies, in which case we would facecompetitors with substantially greater name recognition, and technical,financial and marketing resources than we have.

 

The emergence of new technologies to serve the digital TV headendmarket means that we must continue to invest in these new technologies to maintainour market position.  Digital subscriberline (“DSL”) technologies use sophisticated modulation schemes to pack dataonto copper wires.  DSL technologies aresometimes referred to as “last mile” technologies because they are used onlyfor connections from a telephone switching station to a home or office, notbetween switching stations.  Thelimitations on the amount of data that can be transmitted in a fixed amount oftime (“bandwidth”) and distance limitations of the copper based last mileconstrain both the number of video channels that may be deliveredsimultaneously over a DSL network and the number of customers that arereachable from a telco central office. Emerging advancements in video compression technology will soon enablehigh quality video streams to be transported at lower data transfer rates or“bit rates” than currently deployed. These emerging compression advancements also introduce the possibilityof delivering high-definition television over bandwidth constrained asymmetricDSL, or ADSL, lines for the first time. ADSL is a new technology that allows more data to be sent over existingcopper telephone lines.  Additionally,there are DSL advancements emerging that expand the available bandwidth fromthe telco to the subscriber thereby supporting higher DSL bit rates over longerdistances.  As our products continue toincorporate these new technological advancements we expect demand for ourproducts will increase since they will enable more telcos to reach a higherpercentage of their customers with a larger number of video channels.

 

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

 

The digital media industry continues to beintensely competitive.  We are continuing to focus on developingtechnologies and introducing new products and we expect that our research anddevelopment expenses will increase throughout the remainder of 2004. Wecontinue to aggressively market our new and existing products and to expand ourmarketing efforts domestically and internationally.  Nevertheless, our operations have been subject, and will continueto be subject, to pressure from weakness in the overall technology sector aswell as the digital media industry. During the first quarter of 2004 our sales cycle generally increased andcustomers delayed purchasing decisions.  The deferral of customer ordersreduced our revenue in the first quarter of 2004.  We believe this lengthening of the decision making process is theresult of an increasing variety of other products that interface with our systems.We have been operating at a loss since inception and, based on expectedrevenues, we anticipate that we will continue to operate at loss during theremainder of 2004.  As we announced onApril 26, 2004, we expect revenues during the second quarter of 2004 toincrease by 5% and our gross margin to increase to approximately 40%.  However, the deferral of customer orders weexperienced during the first quarter may continue, which may result in reducedrevenues 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 March 31,2004. This evaluation included various steps that our Chief Executive Officerand Chief Financial Officer undertook in an effort to ensure that informationrequired to be disclosed in our SEC reports is recorded, processed, summarizedand reported within the time periods specified by the SEC and accumulated andcommunicated to our management, including our Chief Executive Officer and ourChief Financial Officer, to allow timely decisions regarding requireddisclosure.  This evaluation alsoincluded consideration of our internal controls and procedures for thepreparation of our financial statements. There are inherent limitations to the effectiveness of any system ofdisclosure controls and procedures, including the possibility of human errorand the circumvention of the controls and procedures.  Accordingly, even effective disclosure controls and procedurescan only provide reasonable assurance of achieving their controlobjectives.  Notwithstanding theselimitations, as of the end of the period covered by this report, based upon theevaluation, our Chief Executive Officer and Chief Financial Officer concludedthat our disclosure controls and procedures are effective.

 

During the three months ended March 31, 2004, we implemented thefollowing measures:

 

•                                          Performquarterly physical inventory counts at all locations;

 

•                                          Establishedimproved inventory systems and accounting controls, hired additional qualifiedpersonnel, improved intra-company communications, implemented appropriateorganizational and line of reporting changes; and

 

•                                          Establishedimproved procedures for the timely reconciliation and confirmation of accountspayable balances.

 

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We implemented these measures because in connection with the completionof PricewaterhouseCoopers LLP’s audit of our financial statements for the yearended December 31, 2003, PricewaterhouseCoopers LLP advised management andthe audit committee of the Board of Directors that it had identifieddeficiencies in our internal controls and processes relating to inventory managementand reporting that it considered to be material weaknesses, as defined byStatement on Auditing Standards No. 60, “Communication of Internal ControlRelated Matters Noted in an Audit.” PricewaterhouseCoopers LLP identified thefollowing two material weaknesses in our internal controls and processes:

 

1.                                       Our internalcontrols were 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.

