**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**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, 2005**

** **

**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 of  incorporation or organization) |       | (I.R.S. Employer  Identification No.) |
|                                                             |       |                                  |
| **6000 SW Meadows Rd, Suite 200  Lake Oswego, Oregon**           | ** ** | **97035**                             |
| (Address  of principal executive offices)                        |       | (Zip  Code)                           |

 

Registrant’s telephone number, including area code: **(971)217-0400**

 

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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  o  No  ý

 

As of May 11, 2005, 25,237,762 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, 2004 and March 31, 2005                              |   |
|              |                                                                                                           |   |
|              | Condensed  Consolidated Statements of Operations for the three months ended March 31,  2004 and March 31, 2005 |   |
|              |                                                                                                           |   |
|              | Condensed  Consolidated Statements of Cash Flows for the three months ended March 31,  2004 and March 31, 2005 |   |
|              |                                                                                                           |   |
|              | 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.           | Unregistered Sales of Equity  Securities and Use of Proceeds                                                   |   |
|              |                                                                                                           |   |
| Item  3.          | Defaults Upon Senior Securities                                                                                |   |
|              |                                                                                                           |   |
| Item 4.           | Submission of Matters to a Vote  of Security Holders                                                           |   |
|              |                                                                                                           |   |
| Item 5.           | Other Information                                                                                              |   |
|              |                                                                                                           |   |
| Item 6.      | Exhibits                                                                                                       |   |
|              |                                                                                                           |   |
| Signatures        |                                                                                                           |   |

 

2

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**PART I****. FINANCIAL INFORMATION**

** **

### **ITEM 1**.  CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

### ** **

**TUT SYSTEMS, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

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

**(unaudited)**

 
| ** **                                                                                                                                  | ** ** | **December 31,  2004** | ** ** | **March 31,  2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|---------------------|------------|
| **ASSETS**                                                                                                                                  |       |                   |       |                |       |
| Current assets:                                                                                                                             |       |                   |       |                |       |
| Cash and cash equivalents                                                                                                                   |       | $                      | 12,440     |                | $          | 9,528 |   |
| Accounts receivable, net of allowance for  doubtful accounts of $139 and $243 in 2004 and 2005, respectively                                |       | 6,585                  |       | 7,277               |       |
| Inventories, net                                                                                                                            |       | 3,994                  |       | 3,511               |       |
| Prepaid expenses and other                                                                                                                  |       | 1,137                  |       | 2,536               |       |
| Total current assets                                                                                                                        |       | 24,156                 |       | 22,852              |       |
| Property and equipment, net                                                                                                                 |       | 1,874                  |       | 2,166               |       |
| Intangibles and other assets                                                                                                                |       | 1,935                  |       | 1,538               |       |
| Total assets                                                                                                                                |       | $                      | 27,965     |                | $          | 26,556 |   |
|                                                                                                                                        |       |                   |       |                |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                               |       |                   |       |                |       |
| Current liabilities:                                                                                                                        |       |                   |       |                |       |
| Accounts payable                                                                                                                            |       | $                      | 2,221      |                | $          | 3,419 |   |
| Accrued liabilities                                                                                                                         |       | 2,324                  |       | 2,603               |       |
| Deferred revenue                                                                                                                            |       | 226                    |       | 391                 |       |
| Total current liabilities                                                                                                                   |       | 4,771                  |       | 6,413               |       |
| Note payable                                                                                                                                |       | 3,816                  |       | 3,892               |       |
| Total liabilities                                                                                                                           |       | 8,587                  |       | 10,305              |       |
| Commitments and contingencies (Note 7)                                                                                                      |       |                   |       |                |       |
| Stockholders’ equity:                                                                                                                  |       |                   |       |                |       |
| Preferred stock, $0.001 par value, 5,000  shares authorized, no shares issued and outstanding in 2004 and 2005,  respectively               |       | —                 |       | —              |       |
| Common stock, $0.001 par value, 100,000  shares authorized, 25,180 and 25,195 shares issued and outstanding in 2004  and 2005, respectively |       | 25                     |       | 25                  |       |
| Additional paid-in capital                                                                                                                  |       | 315,006                |       | 315,215             |       |
| Accumulated other comprehensive loss                                                                                                        |       | (141                   | )          | (157                | )          |
| Accumulated deficit                                                                                                                         |       | (295,512               | )          | (298,832            | )          |
| Total stockholders’ equity                                                                                                             |       | 19,378                 |       | 16,251              |       |
| Total liabilities and stockholders’ equity                                                                                             |       | $                      | 27,965     |                | $          | 26,556 |   |

 

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

 

3

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**TUT SYSTEMS, INC.**

** **

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

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

**(unaudited)**

 
| ** **                                                               | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                               | ** ** | **2004**                          | ** ** | **2005** | ** ** |
|                                                                     |       |                              |       |   |   |
| Revenue                                                                  |       | $                                 | 6,177      |   | $ | 7,053 |   |
| Cost of goods sold                                                       |       | 5,129                             |       | 4,155 |   |
| Gross profit                                                             |       | 1,048                             |       | 2,898 |   |
| Operating expenses:                                                      |       |                              |       |   |   |
| Sales and marketing                                                      |       | 1,905                             |       | 2,488 |   |
| Research and development                                                 |       | 1,822                             |       | 2,121 |   |
| General and administrative                                               |       | 1,117                             |       | 1,159 |   |
| Impairment of intangible assets                                          |       | 202                               |       | — |   |
| Amortization of intangible assets                                        |       | 396                               |       | 376 |   |
| Total operating expenses                                                 |       | 5,442                             |       | 6,144 |   |
| Loss from operations                                                     |       | (4,394                            | )          | (3,246 | ) |
| Interest and other expense, net                                          |       | (56                               | )          | (74 | ) |
| Net loss                                                                 |       | $                                 | (4,450     | ) | $ | (3,320 | ) |
| Net loss per share, basic and diluted (Note 3)                           |       | $                                 | (0.22      | ) | $ | (0.13 | ) |
| Shares used in computing net loss per share, basic and diluted (Note  3) |       | 20,297                            |       | 25,187 |   |

 

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

 

4

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**TUT SYSTEMS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands)**

**(unaudited)**

 
| ** **                                                                   | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                   | ** ** | **2004**                          | ** ** | **2005** | ** ** |
| Cash flows from operating activities:                                        |       |                              |       |   |   |
| Net loss                                                                     |       | $                                 | (4,450     | ) | $ | (3,320 | ) |
| Adjustments to reconcile net loss to net cash used in operating  activities: |       |                              |       |   |   |
| Depreciation                                                                 |       | 328                               |       | 219 |   |
| Provision for doubtful accounts                                              |       | 13                                |       | 104 |   |
| Provision for excess and obsolete inventory and abandoned products           |       | 974                               |       | 20 |   |
| Impairment of intangible assets                                              |       | 202                               |       | — |   |
| Amortization of intangible assets                                            |       | 396                               |       | 376 |   |
| Non cash compensation                                                        |       | —                            |       | 193 |   |
| Deferred interest on note payable                                            |       | 80                                |       | 76 |   |
| Change in operating assets and liabilities:                                  |       |                              |       |   |   |
| Accounts receivable                                                          |       | 966                               |       | (796 | )  |
| Inventories                                                                  |       | (765                              | )     | 463 |   |
| Prepaid expenses and other assets                                            |       | (608                              | )          | (1,394 | ) |
| Accounts payable and accrued liabilities                                     |       | 1,245                             |       | 1,477 |   |
| Deferred revenue                                                             |       | 115                               |       | 165 |   |
| Net cash used in operating activities                                        |       | (1,504                            | )          | (2,417 | ) |
| Cash flows from investing activities:                                        |       |                              |       |   |   |
| Purchase of property and equipment                                           |       | (684                              | )          | (511 | ) |
| Net cash used in investing activities                                        |       | (684                              | )          | (511 | ) |
| Cash flows from financing activities:                                        |       |                              |       |   |   |
| Proceeds from issuances of common stock                                      |       | 88                                |       | 16 |   |
| Net cash provided by financing activities                                    |       | 88                                |       | 16 |   |
| Net decrease in cash and cash equivalents                                    |       | (2,100                            | )          | (2,912 | ) |
| Cash and cash equivalents, beginning of period                               |       | 14,370                            |       | 12,440 |   |
| Cash and cash equivalents, end of period                                     |       | $                                 | 12,270     |   | $ | 9,528 |   |

* *

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

 

5

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**TUT SYSTEMS, INC.**

** **

**NOTES TOUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

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

** **

**NOTE 1—DESCRIPTION OF BUSINESS:**

** **

The Company designs, develops, and sells digital video processingsystems that enable telephony-based service providers to deliver broadcastquality digital video signals over their networks. The Company also offersvideo processing systems that enable private enterprise and government entitiesto transport video signals over satellite, fiber, radio, or copper networks forsurveillance, distance learning, and TV production applications. The Companyalso designs, develops and markets broadband transport and service managementproducts that enable the provisioning of high speed Internet access and otherbroadband data services over existing copper networks within hotels and privatecampus 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. As a result, the Company’srevenue increased from $9,371 in 2002 to $24,992 in 2004. Video-based productsnow represent a majority of the Company’s sales. 