 

Management believes its new controls andprocedures have addressed the conditions identified by PricewaterhouseCoopersLLP as material weaknesses.  We plan tocontinue to monitor the effectiveness of our internal controls and procedureson 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 royalty revenue willdecrease in the foreseeable future. Cost of goods sold, or COGS, consists ofcosts related to raw materials, contract manufacturing, personnel, overhead,test and quality assurance for products, and the cost of licensed technologyincluded in our products. Raw materials, contract manufacturing and licensedtechnology are the principal elements of COGS and vary directly with productsales. Sales and marketing expense consists primarily of selling and marketingpersonnel costs, including sales commissions, travel, trade shows, promotionsand outside services. Research and development expense consists primarily ofpersonnel and facilities costs, contract consultants, outside testing services,and equipment and supplies associated with enhancing existing products and developingnew products. General and administrative expense consists primarily ofpersonnel costs for administrative officers and support personnel, professionalservices and insurance expenses. Amortization of intangible assets consistsprimarily of expenses associated with the amortization of technology andpatents related to prior years’ acquisitions.

 

**Results of Operations**

 

The following table sets forth items from ourstatements of operations as a percentage of total revenues for the periodsindicated: 

 
|                              |   | **Three  months ended  March 31,** |   |
|-----------------------------------|--------|------------------------------------|--------|
|                              |   | **2003**                           |   | **2004** |   |
| Total revenues                    |   | 100.0                              | %      | 100.0 | % |
| Cost of goods sold                |   | 49.4                               |   | 83.0 |   |
| Gross profit (loss)               |   | 50.6                               |   | 17.0 |   |
| Operating expenses:               |   |                               |   |   |   |
| Sales and marketing               |   | 29.2                               |   | 30.8 |   |
| Research and development          |   | 31.6                               |   | 29.5 |   |
| General and administrative        |   | 18.2                               |   | 18.1 |   |
| Impairment of intangible assets   |   | —                             |   | 3.3 |   |
| Amortization of intangible assets |   | 7.0                                |   | 6.4 |   |
| Total operating expenses          |   | 86.0                               |   | 88.1 |   |
| Loss from operations              |   | (35.3                              | )      | (71.1 | ) |
| Interest and other income, net    |   | 1.5                                |   | (0.9 | ) |
| Net loss                          |   | (33.8                              | )%     | (72.0 | )% |

 

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*Three Months Ended March 31, 2003and 2004*

 

*Total Revenues.*  For the three months ended March 31, 2004,our total revenues decreased by 6.4% to $6.2 million from $6.6 millionfor the three months ended March 31, 2003. During this same period, our productrevenue decreased by 3.8% to $6.2 million from $6.4 million for thethree months ended March 31, 2003. This $0.2 million decrease in productrevenue was due primarily to the adverse effect of several digital TV headendsales not closing in the quarter as expected. While the market for digital TV headend sales continues to expand, weare seeing an increase in a variety of factors that is causing many prospectivecustomers to delay their purchase decision. Sales of broadband transport and service management products increasedfrom $1.7 million in the first quarter of 2003 to $1.9 million in the firstquarter of 2004.   For the three monthsended March 31, 2004, our license and royalty revenue decreased to $18 thousandfrom $0.2 million for the three months ended March 31, 2003.

 

*Cost of Goods Sold.*  For the three months ended March 31, 2004,our cost of goods sold increased by $1.8 million to $5.1 million from$3.3 million for the three months ended March 31, 2003. The increase incost of goods sold was due to a $1.0 million increase in our reserves forobsolete inventory and a lower of cost or market adjustment for certaininventory components, an increase in material costs of $0.2 million, directlabor and other direct expenses of $0.5 million related to completion ofcertain project installations, and other miscellaneous expenses of $0.1million.   Our gross profit decreased by$2.3 million to $1.0 million for the three months ended March 31, 2004 from$3.3 million for the three months ended March 31, 2003.  This decrease in gross profit is due to anincrease of $1.0 million in inventory reserves and a gross margin decrease of$1.5 million relating to our video content processing products.  The decrease in our gross margin waspartially offset by an increase of $0.2 million attributable to our broadbandtransport and service management products.

 

*Sales and Marketing.*  For the three months ended March 31, 2004and 2003, our sales and marketing expenses remained consistent at $1.9 million.

 

*Research and Development.*  For the three months ended March 31, 2004,our research and development expense decreased by 12.7% to $1.8 millionfrom $2.1 million for the three months ended March 31, 2003. The$0.3 million decrease in our research and development expense for thefirst quarter of 2004 when compared with the same period in 2003 was due to adecrease of $0.3 million in personnel related costs. We continued toreduce research and development expenses in the first quarter of 2004 to bringthem into better alignment with our current revenues. We expect that ourresearch and development expenses will increase throughout the remainder of2004. Our capital expenditures for research and development were $0.1 millionand $0.3 million for the three months ended March 31, 2003 and 2004,respectively. We expect capital expenditures for research and development todecrease in 2004.

 

*General and Administrative.*  For the three months ended March 31, 2004,our general and administrative expense decreased by 7.1% to $1.1 millionfrom $1.2 million for the three months ended March 31, 2003. The$0.1 million decrease in our general and administrative expense for thefirst quarter of 2004 when compared with the same period in 2003 was due todecreases of $0.2 million in personnel costs from a workforce reduction in thethird quarter of 2003 and $0.1 million in insurance expenses, partially offsetby an increase of $0.2 million in professional 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. There wasno such impairment for the three months ended March 31, 2003.

 

*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

 

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the three months ended March 31, 2004, amortization of intangibleassets decreased by 13.7% to $0.4 million from $0.5 million for thethree months ended March 31, 2003.  The$0.1 decrease for the first quarter of 2004 when compared with the same periodin 2003 was due to a reduction in amortization expense, from an intangibleasset reaching full amortization in the fourth quarter of 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 three months ended March 31, 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 three months ended March 31, 2003.The decrease in the first quarter of 2004 of $0.2 million compared withthe first quarter of 2003 was primarily the result of lower interest rates onlower average cash balances and increased interest expense associated with the$3.2 million note issued in connection with our purchase of VTC inNovember 2002.

 

**Liquidity and Capital Resources**

 

Cash and cash equivalents totaled $12.3 million at March 31, 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$2.1 million.

 

Cash used in operating activities was $1.5 million for the threemonths ended March 31, 2004, compared with $4.4 million for the threemonths ended March 31, 2003. The reduced cash used in operating activities wasprimarily due to a decrease in accounts receivable due to lower revenue levelsin the first quarter of 2004 and an increase in accounts payable and accruedliabilities due to an increase in end of quarter purchases offset by anincrease in prepaid expenses.  Werecorded a provision for inventory within cost of goods sold totaling $1.0million in the first quarter of 2004, related to the costs of raw materials andfinished goods in excess of what we reasonably expected to sell in theforeseeable future as of the first quarter of 2004.  We also reduced inventory costs to market value.

 

Additions to property and equipment were $0.7 million in the firstquarter of 2004, compared with $0.3 million in the first quarter of 2003,primarily reflecting an increased investment in research and developmentassets. In 2004 we expect capital expenditures to be comparable to 2003. Weexpect these capital expenditures to be funded from operations.

 

The following table sets forth our contractual obligations as of March31, 2004:

 
|                         |   | **Payments  due by period** |   |
|------------------------------|--------|-----------------------------|--------|
| **Contractual  Obligations** |   | **Total**                   |   | **Remainder  of 2004** |   | **2005  to  2006** |   | **2007  to  2008** |   | **Thereafter** |   |
| Long-Term Debt Obligations   |   | $                           | 3,603  |   | $ | — |   | $ | — |   | $ | 3,603 |   | $ | — |   |
| Operating Lease Obligations  |   | 960                         |   | 694 |   | 266 |   | — |   | — |   |
| Purchase Obligations         |   | 364                         |   | 364 |   | — |   | — |   | — |   |
| Other Long-Term Liabilities  |   | 31                          |   | — |   | 31 |   | — |   | — |   |
| Total                        |   | $                           | 4,958  |   | $ | 1,058 |   | $ | 297 |   | $ | 3,603 |   | $ | — |   |

 

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$3.6 million at March 31, 2004. Accrued interest in the first quarter of 2004 was $0.1 million.

 

In connection with the settlement of certain legal matters in December2003, we have recorded a liability and a receivable, each in the amount of$10.7 million, in our December 31, 2003 balance sheet. This amountwill be paid by our insurance carriers, and accordingly, such liability is notreflected in the above table. The settlement amount will be reversed from our balancesheet during 2004, at such time as the settlements are formally approved by therespective courts.  One of thesettlements was formally approved by the courts in the first quarter of 2004,and therefore, we reversed $0.7 million relating to that settlement from thebalance sheet.  As of March 31, 2004, wehave a receivable and liability of $10.0, respectively, on our balance sheet.

 

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We have incurred substantial losses and negative cash flows fromoperations since inception. For the three months ended March 31, 2004, weincurred a net loss of $4.5 million, negative cash flows from operatingactivities of $1.5 million, and have an accumulated deficit of$286.5 million.

 

We believe that the cash and cash equivalents as of March 31, 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 cannotassure 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 expensesduring the reporting periods. We base our estimates on historical experienceand on various other assumptions that are believed to be reasonable under thecircumstances, the results of which form the basis for making judgments aboutthe carrying values of assets and liabilities that are not readily apparentfrom other sources. Actual results may differ from these estimates underdifferent assumptions or conditions.

 

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 productsthrough direct sales channels and through distributors. Generally, productrevenue is generated from the sale of video processing systems and componentsand the sale of broadband transport and service management products. Turnkeysolution revenue is principally generated by the sale of complete end-to-endvideo processing systems that are designed, developed and produced according toa buyer’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.