 

The Company has incurred substantial losses and negative cash flowsfrom operations since inception. For the quarter ended March 31, 2005, theCompany incurred a net loss of $3,320 and negative cash flows from operatingactivities of $2,417, and has an accumulated deficit of $298,832 at March 31,2005. Management believes that its cash and cash equivalents and availabilityunder the credit facility as of March 31, 2005, are sufficient to fundoperating activities and capital expenditure needs for at least the next twelvemonths. However, in the event that the Company does not meet its revenue andearnings expectations, the Company may require additional cash to fundoperations. Failure to generate positive cash flow in the future could have amaterial adverse effect on the Company’s ability to achieve its intendedbusiness objectives.  

 

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

** **

**Basis of presentation**

** **

The accompanying condensed consolidated financialstatements as of December 31, 2004 and March 31, 2005 and for the three monthsended March 31, 2004 and 2005 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 tostate fairly the Company’s financial position as of December 31, 2004 and March31, 2005, its results of operations for the three months ended March 31, 2004and 2005 and its cash flows for the three months ended March 31, 2004 and 2005.These condensed consolidated financial statements and the accompanying notesare unaudited and should be read in conjunction with the Company’s auditedfinancial statements included in the Company’s Annual Report on Form 10-K,filed with the Securities and Exchange Commission on February 3, 2005. Thebalance sheet as of December 31, 2004 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, 2005are not necessarily indicative of the expected results for any other interimperiod or the year ending December 31, 2005.

 

**Revenue recognition**

** **

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

 

*Product revenues*

* *

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

 

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

 

6

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The Company’s revenue recognition policies for turnkey solutions are inaccordance with SOP 97-2, *Software RevenueRecognition*, as amended, which is the authoritative guidance forrecognizing revenue on software transactions and transactions in which softwareis more than incidental to the arrangement. SOP 97-2 requires that revenuerecognized from software arrangements be allocated to each element of thearrangement based on the relative fair values of the elements, such ashardware, software products, maintenance services, installation, training orother elements. Under SOP 97-2, the determination of fair value is based onobjective 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. SOP97-2 was amended in February 1998 by SOP 98-4, *Deferral of the Effective Date of a Provision of SOP 97-2*and was amended again in December 1998 by SOP 98-9, *Modification of SOP 97-2, Software RevenueRecognition, with Respect to Certain Transactions*. Those amendmentsdeferred and then clarified, respectively, the specification of what wasconsidered vendor specific objective evidence of fair value for the variouselements in a multiple element arrangement. 

 

In the case of software arrangements which require significantproduction, modification or customization of software, which encompasses all ofthe Company’s turnkey arrangements, SOP 97-2 refers to the guidance in SOP81-1, *Accounting for Performance ofConstruction-Type and Certain Production-Type Contracts*. The Companyrecognizes revenue for all turnkey arrangements in accordance with SOP 97-2 andSOP 81-1. Excluding the PCS element, for which the Company has establishedvendor specific objective evidence of fair value (as defined by SOP 97-2),revenue from turnkey solutions is generally recognized using thepercentage-of-completion method, as stipulated by SOP 81-1. Thepercentage-of-completion method reflects the portion of the anticipatedcontract revenue that has been earned that is equal to the ratio of labor effortexpended to date to the anticipated final labor effort, based on currentestimates of total labor effort necessary to complete the project. Revenue fromthe PCS element of the arrangement is deferred at the point of sale andrecognized over the term of the PCS period. Generally, the terms of the turnkeysolution sales provide for billing of approximately 90% of the contract valueof the arrangement 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. Thecontractual arrangements relative to turnkey solutions include customeracceptance provisions. However, such provisions are generally considered to be incidentalto the arrangement in its entirety because customers are fully obligated withrespect to approximately 99% of the contract value irrespective of whetheracceptance occurs or not. 

 

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

 

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

 

**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 relatedfirm, non-cancelable and unconditional purchase commitments for estimatedobsolescence or unmarketable inventory equal to the difference between the costof the inventory and the estimated market value based upon assumptions aboutthe future demand and market conditions. If actual future demand or marketconditions are less favorable than those estimated by the Company, additionalinventory provisions may be required. 

 

7

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**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 ofany of the Company’s customers were to deteriorate, resulting in such customer’sinability to make payments, 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. 

 

No impairment was recorded in the three months ended March 31, 2004 or2005.  Future events could cause the Companyto conclude that impairment indicators exist. Any resulting impairment losscould have a material adverse impact on the Company’s financial condition andresults of operations. 

 

**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 (“FIN 44”),“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”), “Accountingfor Stock-Based Compensation, Transition and Disclosure.” Under APB No. 25,compensation expense is based on the difference, if any, on the date of thegrant, between the fair market value of the Company’s stock and the exerciseprice. The Company accounts for stock issued to non-employees in accordancewith the provisions of SFAS No. 148 and the Emerging Issues Task Force (“EITF”)Issue No. 96-18, “Accounting for Equity Instruments that are Issued to otherthan Employees for Acquiring, or in Conjunction with Selling Goods 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,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                                                             | ** ** | **2004**                          | ** ** | **2005** | ** ** |
| Net loss – as reported                                                                                                            |       | $                                 | (4,450     | ) | $ | (3,320 | ) |
| Compensation expense included in net loss                                                                                              |       | —                            |       | 193 |   |
| Total stock-based employee compensation expense determined under a  fair value based method for all grants, net of related tax effects |       | (812                              | )          |  

 

(363 | ) |
| Net loss – pro forma                                                                                                              |       | $                                 | (5,262     | ) | $ | (3,490 | ) |
| Basic and diluted net loss per share – as reported                                                                                |       | $                                 | (0.22      | ) | $ | (0.13 | ) |
| Basic and diluted net loss per share – pro forma                                                                                  |       | $                                 | (0.26      | ) | $ | (0.14 | ) |

 

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 price volatility.The Company uses projected volatility rates, which are based upon historicalvolatility rates trended into future years. Because employee stock options havecharacteristics significantly different from those of traded options, andbecause changes in the subjective input assumptions can materially affect thefair value estimate, in management’s opinion, the 

 

8

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existing models do not necessarily provide a reliablesingle 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 December 2004, the FASB issued SFAS No. 123(R) (revised 2004), “Share-BasedPayment”, which amends FASB Statement No. 123 and will be effective for publiccompanies first fiscal year beginning after June 15, 2005. Thus, the Companywill adopt SFAS(R) on January 1, 2006. The new standard will require theCompany to expense employee stock options and other share-based payments. TheFASB believes the use of a binomial lattice model for option valuation iscapable of more fully reflecting certain characteristics of employee shareoptions compared to the Black-Scholes options pricing model.  The new standardmay be adopted in one of three ways - the modified prospective transitionmethod, a variation of the modified prospective transition method or themodified retrospective transition method. The Company is currently evaluatingthe method of adoption and the effect that the adoption of SFAS 123(R) willhave on its financial position and results of operations. 

 

**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 net loss per share is computed usingthe weighted average number of common shares outstanding. Options were notincluded in the computation of diluted net loss per share because the effectwould be antidilutive.

 

The calculation of net loss per share follows:

 
| ** **                                                               | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                               | ** ** | **2004**                          | ** ** | **2005** | ** ** |
| Net loss per share, basic and diluted:                                   |       |                              |       |   |   |
| Net loss                                                                 |       | $                                 | (4,450     | ) | $ | (3,320 | ) |
| Net loss per share, basic and diluted                                    |       | $                                 | (0.22      | ) | $ | (0.13 | ) |
| Shares used in computing net loss per share, basic and diluted           |       | 20,297                            |       | 25,187 |   |
| Antidilutive securities not included in net loss per share  calculations |       | 4,446                             |       | 4,208 |   |

** **

**NOTE 4—COMPREHENSIVE LOSS:**

** **

Comprehensive loss includes net loss, unrealized gainsand losses on investments, and foreign currency translation adjustments thathave been previously excluded from net loss and reflected instead instockholders’ equity. The following table sets forth the calculation ofcomprehensive loss:

 
| ** **                               | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------------|------------|-----------------------------------|------------|
| ** **                               | ** ** | **2004**                          | ** ** | **2005** | ** ** |
| Net loss                                 |       | $                                 | (4,450     | ) | $ | (3,320 | ) |
| Unrealized gains on investments          |       | 16                                |       | 19 |   |
| Foreign currency translation adjustments |       | (7                                | )          | (3 | ) |
| Net change in other comprehensive loss   |       | 9                                 |       | 16 |   |
| Total comprehensive loss                 |       | $                                 | (4,441     | ) | $ | (3,304 | ) |

 

9

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**NOTE 5—BALANCE SHEET COMPONENTS:**

 
| ** **                                                        | ** ** | **December 31,  2004** | ** ** | **March 31,  2005** | ** ** |
|-------------------------------------------------------------------|------------|------------------------|------------|---------------------|------------|
| Inventories, net:                                                 |       |                   |       |                |       |
| Finished goods                                                    |       | $                      | 5,038      |                | $          | 4,059 |   |
| Raw materials                                                     |       | 184                    |       | 673                 |       |
| Allowance for excess and obsolete inventory and abandoned product |       | (1,228                 | )          | (1,221              | )          |
|                                                              |       | $                      | 3,994      |                | $          | 3,511 |   |
| Property and equipment:                                           |       |                   |       |                |       |
| Computers and software                                            |       | $                      | 1,811      |                | $          | 1,910 |   |
| Test equipment                                                    |       | 3,169                  |       | 3,554               |       |
| Office equipment                                                  |       | 56                     |       | 68                  |       |
|                                                              |       | 5,036                  |       | 5,532               |       |
| Less: accumulated depreciation                                    |       | (3,162                 | )          | (3,366              | )          |
|                                                              |       | $                      | 1,874      |                | $          | 2,166 |   |
| Accrued liabilities:                                              |       |                   |       |                |       |
| Professional Services                                             |       | $                      | 872        |                | $          | 1,416 |   |
| Compensation                                                      |       | 1,164                  |       | 905                 |       |
| Other                                                             |       | 288                    |       | 282                 |       |
|                                                              |       | $                      | 2,324      |                | $          | 2,603 |   |
|                                                                   |            |                        |            |                     |            |  |  |  |  |

 

The Company recorded aprovision for excess inventory within cost of goods sold totaling $974 and $20in the three months ended March 31, 2004 and March 31, 2005, respectively,relating to the costs of raw materials and finished goods in excess of what theCompany reasonably expected to sell in the foreseeable future as of the firstquarter of 2004.  The Company alsoreduced inventory costs to lower of cost or market value for certain inventorycomponents.

 

Intangibleand other assets:

 
|                             |       | **As of December  31, 2004** |       |
|----------------------------------|------------|------------------------------|------------|
| ** **                       | ** ** | **Gross  Carrying  Amount**  | ** ** | **Accumulated  Amortization** | ** ** | **Net  Intangibles** | ** ** |
| Intangible and other assets:     |       |                         |       |   |   |   |   |
| Completed technology and patents |       | $                            | 7,922      |   | $ | (6,460 | ) | $ | 1,462 |   |
| Contract backlog                 |       | 247                          |       | (247 | ) | — |   |
| Customer list                    |       | 86                           |       | (27 | ) | 59 |   |
| Maintenance contract renewals    |       | 50                           |       | (22 | ) | 28 |   |
| Trademarks                       |       | 315                          |       | (97 | ) | 218 |   |
|                             |       | $                            | 8,620      |   | $ | (6,853 | ) | 1,767 |   |
|                             |       |                         |       |   |   |   |   |
| Other non-current assets         |       |                         |       |   |   | 168 |   |
|                             |       |                         |       |   |   | $ | 1,935 |   |

 
|                             |       | **As of  March 31, 2005**   |       |
|----------------------------------|------------|-----------------------------|------------|
| ** **                       | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Intangibles** | ** ** |
| Amortized intangible assets:     |       |                        |       |   |   |   |   |
| Completed technology and patents |       | $                           | 7,922      |   | $ | (6,819 | ) | $ | 1,103 |   |
| Contract backlog                 |       | 247                         |       | (247 | ) | — |   |
| Customer list                    |       | 86                          |       | (30 | ) | 56 |   |
| Maintenance contract renewals    |       | 50                          |       | (24 | ) | 26 |   |
| Trademarks                       |       | 315                         |       | (109 | ) | 206 |   |
|                             |       | $                           | 8,620      |   | $ | (7,229 | ) | 1,391 |   |
|                             |       |                        |       |   |   |   |   |
| Other non-current assets         |       |                        |       |   |   | 147 |   |
|                             |       |                        |       |   |   | $ | 1,538 |   |

 

During the three monthsended March 31, 2004, the Company determined that certain of the technologyacquired as part of the purchase of the Viagate Technologies, Inc. assets inSeptember 2001 had become impaired.  As aresult, the Company incurred a loss of $202 to write-off the technology.

 

The aggregate amortization expense for the threemonths ended March 31, 2004 and 2005 was $396 and $376, respectively.

 

10

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Minimum future amortization expense as of March 31,2005 is as follows:

 
| Remainder of 2005 |   | $   | 498    |   |
|-------------------|--------|-----|--------|--------|
| 2006              |   | 424 |   |
| 2007              |   | 363 |   |
| 2008              |   | 57  |   |
| Thereafter        |   | 49  |   |
|              |   | $   | 1,391  |   |

 

**NOTE 6 – INDEBTEDNESS**

** **

### ***Line of Credit***

### *** ***

OnSeptember 23, 2004, the Company entered into a revolving asset basedcredit facility (“credit facility”), with Silicon Valley Bank (“the Bank”).This facility has a term of two years and expires on September 23, 2006.  Borrowings under the credit facility are formula based and limited to thelesser of $7.0 million or an amount based on a percentage of eligible accountsreceivable and eligible inventories.    The interest rate on outstanding borrowingsis equal to the bank’s prime rate, 5.75% as of March 31, 2005, plus 0.5%. Therate may increase by 1.0% if the Company does not meet certain financialcovenants. The credit facility is collateralized by all of the Company’sassets, and contains various covenants. Based on the maximum percentages of eligible accounts receivable andeligible inventory levels, available borrowings under this facility were $4,661as of March 31, 2005. The Company had no outstanding borrowings under thiscredit facility at March 31, 2005.

 

#### ***Note Payable***

#### *** ***

As part of the Company’s acquisition of VTC from Tektronix, Inc.in November 2002, the Company issued a note payable toTektronix, Inc. for $3,232, with repayment in sixty months, orNovember 2007. The interest rate on this note is 8% and is compoundedannually. Through January 31, 2006, the accrued interest is added to theprincipal balance of the note. Thereafter, the Company 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 due in full in November 2007. As of December 31, 2004 and March31, 2005, this note payable balance, including accrued interest, was $3,816 and$3,892, respectively. 

 

**NOTE 7—COMMITMENTS AND CONTINGENCIES:**

** **

*Lease obligations*

* *

The Company leases equipment and office, assembly andwarehouse space under non-cancelable operating leases that expire from 2005through 2007.

 

Minimum future lease payments under operating leasesas of March 31, 2005 are as follows:

 
| Remainder of 2005 |   | $  | 459    |   |
|-------------------|--------|----|--------|--------|
| 2006              |   | 52 |   |
| Thereafter        |   | 27 |   |
|              |   | $  | 538    |   |

 

*Purchase commitments*

* *

The Company had non-cancelable commitments to purchasefinished goods inventory totaling $469 and $1,112 in aggregate at December 31,2004 and March 31, 2005, respectively.