 

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 amendments deferred and thenclarified, respectively, the

 

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specification of what was considered vendor specific objective evidenceof fair value for the various elements 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 ourcredit review policy.  We sell tocustomers for which there is a history of successful collection and to newcustomers for which such history may not exist.  New customers are subject to a credit review process, whichevaluates the customers’ financial position and ability to pay. New customersare typically assigned a credit limit based on a review of their financialposition.  Such credit limits are onlyincreased after a successful collection history with the customer has beenestablished.  If it is determined fromthe outset of an arrangement that collectibility is not probable based upon ourcredit review process, no credit is extended and revenue is recognized on acash-collected basis.

 

We also maintain accruals and allowances for all cooperative marketingand other programs, as necessary. Estimated sales returns and warranty costs arebased 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. 

 

No such impairment was recorded in the first quarter of 2003.  During 2004, we determined that certainintangible long-lived assets were impaired and recorded a loss of$0.2 million under SFAS No. 144. Future events could cause us toconclude that impairment indicators once again exist. Any resulting impairmentloss could have a material adverse impact on our financial condition andresults of operations.

 

*Legal contingencies.*    We are currentlyinvolved in certain legal proceedings as discussed in note 6. Because ofuncertainties related to both the potential amount and range of loss from thepending litigation, management is unable to make a reasonable estimate of theliability that could result if there is an unfavorable outcome in certain ofthese legal proceedings. We recorded a liability for the *In re Tut Systems, Inc. Securities Litigation*matter,as well as an equal and corresponding receivable. We have not recorded aliability 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.

 

**Recent Accounting Pronouncements**

 

In January 2003, the Financial Accounting Standards Board, the(“FASB”) issued FASB Interpretation No. 46 (FIN 46), “Consolidation ofVariable Interest Entities, an Interpretation of ARB No. 51, ConsolidatedFinancial Statements,” and subsequently revised in December 2003 with theissuance of FIN 46-R. This interpretation requires certain variable interestentities to be consolidated by the primary beneficiary of the entity if theequity investors in the entity do not have the characteristics of a controllingfinancial interest or do not have sufficient equity at risk for the entity to financeits activities without additional subordinated financial support from otherparties. Application of this Interpretation is required in financial statementsfor periods ending after March 15, 2004. The adoption of this Interpretation in the period ended March 31, 2004did not have a material impact on our results of operations, financial positionor cash flows. 

 

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**ADDITIONAL RISK FACTORS THAT COULD AFFECT OUR OPERATINGRESULTS AND THE MARKET PRICE OF OUR 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 March 31, we had anaccumulated deficit of $286.5 million. We expect to incur losses in thenear future. Moreover, we may never achieve profitability and, if we do so, wemay not be able to maintain profitability. We may not be able to generate asufficient level of revenue to offset our current level of expenditures.Moreover, because our expenditures for sales and marketing, research anddevelopment, and general and administrative functions are relatively fixed inthe short term, we may be unable to adjust our spending in a timely manner to respondto any unanticipated decline in revenue. If we fail to achieve profitabilitywithin the timeframe expected by securities analysts or investors, then themarket price of our common stock will likely decline. 

 

**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 totarget larger telco customers for our video content processing systems, weexpect more competition from large public companies like Harmonic, Inc.,Tandberg Television ASA, and Motorola, Inc., all of which havesubstantially greater financial, technical and other resources than we do.These competitors have

 

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achieved success in providing headend components for cable multiplesystem operators and satellite TV providers and we expect these competitors tomarket some of their products for use in TV over DSL applications. For example,in the past, Harmonic provided video content processing systems to SaskTel, alarge Canadian telephone service provider. Harmonic also recently announcedthat it will provide video content processing systems to Video NetworksLimited, a video-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 TandbergTelevision that together offer a wide array of products with special featuresand functions. 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 downward pressureon 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 as 12-18 months.Additionally, with respect to the sale of our products to U.S. and foreigngovernment organizations, we may experience long sales cycles as a result ofgovernment procurement processes. As a result, while we continue to incur costsassociated with a particular sale prior to payment from the customer, we maynot recognize revenue from efforts to sell particular products for extendedperiods of time. 