 

*Contingencies*

* *

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

*** ***

On October 30,2001, the Company and certain of its current and former officers and directorswere named as defendants in *Whalen v. TutSystems, Inc. et al.,*Case No. 01-CV-9563, a purported securitiesclass action lawsuit filed in the United States District Court for the SouthernDistrict of New York. An amended complaint was filed on December 5, 2001. Aconsolidated amended complaint was filed on April 19, 2002. The consolidatedamended complaint asserts that the prospectuses from the Company’s January 29,1999 initial public offering and its March 23, 2000 secondary offering failedto disclose certain alleged actions by the underwriters for the offerings. Thecomplaint alleges claims against the Company and certain of its current andformer officers and 

 

11

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directors under Section 11 of the Securities Act of 1933, as amended,and under Section 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. Thecomplaint also names as defendants the underwriters for the Company’s initialpublic offering and secondary offering. Similar suits were filed in the Southern District of New Yorkchallenging over 300 other initial public offerings and secondary offeringsconducted in 1999 and 2000.  Therefore,for pretrial purposes, the *Whalen*action is being coordinated with the approximately 300 other suits beforeUnited States District Court Judge Shira Scheindlin of the Southern District ofNew York under the matter *In Re InitialPublic Offering Securities Litigation. *Theindividual defendants in the *Whalen*action, namely, Nelson Caldwell, Salvatore D ‘Auria and Matthew Taylor, weredismissed without prejudice by an October 9, 2002 Order of the Court, approvingthe parties’ October 1, 2002 Stipulation of Dismissal.  On February 19, 2003, the Court issued anOpinion and Order denying the Company’s motion to dismiss.

 

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

 

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

 

In the event that all or substantially all of the issuer-defendantsparticipate in the final settlement, the amount that may be paid to theplaintiffs on behalf of the Company could range from zero to approximately $3.5million, depending on plaintiffs’ recovery from the underwriter-defendants andfrom other non-settling parties.  If theplaintiffs recover at least $1 billion from the underwriter-defendants, nosettlement payments would be made on behalf of the Company under the proposedterms of the settlement.  If theplaintiffs recover less than $1 billion, the Company believes that 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 theCompany will ultimately be required to pay, if any, as of March 31, 2005, theCompany has not accrued a liability for this matter.

 

**NOTE 8—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. Revenue related to videoprocessing systems was $4,241 and $5,911 for the three months ended March 31,2004 and 2005, respectively. Revenue relating to the broadband transport andservice management products was $1,936 and $1,142 for the three months endedMarch 31 2004 and 2005, respectively. Revenues are attributed to the followingcountries based on the location of customers: 

 
| ** **          | ** ** | **Three Months Ended  March 31,** | ** ** |
|---------------------|------------|-----------------------------------|------------|
| ** **          | ** ** | **2004**                          | ** ** | **2005** | ** ** |
| United States       |       | $                                 | 5,488      |   | $ | 5,786 |   |
| International:      |       |                              |       |   |   |
| Canada              |       | 299                               |       | 384 |   |
| Ireland             |       | 145                               |       | 281 |   |
| China               |       | 2                                 |       | 208 |   |
| Japan               |       | 123                               |       | 102 |   |
| All other countries |       | 120                               |       | 292 |   |
|                |       | $                                 | 6,177      |   | $ | 7,053 |   |

 

Two customers, FTC Management Inc. and Major LeagueBaseball Advanced Media accounted for 23% and 11%, respectively of the Company’srevenue for the three months ended March 31, 2005.  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

 

12

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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.

 

**NOTE 9—PENDING ACQUISITIONS**

** **

On January 7, 2005, the Company entered into anAgreement and Plan of Merger with CoSine Communications, Inc., (“CoSine”).  The proposed merger is a stock-for-stocktransaction valued at approximately $24,100, at the time it was enteredinto.  By the terms of the agreement,upon closing, the Company would issue approximately 6.0 million shares of itscommon stock to the shareholders of CoSine. The transaction would result in net cash to the Company of approximately$22,750, and is expected to close as soon as practicable following approval bythe stockholders of both companies.  TheCompany is proposing to acquire CoSine primarily to provide additionalfinancial resources.  Upon closing, theCompany plans to honor CoSine’s existing customers’ support agreements, butdoes not expect to offer its products for sale to new customers.  The Company will not have any additionalemployees or facilities as a result of the transaction.

 

The CoSine merger isconditional upon approval of the merger by the holders of a majority of theshares of CoSine common stock, and approval of the issuance of additionalshares of common stock by the holders of a majority of the shares of TutSystems common stock, as well as other customary closing conditions.   Therecan be no assurance that the CoSine merger will be approved by the requiredvote of the respective companys’ stockholders.

 

On February 11, 2005 the Company entered into an Agreement andPlan of Merger and Reorganization with Copper Mountain Networks, Inc. (“*Copper Mountain*”). The proposed mergerwill be a stock-for-stock transaction valued at approximately $10 million.Upon closing the Copper Mountain transaction, the Company will issueapproximately 2.5 million shares of its common stock to the stockholdersof Copper Mountain. The Copper Mountain transaction is conditioned upon theapproval of the merger by the holders of a majority of the shares of CopperMountain common stock, and other customary closing conditions.  The transaction is expected to close in thesecond quarter of 2005.  The Company isacquiring Copper Mountain to expand and upgrade the Company’s line of videoprocessing products. The Company will honor Copper Mountain’s existing customersupport agreements, but does not expect to offer any of Copper Mountain’sexisting products for sale after the completion of the transaction. The Companywill have approximately 40 additional employees and will add a research anddevelopment facility in San Diego, California as a result of the transaction.

 

13

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**ITEM 2****.    MANAGEMENT’SDISCUSSION AND ANALYSIS 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 negative of theseterms or similar expressions are generally intended to identify forward-lookingstatements. We have based these forward-looking statements on our currentexpectations and projections about future events. Such forward-lookingstatements are subject to various risks and uncertainties that could causeactual results to differ materially from those projected in such statements.Readers are cautioned not to place undue reliance on these forward-lookingstatements, which speak only as of the date hereof. The forward-lookingstatements contained in this quarterly report include statements about thefollowing: (1) our belief that video products will provide most of ourgrowth opportunities for the foreseeable future, (2) our belief that thenumber of telco video subscribers will grow significantly between 2004 and 2007and that this market space will continue to become more competitive,(3) our expectation that we will compete with larger public companies aswe begin to target larger telco customers, (4) our expectation thatdigital subscriber line or DSL technology will continue to dominate telcobroadband networks for the foreseeable future, (5) our expectation that demandfor our products will increase, (6) our expectation that our sales andmarketing expenses will increase for the remainder of 2005, (7) our expectationthat sales of broadband transport and service management products will remainunchanged until new product introductions in 2005 (8) our expectation thatcapital expenditures for research and development will increase in 2005, (9)our expectation that capital expenditures in 2005 will increase compared to2004 and that these capital expenditures will be funded from cash, cashequivalents and availability under the credit facility, (10) our beliefthat our cash and cash equivalents and availability under the credit facilityas of March 31, 2005 are sufficient to fund our operating activities andcapital expenditure needs for the next twelve months, (11) our expectationthat the CoSine transaction will result in net cash to us of $22.75million  (12) our expectation that theCosine transaction will close as soon as practicable following approval by theshareholders of both companies, (13) our expectation that the shareholders ofCopper Mountain will approve the merger with the company, (14) our expectationthat we 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.*

* *

*The cautionary statements containedunder the caption**“Additional Risk Factors that Could AffectOur Operating Results and the Market Price of Our Stock” and other similarstatements contained elsewhere in this report, identify important factors withrespect to such forward-looking statements, including certain risks anduncertainties that could cause our actual results, performance or achievementsexpressed 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.*

 

**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. With our November 2002acquisition of Tektronix’s subsidiary VTC, we extended our product offerings toadd video processing systems for digital TV headends and for the transmissionof video signals over private and government networks. The acquisition of VTCresulted in significant changes in our business, including: (1) changes inour organizational structure and employee staffing; (2) relocation of our 

 

14

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administrative offices, executive offices (as of January 2004) anda significant portion of our operations from Pleasanton, California to LakeOswego, Oregon, the prior headquarters of VTC; (3) an expansion of oursales and marketing efforts to include VTC products; and (4) areprioritization of our research and development efforts to focus on productsassociated with VTC product lines. With our acquisition of VTC, sales of videoprocessing systems now represent a majority of our total revenues and willprovide most of our growth opportunities in the foreseeable future. 

 

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. 

 

Although international sales are still a material portion of our totalsales, since our acquisition of VTC, international sales have represented asmaller percentage of our overall business relative to prior years. During theyears ended December 31, 2002, 2003 and 2004, international sales represented43.0%, 18.4% and 23.3% of our total sales.  During the three months ended March 31, 2004 and 2005, internationalsales represented 11.2% and 18.0% of our total sales, respectively.