 

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. Weoften make significant up-front financial commitments with our contractmanufacturers, OEMs and suppliers in order to procure the raw materials andbegin manufacturing and assembly of the products. If we fail to accuratelyforecast demand or coordinate our efforts with our suppliers, OEMs and contractmanufacturers, we may face supply, manufacturing or testing capacityconstraints. These constraints could result in delays in the delivery of ourproducts, which could lead to the loss of existing or potential customers andcould thereby result in lost sales and damage to our reputation, which wouldadversely affect our revenue and profitability. Further, we outsource themanufacturing of our products based on forecasts of sales. If orders for ourproducts exceed our forecasts, we may have difficulty meeting customers’ ordersin a timely manner, which could damage our reputation or result in lost sales.Conversely, if our forecasts exceed the orders we actually receive and we areunable to cancel future purchase and manufacturing commitments in a timelymanner, our inventory levels would increase. This could expose us to lossesrelated to slow moving and obsolete inventory, which would have a materialadverse effect on our profitability. 

 

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**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 bandwidth constrained ADSL lines for the first time. Furtheradvances in compression technology, or the emergence of new industry standardswould require that we further redesign our products to incorporate, and remaincompatible with, emerging technologies and industry standards. 

 

We cannot assure you that we will be able to respond quickly andeffectively to technological change. We may have only limited time to entercertain markets, and we cannot assure you that we will be successful inachieving widespread acceptance of our products before competitors can offer productsand services similar or superior to our products. If we fail to introduce newproducts that address technological changes or if we experience delays in ourproduct introductions, our ability to compete would be adversely affected,thereby harming 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 13.2% and 11.2% for the three months ended March 31, 2003 and2004, respectively. Sales and operating activities outside of the United Statesare subject to inherent risks, including fluctuations in the value of theUnited States dollar relative to foreign currencies; tariffs, quotas, taxes andother market barriers; political and economic instability; restrictions on theexport or import of technology; potentially limited intellectual propertyprotection; difficulties in staffing and managing international operations andpotentially adverse tax consequences. Any of these factors may have a materialadverse effect on our ability to grow or 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 the

 

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suppliers. 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.**

** **

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 orlicensing agreements, if required, may not be available on terms acceptable tous. In addition, any such litigation could force us to cease selling or usingcertain products or services, or to redesign such products or services.Further, we may in the future initiate claims or litigation againstthird-parties for infringement of our intellectual property rights or todetermine the scope and validity of our intellectual property rights or thoseof competitors. Such litigation could result in substantial costs and diversionof resources. Any of the foregoing could have an adverse effect upon ourrevenue, 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

 

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training with respect to our products, particularly in the initialdeployment and implementation stage. As our systems and products become morecomplex, we believe our ability to provide adequate customer support will beincreasingly important to our success. We have limited experience withwidespread deployment of our products to a diverse customer base, and we cannotassure you that we will have adequate personnel to provide the levels ofsupport that our customers may require during initial product deployment or onan ongoing basis. Our failure to provide sufficient support to our customerscould delay or prevent the successful deployment of our products. Failure toprovide adequate support could also have an adverse impact on our reputationand relationship with our customers, could thereby prevent us from gaining newcustomers and could harm our 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 other third-parties.We cannot assure you that our systems, procedures or controls will be adequateto support our operations or that our management will be able to achieve therapid execution necessary to exploit fully the market for our products orsystems. If we are unable to manage our operations effectively, our revenue,operations and share price could be harmed. 

** **

**If we are unable to address the materialweaknesses in our internal controls that our auditors identified in the fourthquarter of fiscal 2003, such weaknesses could materially and adversely affectour ability to provide the public with timely and accurate material informationabout our company, which could harm our reputation and share price.**

** **

In January 2004, our auditors identified deficiencies in our internalcontrols that they considered to be material weaknesses. Based on theseweaknesses, our CEO and CFO determined that, as of December 31, 2003, ourdisclosure controls and procedures were not sufficient to record, process,summarize and report information required to be reported within the timeperiods specified by the SEC.  Thesematerial weaknesses related to our inventory and our accounts payableprocesses, both of which affect our balance sheet and may also affect ourincome statement reporting.  (Seepage 20 of the Form 10-K/A for further discussion of theseweaknesses.)  In order for investors andthe equity analyst community to make informed investment decisions andrecommendations about our securities, it is important that we provide them withaccurate and timely information in accordance with the Exchange Act and therules promulgated thereunder.  If wecannot do so, investors will sell our shares and industry analysts will eithermake incorrect recommendations about our company or else end coverage of ourcompany altogether, any of which results could harm our reputation andadversely impact our share price. 

 

**We are currently engaged in two securitiesclass action lawsuits, either of which, if they were to result in anunfavorable resolution, could adversely affect our reputation, profitabilityand share price.**

** **

We are currently engaged as a defendant in two lawsuits (i.e., *In re Tut Systems, Inc. Securities Litigation*and *Whalen v. Tut Systems, Inc. et al.*)that allege securities law violations against us and certain of our current andformer officers and directors under Section 11 of the Securities Act of1933, as amended, and Section 10(b) and Rule 10b-5 of the SecuritiesExchange Act of 1934, as amended. While we have reached settlements with theplaintiffs in these lawsuits, the settlements are subject to certaincontingencies, including court approval of the terms of settlement. If thecourts do not approve these settlements, or any other applicable contingenciesare not resolved or otherwise addressed, we would be required to resumelitigation in these matters. If we were to resume litigation in these matters,there is no assurance that we would prevail and, if either of the outcomes ofsuch litigation were unfavorable to us, our reputation, profitability and shareprice could be adversely affected. 