 

*Material Trends and Uncertainties*

* *

We pay close attention to and monitor various trends and uncertaintiesabout our business. There is a growing demand by independent operatingtelephone companies to offer video services to their customer base. Accordingto a report released by InStat/MDR in April 2003, the number of telco videosubscribers worldwide will increase from 572,000 at the end of 2003 to over19.0 million by the end of 2007. While this growing market presentsopportunities to serve a larger customer base, we are also seeing the emergenceof intense competition as more companies compete to sell digital TV headendproducts. We expect this market space will continue to become more competitivein the future. Our immediate competitors in the digital TV headend markets areprimarily small private companies that are focused on a more narrow productline than ours and thereby may be able to devote substantially more targetedresources to developing, marketing and selling new products than we are ableto. In addition, these companies may become targets for acquisition by largercompanies, in which case we would face competitors with substantially greatername recognition, and technical, financial and marketing resources than wehave. This increased competitive pressure may adversely affect the amount andtiming of our revenue in future periods, thereby making it more difficult forus to accurately forecast our future revenue, and may also adversely affect ourproduct and service margins. 

 

The growth in the market for delivery of switched digital video hasbegun to accelerate as larger tier one telcos and cable multi system operators,or MSOs, are evaluating this new technology. As we begin to target larger telco customers, we expect to compete withlarger public companies, including Harmonic, Motorola and Tandberg Television.

 

The emergence of new technologies to serve the digital TV headendmarket means that we must continue to invest in these new technologies tomaintain our market position. Digital subscriber line, or DSL, technologies usesophisticated signal blending techniques to transmit data through copper wires.The limitations on the amount of data that can be transmitted in a fixed amountof time (such limitations are referred to as bandwidth) and the distance datamay be transmitted using copper wire constrain both the number of videochannels that may be delivered simultaneously and the number of customers thatare reachable from a telco central office over a DSL network. Emergingadvancements in video compression technology are now enabling high qualityvideo streams to be transported at lower data transfer rates than has beenpreviously available. These emerging compression advancements also introducethe possibility of delivering high-definition television over bandwidthconstrained asymmetric DSL, or ADSL, lines for the first time. ADSL is a newtechnology that allows more data to be transmitted over existing coppertelephone lines compared with standard DSL. Additionally, DSL advancements areemerging that expand the available bandwidth from the telco to the subscriberthereby supporting higher DSL data transfer rates over longer distances. As ourproducts continue to incorporate these new technological advancements, weexpect the demand for our products will increase because our products willenable more telcos to reach more of their customers with a greater number ofvideo channels. However, because of the increasing competition in the marketsin which we compete, regardless of our revenue and product and service marginsin future periods, we will have to continue to devote significant resources toresearch and development in future periods in order to continue to offer ourcustomers competitive products that incorporate these emerging technologies. Asa consequence, we expect that our research and development expenses willincrease for the remainder of 2005 compared to our spending in 2004. 

 

As we continue to capitalize on the growing number of telcos deployingvideo services in the United States and abroad, we will also have to continueto aggressively market our new and existing products and expand our marketingand sales efforts domestically and internationally. Nevertheless, ouroperations have been and will continue to be subject to pressure from weaknessin the overall technology sector as well as the digital media industry, thecontinued lengthening of our sales cycle and delays of customer purchasingdecisions, which may continue to reduce our expected revenue.  We believe that the lengthening of thepurchase decision by prospective customers has occurred and may continuebecause of several factors that are affecting the overall digital TV headendmarket. Such factors 

 

15

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include, but are not limited to, the delays in the introduction ofadvanced compression technology set top boxes, the transition to more efficientdata transmission technologies and the emergence of video signal encryptionrequirements. Nevertheless, given the opportunities offered by the growingnumber of telcos deploying video services and despite the length of the salescycle, we expect our sales and marketing expenses to increase for the remainderof 2005 compared to our spending in 2004. 

 

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

*** ***

Our discussion of our results of operations focuses on the followingitems from our income statement: Revenue consists of sales of our videoprocessing systems, which includes both digital TV headend and videotransmission systems. Revenue also includes sales of our broadband transportand service management products. Since our acquisition of VTC, a large part ofour revenue has been associated with the sale of digital TV headends.Furthermore, each individual headend sale has represented a significant portionof our revenue. If we were to sell even one less system than our forecastednumber of headend sales, our revenue would be materially impacted. Cost ofgoods sold, or COGS, consists of costs related to raw materials, contractmanufacturing, personnel, overhead, test and quality assurance for products,and the cost of licensed technology included in our products. Raw materials,contract manufacturing and licensed technology are the principal elements ofCOGS and vary directly with product sales. Sales and marketing expense consistsprimarily of selling and marketing personnel costs, including salescommissions, travel, trade shows, promotions and outside services. Research anddevelopment expense consists primarily of personnel and facilities costs,contract consultants, outside testing services, and equipment and suppliesassociated with enhancing existing products and developing new products.General and administrative expense consists primarily of personnel costs foradministrative officers and support personnel, professional services andinsurance expenses. Amortization of intangible assets consists primarily ofexpenses associated with the amortization of technology and patents related toprior 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,** | ** ** |
|-----------------------------------|------------|-----------------------------------|------------|
| ** **                        | ** ** | **2004**                          | ** ** | **2005** | ** ** |
| Total revenues                    |       | 100.0                             | %          | 100.0 | % |
| Cost of goods sold                |       | 83.0                              |       | 58.9 |   |
| Gross profit (loss)               |       | 17.0                              |       | 41.1 |   |
| Operating expenses:               |       |                              |       |   |   |
| Sales and marketing               |       | 30.8                              |       | 35.3 |   |
| Research and development          |       | 29.5                              |       | 30.1 |   |
| General and administrative        |       | 18.1                              |       | 16.4 |   |
| Impairment of intangible assets   |       | 3.3                               |       | — |   |
| Amortization of intangible assets |       | 6.4                               |       | 5.3 |   |
| Total operating expenses          |       | 88.1                              |       | 87.1 |   |
| Loss from operations              |       | (71.1                             | )          | (46.0 | ) |
| Interest and other income, net    |       | (0.9                              | )          | (1.1 | ) |
| Net loss                          |       | (72.0                             | )%         | (47.1 | )% |

 

*Three Months Ended March 31, 2004and 2005*

* *

*Total Revenues.*  For the three months ended March 31, 2005,our total revenues increased by 14.2% to $7.1 million from$6.2 million for the three months ended March 31, 2004. This$0.9 million increase in product revenue was due primarily to theintroduction of our upgraded Astria video processing systems that incorporaterecent Motion Pictures Experts Group (MPEG) advanced video compressiontechnologies or MPEG-4.  Our upgradedAstria products enable our customers toaddress a larger percentage of their geographic market and deliver advancedvideo services.  Sales of videoprocessing system products increased from $4.2 million in the first quarter of2004 to $5.9 million in the first quarter of 2005. Sales of broadband transportand service management products decreased from $1.9 million in the firstquarter of 2004 to $1.1 million in the first quarter of 2005.  Thedecrease in broadband transport and service management products revenue wasprimarily the result of customers choosing competing products that transmitdata via wireless data transmission technologies instead of our products whichtransmit data over telephone wires. In future quarters, we expect sales ofbroadband transport and service management products to remain the same as ourfirst quarter sales until the expected introductions of next generation servicemanagement products for the multiple dwelling unit and enterprise market duringthe second half of 2005.

 

*Cost of Goods Sold.*  For the three months ended March 31, 2005,our cost of goods sold decreased by $1.0 million to $4.2 million from$5.1 million for the three months ended March 31, 2004. Included in thecost of goods sold for the three months 

 

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ended March 31, 2004 was a $1.0 million increase in our reserves forobsolete inventory and a lower of cost or market adjustment for certain inventorycomponents.  Our gross profit increasedby $1.9 million to $2.9 million for the three months ended March 31, 2005 from$1.0 million for the three months ended March 31, 2004.  Included in gross profit during the firstquarter of 2004 was a charge of $1.0 million due to an increase in ourinventory reserves.  The remaining $0.9increase in gross profit for the first quarter of 2005 was due to an increaseof $1.4 million relating to our video content processing products, partiallyoffset by a decrease of $0.5 million attributable to our broadband transportand service management products.

 

*Sales and Marketing.*  For the three months ended March 31, 2005,our sales and marketing expenses increased by 30.6% to $2.5 million from $1.9million for the three months ended March 31, 2004.  The $0.6 million increase for the firstquarter of 2005 when compared with the same period in 2004 was due to $0.5million of personnel related costs, and $0.1 million of equipment costsrelating to the purchase of additional supplies and demonstration supplies.