 

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**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 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 of

 

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our acquisition of VTC, the closing price of our common stock, astraded on the Nasdaq National Market, has fluctuated from a low of $1.22 to ahigh of $7.49 per share. The value of our common stock may decline regardlessof our operating performance or prospects. Factors affecting our market priceinclude: 

 

•                                          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 our competitors;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. Themarket price 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 in connectionwith our November 2002 acquisition of VTC are restricted securities, asthat term is defined in Rule 144 under the Securities Act, and thereforesubject to certain restrictions. However, we are contractually obligated tofile and keep effective a registration statement in order to allow Tektronix tosell these shares to the public. Likewise, Tektronix has the right (subject tocertain exceptions) to include these shares in certain registration statementspursuant 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

 

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vote or action by the stockholders. The issuance of preferred stock,while providing flexibility in connection with possible financings oracquisitions or other corporate purposes, could have the effect of making itmore difficult for a third-party to acquire a majority of our outstandingvoting stock. The Plans provide for severance payments and accelerated stockoption vesting in the event of termination of employment following a change ofcontrol. The provisions of the charter and bylaws, and the Plans, as well asSection 203 of the Delaware General Corporation Law, to which we aresubject, could discourage potential acquisition proposals, delay or prevent achange of control and prevent changes in our management. 

 

**ITEM 3****.**     ***QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK*******

 

We are exposed to changes in interest rates primarilyfrom our investments in certain cash equivalents. Under our current policies,we do not use interest rate derivative instruments to manage exposure tointerest rate changes. A hypothetical 100 basis point adverse move in interestrates along the entire interest rate yield curve would not materially affectthe fair value of our interest-sensitive financial instruments at March 31,2004. 

 

We have no investments, nor are any significant sales,expenses, or other financial items denominated in foreign country currencies.All of our international sales are denominated in U.S. dollars. An increase inthe value of the U.S. dollar relative to foreign currencies could make ourproducts more expensive and, therefore, reduce the demand for our products. 

 

**ITEM 4****.**     ***CONTROLS AND PROCEDURES*******

 

(a)           Our Chief Executive Officerand Chief Financial Officer carried out an evaluation of the effectiveness ofour disclosure controls and procedures (as defined in Rule 13a-15(e) underthe Exchange Act) as of March 31, 2004. This evaluation included varioussteps that our Chief Executive Officer and Chief Financial Officer undertook inan effort to ensure that information required to be disclosed in our SECreports is recorded, processed, summarized and reported within the time periodsspecified by the SEC and accumulated and communicated to our management,including our Chief Executive Officer and our Chief Financial Officer, to allowtimely decisions regarding required disclosure.  This evaluation also included consideration of our internalcontrols and procedures for the preparation of our financial statements.  There are inherent limitations to theeffectiveness of any system of disclosure controls and procedures, includingthe possibility of human error and the circumvention of the controls andprocedures.  Accordingly, even effectivedisclosure controls and procedures can only provide reasonable assurance ofachieving their control objectives. Notwithstanding these limitations, as of the end of the period coveredby this report, based upon the evaluation, our Chief Executive Officer andChief Financial Officer concluded that our disclosure controls and proceduresare effective.

 

During the three months ended March 31, 2004, we implemented thefollowing measures: 

 

•                                          Performquarterly physical inventory counts at all locations;

 

•                                          Establishedimproved inventory systems and accounting controls, hired additional qualifiedpersonnel, improved intra-company communications, implemented appropriateorganizational and line of reporting changes; and 

 

•                                          Establishedimproved procedures for the timely reconciliation and confirmation of accountspayable balances. 

 

We implemented these measures because in connection with the completionof PricewaterhouseCoopers LLP’s audit of our financial statements for the yearended December 31, 2003, PricewaterhouseCoopers LLP advised management andthe audit committee of the Board of Directors that it had identifieddeficiencies in our internal controls and processes relating to inventorymanagement and reporting that it considered to be material weaknesses, asdefined by Statement on Auditing Standards No. 60, “Communication ofInternal Control Related Matters Noted in an Audit.” PricewaterhouseCoopers LLPidentified the following two material weaknesses in our internal controls andprocesses: 

 

1.                                       Our internalcontrols were 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.