 

*Research and Development.*  For the three months ended March 31, 2005,our research and development expense increased by 16.4% to $2.1 millionfrom $1.8 million for the three months ended March 31, 2004. The$0.3 million increase in our research and development expense for thefirst quarter of 2005 when compared with the same period in 2004 was due to anincrease of $0.2 million in personnel related costs, $0.2 million inpurchasing of supplies related to the acceleration of the development of ourAstria Video Services Processor for specific customer trials anddemonstrations, partially offset by a decrease of $0.1 million in depreciationcosts. We expect that our research and development expenses will increasethroughout the remainder of 2005. Our capital expenditures for research anddevelopment were $0.3 million and $0.2 million for the three months endedMarch 31, 2005 and 2004, respectively. We expect capital expenditures forresearch and development to increase in 2005.

 

*General and Administrative.*  For the three months ended March 31, 2005,our general and administrative expenses increased to by 3.8% to $1.2 millionfrom $1.1 million. The $0.1 million increase in our general andadministrative expense for the first quarter of 2005 when compared with thesame period in 2004 was due primarily to an increase in bad debt expense of$0.1 million.

 

*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, 2005.

 

*Amortization of Intangible Assets.*  Amortization of intangible assets iscomprised of intangibles related to the acquisitions of Xstreamis Limited in2000, and VTC in 2002. The remaining intangible assets subject to amortizationfrom these acquisitions consist primarily of completed technology and patents.For the three months ended March 31, 2005 and March 31, 2004, amortization ofintangible assets remained consistent at $0.4 million.  

 

*Interest and Other Expense, 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, 2005 and March 31, 2004, ourinterest and other income remained consistent at $0.1 million.

 

**Liquidity and Capital Resources**

** **

Cash and cash equivalents totaled $9.5 million at March 31, 2005,compared with cash and cash equivalents of $12.4 million at December 31,2004, reflecting a net reduction in cash and cash equivalents of$2.9 million.

 

Cash used in operating activities was $2.4 million for the threemonths ended March 31, 2005, compared with $1.5 million for the threemonths ended March 31, 2004. The increased cash used in operating activitieswas primarily due to an increase in accounts receivable due to higher revenuelevels in the first quarter of 2005, an increase in prepaid expenses due tocosts incurred in conjunction with CoSine and Copper Mountain merger activitiesoffset by an increase in accounts payable and accrued liabilities due to anincrease in end of quarter purchases.  

 

Additions to property and equipment were $0.5 million in the firstquarter of 2005, compared with $0.7 million in the first quarter of 2004.In 2005 we expect capital expenditures to increase. We expect these capitalexpenditures to be funded from cash, cash equivalents and availability underthe credit facility.

 

*Contractual Obligations*

* *

The following table sets forth our contractual obligations as of March31, 2005:

 
| ** **                                      | ** ** | **Payments due by period** | ** ** |
|-------------------------------------------------|------------|----------------------------|------------|
| **Contractual  Obligations**                    | ** ** | **Total**                  | ** ** | **Remainder  of 2005** | ** ** | **2006  to  2007** | ** ** | **2007  to  2008** | ** ** | **Thereafter** | ** ** |
| Long-Term Debt Obligations, including  interest |       | $                          | 4,185      |   | $ | — |   | $ | — |   | $ | 4,185 |   | $ | — |   |
| Operating Lease Obligations                     |       | 538                        |       | 459 |   | 52 |   | 27 |   | — |   |
| Purchase Obligations                            |       | 1,112                      |       | 1,112 |   | — |   | — |   | — |   |
| Total                                           |       | $                          | 5,835      |   | $ | 1,571 |   | $ | 52 |   | $ | 4,212 |   | $ | — |   |

 

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We do not have any off balance sheet arrangements.

 

OnSeptember 23, 2004, we entered into a revolving asset based credit facility (“creditfacility”), with Silicon Valley Bank (“the Bank”). This facility has a term oftwo years and expires on September 23, 2006.   Borrowings under the creditfacility are formula based and limited to the lesser of $7.0 million or anamount based on a percentage of eligible accounts receivable and eligibleinventories. The interest rate on outstanding borrowings is equal to thebank’s prime rate, 5.75% as of March 31, 2005, plus 0.5%. The rate may increaseby 1.0% if we do not meet certain financial covenants. The credit facility iscollateralized by all of our assets, and contains various covenants.  Based on the maximum percentages of eligibleaccounts receivable and eligible inventory levels, borrowings available underthis facility were $4.7 million as of March 31, 2005. We had no outstandingborrowings under this credit facility at March 31, 2005.

 

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 in November 2007. Principal and accrued interest on thenote payable is $3.9 million at March 31, 2005.  Accrued interest during the first quarter of2005 was $0.1 million.

 

In order to obtain additional financial resources, weentered into an Agreement and Plan of Merger with CoSine Communications, Inc.,(“CoSine”) on January 7, 2005.  Theproposed merger is a stock-for-stock transaction valued at approximately $24.1million, at the time it was entered into. By the terms of the agreement, upon closing, we would issue approximately6.0 million shares of our common stock to the stockholders of CoSine.  The transaction would result in net cash toTut Systems of approximately $22.75 million, and the transaction is expected toclose as soon as practicable following approval by the stockholders of bothcompanies. We are proposing to acquire CoSine primarily to provide additionalfinancial liquidity.  Upon closing, weplan to honor CoSine’s existing customers’ support agreements, but do notexpect to offer its products for sale to new customers.  We will not have any additional employees orfacilities as a result of the transaction.

 

The CoSine merger is conditionalupon approval of the merger by the holders of a majority of the shares ofCoSine common stock, and approval of the issuance of additional shares ofcommon stock by the holders of a majority of the shares of Tut Systems commonstock, as well as other customary closing conditions.  There can be no assurance that the CoSinemerger will be approved by the required vote of the respective companys’stockholders.

 

On February 11, 2005 we entered into an Agreement and Plan ofMerger and Reorganization with Copper Mountain Networks, Inc. (“*Copper Mountain*”). The proposed mergerwill be a stock-for-stock transaction valued at approximately $10 million.Upon closing the Copper Mountain transaction, we will issue approximately2.5 million shares of our common stock to the stockholders of CopperMountain. The Copper Mountain transaction is conditioned upon the approval ofthe merger by the holders of a majority of the shares of Copper Mountain commonstock, and other customary closing conditions. We are acquiring CopperMountain to expand and upgrade our line of video processing products. We willhonor Copper Mountain’s existing customer support agreements, but do not expectto offer any of Copper Mountain’s existing products for sale after thecompletion of the transaction. We will have approximately 41 additionalemployees and will add a research and development facility in San Diego,California as a result of the transaction.

 

We have incurred substantial losses and negative cash flows fromoperations since inception. For the three months ended March 31, 2005, weincurred a net loss of $3.3 million, negative cash flows from operatingactivities of $2.4 million, and have an accumulated deficit of$298.8 million.

 

We believe that the cash and cash equivalents and availability underthe credit facility as of March 31, 2005, are sufficient to fund our operatingactivities and capital expenditure needs for at least the next twelvemonths.  However, in the event thatgeneral economic conditions worsen, we may require additional cash to fund ouroperations. Failure to generate positive cash flow in the future could have amaterial adverse effect on our ability to achieve our intended businessobjectives.

 

**Critical Accounting Policies and Estimates**

** **

Our discussion and analysis of our financial condition and results ofoperations are based upon our consolidated financial statements, which have beenprepared in accordance with generally accepted accounting principles in theUnited States. The preparation of these financial statements requires us tomake estimates and assumptions that affect the reported amounts of assets andliabilities, the disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenue and expenses

 

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during 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, *Software RevenueRecognition,* as amended, which is the authoritative guidance forrecognizing revenue on software transactions and transactions in which softwareis more than incidental to the arrangement. SOP 97-2 requires that revenuerecognized from software arrangements be allocated to each element of thearrangement based on the relative fair values of the elements, such ashardware, software products, maintenance services, installation, training orother elements. Under SOP 97-2, the determination of fair value is based onobjective 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. SOP97-2 was amended in February 1998 by SOP 98-4, *Deferral of the Effective Date of a Provision of SOP 97-2*and was amended again in December 1998 by SOP 98-9, *Modification of SOP 97-2, Software RevenueRecognition, with Respect to Certain Transactions*. Those amendmentsdeferred and then clarified, respectively, the specification of what wasconsidered vendor specific objective evidence of fair value for the variouselements in a multiple element arrangement. 

 

In the case of software arrangements that require significantproduction, modification or customization of software, which encompasses all ofour turnkey arrangements, SOP 97-2 refers to the guidance in SOP 81-1, *Accounting for Performance of Construction-Type andCertain Production-Type Contracts.* We recognize revenue for allturnkey arrangements in accordance with SOP 97-2 and SOP 81-1. Excluding thePCS element of the multi-element arrangement, for which we have establishedvendor specific objective evidence of fair value (as defined by SOP 97-2),revenue from turnkey solutions is generally recognized using thepercentage-of-completion method, as stipulated by SOP 81-1. Thepercentage-of-completion method reflects the portion of the anticipatedcontract revenue that has been earned that is equal to the ratio of laboreffort expended to date to the anticipated final labor effort, based on currentestimates of total labor effort necessary to complete the project. Revenue fromthe PCS element of the arrangement is deferred at the point of sale andrecognized over the term of the PCS period. Generally, the terms of the turnkeysolution sales provide for billing of approximately 90% of the contract valueprior to the time of delivery to the customer site, with an additionalapproximately 9% of the contract value billed upon substantial completion ofthe project and the balance upon customer acceptance. The contractualarrangements relative to turnkey solutions include customer acceptanceprovisions. However, such provisions are generally considered to be incidentalto the arrangement in its entirety because customers are fully obligated withrespect to approximately 99% of the contract value irrespective of whetheracceptance 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, includingspecific contract and purchase order terms, completion and timing of deliveryto 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. Management’sjudgment of collectibility is applied on a customer-by-customer basis pursuantto our credit review policy. We sell to customers with a history of successfulcollection and to new customers for which such history may not 

 

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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 only increased 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 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 costsare based on historical experience and are recorded at the time revenue isrecognized, as necessary. Our products generally carry a one-year warranty fromthe date of purchase. To date, warranty costs have been insignificant to theoverall financial statements taken as a whole. 

 

*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 firm, non-cancelable and unconditional purchasecommitments for estimated obsolescence or unmarketable inventory equal to thedifference between the cost of the inventory and the estimated market valuebased upon assumptions about the future demand and market conditions. If actualfuture demand or market conditions are less favorable than we estimate,additional inventory provisions may be required. 

 

**Recent Accounting Pronouncements**

** **

In December 2004, the FASB issued SFAS No. 123(R) (revised 2004), “Share-BasedPayment”, which amends FASB Statement No. 123 and will be effective for publiccompanies for first fiscal years beginning after June 15, 2005. We will adoptSFAS 123(R) on January 1, 2006. The new standard will require us to expenseemployee stock options and other share-based payments. The FASB believes theuse of a binomial lattice model for option valuation is capable of more fullyreflecting certain characteristics of employee share options compared to theBlack-Scholes options pricing model.  The new standard may be adopted inone of three ways - the modified prospective transition method, a variation ofthe modified prospective transition method or the modified retrospectivetransition method. We are currently evaluating how we will adopt the standardand evaluating the effect that the adoption of SFAS 123(R) will have on ourfinancial position and results of operations. 

 

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**ADDITIONAL RISK FACTORS THAT COULDAFFECT OUR OPERATING RESULTS 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, 2005, we had anaccumulated deficit of $298.8 million. We expect to incur losses in thenear future. Moreover, we may never achieve profitability and, if we do so, wemay not be able to maintain profitability. We may not be able to generate asufficient level of revenue to offset our current level of expenditures.Moreover, because our expenditures for sales and marketing, research anddevelopment, and general and administrative functions are relatively fixed inthe short term, we may be unable to adjust our spending in a timely manner torespond to any unanticipated decline in revenue. If we fail to achieveprofitability within the timeframe expected by securities analysts orinvestors, then the market price of our common stock will likely decline. 

 

**Each sale of our digital headend systems representsa significant portion of our revenue for any given quarter. Our failure to meetour quarterly forecast of sales of digital headend systems in any given quartercould have a material adverse impact on our financial results for a givenquarter.**

** **

Since we acquired VTC in November 2002, a large part of ourquarterly revenue is associated with the sale of digital headend systems. Eachsale represents a significant portion of our revenue for each quarter. We baseour operating forecast on our historical sales. Because of the high cost perunit of our digital headend systems, if we were to sell even one less systemthan our forecasted number of headend sales per quarter, such a decrease insales would have a material and adverse impact on our revenue for that quarter,and we may fail to meet investor expectations. 

 

**We operate in an intensely competitivemarketplace, and many of our competitors have greater 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 targetlarger telco customers for our video content processing systems, we expect morecompetition from large public companies like Harmonic, Inc., TandbergTelevision ASA, and Motorola, Inc., all of which have substantiallygreater financial, technical and other resources than we do. These competitorshave achieved success in providing headend components for cable multiple systemoperators and satellite TV providers and, we expect these competitors to marketsome of their products for use in TV over DSL applications. For example, in thepast, Harmonic provided video content processing systems to SaskTel, a largeCanadian telephone service provider. Harmonic also recently announced that itwill provide video content processing systems to Video Networks Limited, avideo-over-DSL provider in the United Kingdom. 

 

Our competition in the market for video transmission processingproducts primarily comes from small private companies such as SkyStreamNetworks and public companies such as Optibase Inc. and 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 downwardpressure on our pricing, either of which would adversely affect our revenue andprofitability. 

 

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

** **

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

 

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**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 of maintainingand growing their market share in their core business that do not require thatthey offer video services, demand for our products will decrease substantially.Moreover, if technological advancements are developed that allow our customersto 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. 

 

**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 have fluctuated betweenapproximately 5.2% and 691% of revenue. We anticipate that our sales andoperating margins will continue to fluctuate. We expect this fluctuation tocontinue for a variety of reasons, including: the timing of customers’ purchasedecisions, acceptance of our new products and possible cancellations;competitive pressures, including pricing pressures from our partners andcompetitors; delays or problems in the introduction of our new products;announcements of new products, services or technological innovations by us orour competitors; and management of inventory levels. Fluctuations in our salesand operating margins will make it more difficult for us to accurately forecastour results of operations and this could negatively impact the market price ofour stock.

 

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

** **

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

 

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

 

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

** **

We rely on contract manufacturers and third-party equipment manufacturers,or OEMs, to manufacture, assemble, test and package our products. We alsodepend on third-party suppliers for the materials and parts that constitute ourproducts. Our reliance on contract manufacturers, OEMs and third-partysuppliers requires us to accurately forecast the demand for our products andcoordinate our efforts with those of our contract manufacturers, OEMs andsuppliers. We often make significant up-front financial commitments with ourcontract manufacturers, OEMs and suppliers in order to procure the rawmaterials and begin manufacturing and assembly of the products. If we fail toaccurately forecast demand or coordinate our efforts with our suppliers,OEMs and contract manufacturers, we may face supply, manufacturing ortesting capacity constraints. These constraints could result in delays in thedelivery of our products, which could lead to the loss of existing or potentialcustomers and could thereby result in lost sales and damage to our reputation,which would adversely affect our revenue and profitability. Further, weoutsource the manufacturing of our products based on forecasts of sales. Iforders for our products exceed our forecasts, we may have difficulty meetingcustomers’ orders in a timely manner, which could damage our reputation orresult in lost sales. Conversely, if our forecasts exceed the orders weactually receive and we are unable to cancel future purchase and manufacturingcommitments in a timely manner, our inventory levels would increase. This couldexpose us to losses related to slow moving and obsolete inventory, which wouldhave a material adverse effect on our profitability. 

 

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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 asymmetric digital subscriber lines, or ADSL, for the firsttime. ADSL is a new technology that allows more data to be transmitted overcopper telephone lines than standard DSL. Further advances in compressiontechnology, or the emergence of new industry standards would require that wefurther redesign our products to incorporate, and remain compatible with,emerging technologies and industry standards. 

 

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 offerproducts and services similar or superior to our products. If we fail tointroduce new products that address technological changes or if we experiencedelays in our product introductions, our ability to compete would be adverselyaffected, 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 11.2% and 18.0% of revenue for the three months ended March 31,2004 and 2005, respectively. Sales and operating activities outside of theUnited States are subject to inherent risks, including fluctuations in thevalue of the United States dollar relative to foreign currencies; tariffs,quotas, taxes and other market barriers; political and economic instability;restrictions on the export or import of technology; potentially limitedintellectual property protection; difficulties in staffing and managinginternational operations and potentially adverse tax consequences. Any of thesefactors may have a material adverse effect on our ability to grow or maintaininternational revenue. 