 

Management believes its new controls andprocedures have addressed the conditions identified by PricewaterhouseCoopersLLP as material weaknesses.  We plan tocontinue to monitor the effectiveness of our internal controls and procedureson an ongoing basis and will take further action as appropriate.

 

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**PART II. OTHER INFORMATION**

 

**ITEM 1.**     ***LEGAL PROCEEDING******S*******

 

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

*** ***

On October 30, 2001, we and certain of our current and formerofficers and directors were named as defendants in *Whalen v. Tut Systems, Inc. et al.*, Case No. 01-CV-9563, apurported securities class action lawsuit filed in the United States DistrictCourt for the Southern District of New York. An amended complaint was filed onDecember 5, 2001. A consolidated amended complaint was filed onApril 19, 2002. The consolidated amended complaint asserts that theprospectuses from our January 29, 1999 initial public offering and itsMarch 23, 2000 secondary offering failed to disclose certain allegedactions by the underwriters for the offerings. The complaint alleges claimsagainst us and certain of our current and former officers and directors underSection 11 of the Securities Act of 1933, as amended, and underSection 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934,as amended, and alleges claims against certain of our current and formerofficers and directors under Sections 15 and 20(a) of the Securities Act.The complaint also names as defendants the underwriters for our initial publicoffering and secondary offering. Similar suits were filed in the SouthernDistrict of New York challenging over 300 other initial public offerings andsecondary offerings conducted in 1999 and 2000. Therefore, for pretrialpurposes, the *Whalen* action isbeing coordinated with the approximately 300 other suits before United StatesDistrict Court Judge Shira Scheindlin of the Southern District of New Yorkunder the matter *In Re Initial PublicOffering Securities Litigation*. The individual defendants in the *Whalen* action, namely, Nelson Caldwell,Salvatore D’Auria and Matthew Taylor, were dismissed without prejudice by anOctober 9, 2002 Order of the Court, approving the parties’ October 1,2002 Stipulation of Dismissal. On February 19, 2003, the Court issued anOpinion and Order denying our motion to dismiss. 

 

In June and July 2003, nearly all of the issuers named as defendants inthe *In Re Initial Public Offering SecuritiesLitigation* (collectively, the “issuer-defendants”), including ourCompany, approved a tentative settlement proposal that is reflected in amemorandum of understanding. Our Board of Directors approved the memorandum ofunderstanding in June 2003 on certain conditions, including the number ofissuers participating in the settlement. The memorandum of understanding is nota legally binding agreement. Further, any final settlement agreement would besubject to a number of conditions, most of which would be outside of ourcontrol, including approval by the Court. The underwriter-defendants in the *In Re Initial Public Offering Securities Litigation*(collectively, the “underwriter-defendants”), including the underwriters namedin the *Whalen* suit, are notparties to the memorandum of understanding. 

 

The memorandum of understanding provides that, in exchange for arelease of claims against the settling issuer-defendants, the insurers of allof the settling issuer-defendants will provide a surety undertaking toguarantee plaintiffs a $1 billion recovery from the non-settling defendants,including the underwriter-defendants. The ultimate amount, if any, that may bepaid on our behalf will therefore depend on the final terms of the settlementagreement, including the number of issuer-defendants that ultimately approvethe final settlement agreement, and the amounts, if any, recovered by theplaintiffs from the underwriter-defendants and other non-settling defendants.In the event that all or substantially all of the

 

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issuer-defendants approve the final settlement agreement, the amountthat we would be required to pay to the plaintiffs could range from zero toapproximately $3.5 million, depending on plaintiffs’ recovery from theunderwriter-defendants and from other non-settling parties. If the plaintiffsrecover at least $1 billion from the underwriter-defendants, we would have noliability for settlement payments under the proposed terms of the settlement.If the plaintiffs recover less than $1 billion, we believe that our insurancewill likely cover some or all of our share of any payments towards satisfyingplaintiffs’ $1 billion recovery deficit. Management estimates that itsrange of loss relative to this matter is zero to $3.5 million. Presentlythere is no more likely point estimate of loss within this range. As aconsequence of the uncertainties described above regarding the amount we willultimately be required to pay, if any, as of March 31, 2004, we have notaccrued 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 betweenJuly 20, 2000 and January 31, 2001, seeking unspecified damages. Thecomplaints allege that we and certain of our current and former officers anddirectors made false and misleading statements about our business during theputative class period. Specifically, the complaints allege violations ofSection 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended. Thecomplaints were consolidated under the name *Inre Tut Systems, Inc. Securities Litigation*, Master File No.C-01-2659-CW (the “Securities Litigation Action”). Lead plaintiffs and leadcounsel for plaintiffs were appointed. Plaintiffs filed a consolidated classaction complaint on February 4, 2002. Defendants filed a Motion to Dismisson March 29, 2002. On August 15, 2002, the Court granted in part anddenied in part the Motion to Dismiss. On September 23, 2002, plaintiffsfiled an amended complaint. Defendants filed a Motion to Dismiss the amendedcomplaint, and on August 6, 2003 the Court granted in part that Motion. OnSeptember 24, 2003, defendants answered the remaining allegations of theamended complaint. Defendants reached a settlement of the Securities LitigationAction in December 2003. Subject to preliminary and final approval by theCourt, our insurance carriers agreed to pay $10 million, on our behalf, tosettle the suit. The settlement includes a release of all defendants. TheCompany has recorded a liability in its financial statements for the proposedamount of the settlement. In addition, because the insurance carriers agreed topay the entire $10 million settlement amount and, therefore, recovery from theinsurance carriers was probable, a receivable was also recorded for the sameamount. Accordingly, there is no impact to the statement of operations becausethe amounts of the settlement and the insurance recovery fully offset eachother. The insurance carriers paid the settlement amount to plaintiffs’ escrowagent in January 2004. The Court preliminarily approved the settlement onFebruary 24, 2004. The settlement amount will be paid out of escrow if andwhen the Court finally approves the settlement. A hearing before the Court toconsider final approval of the terms of settlement is currently scheduled forMay 14, 2004.  Because thesettlement is subject to Court approval, there is no guarantee the settlementwill become final. 

 

***Lefkowitzv. D’Auria, et al***

*** ***

On March 19, 2003, Chesky Lefkowitz, one of our stockholders,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 our current andformer officers and directors. The complaint alleges causes of action forbreach of fiduciary duty, gross negligence, breach of contract, unjustenrichment, 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 our behalf, equitablerelief, and attorneys’ fees. On May 21, 2003, we and the individualdefendants filed separate demurrers to the complaint. We and the individualdefendants reached a settlement of the derivative action in December 2003. Thesettlement involves our adoption of certain corporate governance measures andpayment of attorneys’ fees and expenses to the derivative plaintiff’s counselin the amount of $722,000 and an incentive award to the derivative plaintiff inthe amount of $3,000. We have recorded a liability in our financial statementsfor the proposed amount of the settlement. In addition, because the insurancecarrier involved in this suit agreed to pay the entire $725,000 settlementamount and, therefore, recovery from the insurance carrier was probable, areceivable was also recorded for the same amount. Accordingly, there is noimpact to the statement of operations because the amounts of the settlement andthe insurance recovery

 

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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 our company and the individualdefendants. 

 

We are subject to other legal proceedings, claims and litigationarising in the ordinary course of business. Our management does not expect thatthe ultimate costs to resolve these matters will have a material adverse effecton our consolidated financial position, results of operations, or cash flows. 

 

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

 

None 

 

**ITEM 3.**     ***DEFAULTS******UPONSENIOR SECURITIES*******

 

None 

 

## ***ITEM 4.***     SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS 

 

None 

 

## ***ITEM 5.***     OTHER INFORMATION  

 

None 

 

## ***ITEM 6.***     EXHIBITS AND REPORTS ON FORM 8-K 

 

(a) Exhibits 

 
| **Exhibit  Number** |   | **Description** |
|---------------------|--------|-----------------|
|                |   |            |
| 2.1                 |   |            | Agreement and Plan of Merger by and among Tut Systems, Inc., Tiger  Acquisition Corporation, Tektronix, Inc. and VideoTele.com, Inc. dated as of  October 28, 2002.(8) |
|                |   |            |   |
| 3.1                 |   |            | Second Amended and Restated Certificate of Incorporation of the  Company.(1) |
|                |   |            |   |
| 3.2                 |   |            | Bylaws of the Company, as currently in effect. |
|                |   |            |   |
| 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) |

 

39

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

 

40

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(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 by referenceto our Annual Report on Form 10-K for the year ended December 31,2002. 

 

*                                         Indicatesmanagement contracts or compensatory plans and arrangements.

 

(b) Reports on Form 8-K. 

 

The Company filed the following Current Reports onForms 8-K during the quarter ended March 31, 2004: 

 

On February 2, 2004, the Company furnished a CurrentReport on Form 8-K regarding the Company’s issuance of a press release statingits earnings for the fourth quarter and year ended December 31, 2003. 

 

On April 2, 2004, the Company furnished a CurrentReport on Form 8-K regarding the Company’s issuance of a press releaseregarding its preliminary revenue for the first quarter ended March 31, 2004.

 

**SIGNATURE**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly 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: May 7,  2004 |              |   |

 

41

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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. |
|                |   |            |   |
| 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) |

 

42

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| **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 by referenceto our Annual Report on Form 10-K for the year ended December 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. 

 

*                                         Indicatesmanagement contracts or compensatory plans and arrangements.

 

43

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