 

We expect sales to customers outside of the United States to representa significant and growing portion of our revenue. However, we cannot assure youforeign markets for our products will develop at the rate or to the extent thatwe 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 partsin a timely 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 ofour products and to purchase most of the raw materials and components used inour products. Additionally, we depend on third-party suppliers to providequality parts and materials to our contract manufacturers and OEMs, and weobtain some of the key components and sub-assemblies used in our products froma single supplier or a limited group of suppliers. Neither we nor our contractmanufacturers or OEMs have any guaranteed supply arrangements with thesuppliers. If our suppliers fail to provide a sufficient supply of key components,we could experience difficulties in obtaining alternative sources at reasonableprices, if at all, or in altering product designs to use alternativecomponents. 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 qualitycontrol and testing of our products, we would experience increased productioncosts for product repair and replacement, and our profitability would beharmed. Moreover, defects in products that are not discovered in the qualityassurance process could damage customer relationships and result in productreturns or product liability claims, each of which could harm our revenue,profitability and reputation. 

 

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**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 other resourcesfor a significant period of time to develop new product designs. We cannotassure you that we would be successful in addressing any design defects in ourproducts or in developing new product designs in a timely manner, if at all.Any of these events, individually or in the aggregate, could harm our revenue,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 against third-parties forinfringement of our intellectual property rights or to determine the scope andvalidity of our intellectual property rights or those of competitors. Suchlitigation could result in substantial costs and diversion of resources. Any ofthe foregoing could have an adverse effect upon our revenue, profitability,reputation or growth strategy. 

 

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

** **

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

 

**Failure tocomplete our mergers with CoSine and Copper Mountain could cause our stockprice to decline and negatively affect our expected cash position.**

 

OnJanuary 7, 2005, we announced that we had signed a definitive merger agreementto acquire all of the outstanding shares of common stock of CoSineCommunications, Inc. The CoSine transaction is expected to result in net cashto us of approximately $22.75 million. On February 11, 2005 we enteredinto an Agreement and Plan of Merger and Reorganization with Copper MountainNetworks, Inc. We are acquiring Copper Mountain to expand and upgrade our lineof video processing products and related engineering capabilities. We will haveapproximately 41 additional employees and will add a research and developmentfacility in San Diego, California as a result of the Copper Mountaintransaction.

 

Our proposed acquisition of CoSine is subject to,approval by the stockholders of both CoSine and Tut Systems, in addition toother customary closing conditions. Certain CoSine stockholders have expressedtheir intent not to support the transaction.Our proposed acquisition of CopperMountain is subject to approval by the stockholders of Copper Mountain.Additionally, the price of our common stock has been volatile and has fallenbelow its price at the time that we entered into the definitive mergeragreements 

 

24

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with CoSine and CopperMountain. We cannot be certain that the transactions will be approved by eitherCoSine’s or Copper Mountain’s stockholders. 

 

Ifthe mergers with CoSine and Copper Mountain are not completed, our stock pricemay decline due to a number of factors. First, our costs related to themergers, such as legal, accounting and financial advisor fees, must be paideven if the mergers are not completed. In addition, our stock price may declineto the extent that the current market price of our common stock reflects amarket assumption that the mergers will be completed. Moreover, if we do notcomplete the CoSine merger, we will not obtain the expected increase to ourfuture cash position, and as a result we will need to engage in alternativefuture transactions to raise additional working capital, at prices and withresulting dilution to our stockholders that may be less favorable than theproposed CoSine acquisition.

 

**Failure to integrate acquired businesses into our operationssuccessfully could adversely affect our business.**

** **

As part of our strategy to develop andidentify new products and technologies, we have made acquisitions, and arelikely to make more. Our integration of the operations of acquired businessesrequires significant efforts, including the coordination of informationtechnologies, research and development, sales and marketing, operations,manufacturing and finance. These efforts result in additional expenses andinvolve significant amounts of management’s time that cannot then be dedicatedto other projects. Our failure to manage successfully and coordinate the growthof the combined company could also have an adverse impact on our business. Inaddition, there is no guarantee that any of the businesses we acquire willbecome profitable or remain so. If our acquisitions do not reach our initialexpectations, we may record unexpected impairment charges. Factors that willaffect the success of our acquisitions include: absence of adequate internalcontrols or presence of significant fraud in the financial systems of acquiredcompanies; any decrease in customer loyalty and product orders caused bydissatisfaction with the combined companies’ product lines and sales andmarketing practices, including price increases; our ability to retain keyemployees; and the ability of the combined company to achieve synergies amongits constituent companies, such as increasing sales of the combined company’sproducts, achieving cost savings and effectively combining technologies todevelop new products.  

 

These factors, among others, will affectwhether our recent and proposed acquisitions are successfully integrated intoour business. If we fail to integrate acquired businesses into our operationssuccessfully, we may be unable to achieve our strategic goals and ourcompetitive position in the marketplace could suffer. 

 

**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,results of operations and share price could be harmed. 

 

**If material weaknesses in our internalcontrols over financial reporting were to develop (such as those that ourindependent registered public accounting firm identified in the fourth quarterof fiscal 2003) and we were unable to remedy such weaknesses in an effective-and timely manner, such weaknesses could materially and adversely affect ourability to provide the public with timely and accurate material informationabout our Company, which could harm our reputation and share price.**

** **

In January 2004, our independent registered public accounting firmidentified deficiencies in our internal controls that they considered to bematerial weaknesses. Based on these weaknesses, our chief executive officer(CEO) and chief financial officer (CFO) determined that, as ofDecember 31, 2003, our disclosure controls and procedures were notsufficient to record, process, summarize and report information required to bereported within the time periods specified by the SEC and accumulated and communicatedto our management, including our CEO and CFO, to allow timely discussionsregarding required disclosure. These material weaknesses related to ourinventory and our accounts payable processes, both of which affect our balancesheet and may also affect our income statement reporting. We believe that wehave fully addressed these issues, and, therefore, our Chief Executive Officer’sand Chief Financial Officer’s evaluation of our disclosure controls andprocedures as of March 31, 2005 concluded that they were effective. In orderfor investors and the equity analyst community to make informed investmentdecisions and recommendations about our securities, it is important that weprovide them with accurate and timely information in accordance with the ExchangeAct and the rules promulgated thereunder. Material weaknesses in our internalcontrols over financial reporting and our disclosure controls and procedureswould hinder the flow of timely and accurate information to investors.  If such material weaknesses were to developand we did not address them in a timely matter, investors might sell our sharesand industry analysts might either make incorrect recommendations about ourCompany or 

 

25

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else end coverage of ourcompany altogether, any of which results could harm our reputation andadversely impact our share price. 

 

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

 

Weare currently engaged as a defendant in a lawsuit (i.e., *Whalen v. Tut Systems, Inc. et al.*)that alleges securities law violations against us and certain of our currentand former officers and directors under Section 11 of the Securities Actof 1933, as amended, and Section 10(b) and Rule 10b-5 of theSecurities Exchange Act of 1934, as amended. While we have reached a settlementwith the plaintiffs in this lawsuit, the settlement is subject to certaincontingencies, including court approval of the terms of settlement. If thecourt does not approve this settlement, or any other applicable contingenciesare not resolved or otherwise addressed, we would be required to resumelitigation in this matter. Additionally, Copper Mountain and CoSine are bothinvolved in similar lawsuits (i.e. In re Copper Mountain Networks, Inc. InitialPublic Offering Securities Litigation and In re Initial Public OfferingSecurities Litigation respectively). Further, on January 18, 2005, a complaintentitled Senior v. CoSine Communications, Inc., et al., Case No. CIV444292, wasfiled in San Mateo County Superior Court against CoSine and its officers anddirectors, requesting that the acquisition of CoSine by Tut Systems, Inc. beenjoined due to alleged self-dealing and breach of fiduciary duties by CoSine’sofficers and directors. We may inherit the risks associated with these lawsuitsin addition to our own lawsuit. If we were to resume litigation in the mattersof Copper Mountain and CoSine, there is no assurance that we would prevail. Ifthe outcome of such litigation were unfavorable to us, our reputation,profitability and share price could be adversely affected.

 

**If our products do not comply with complexgovernment regulations, our product sales will suffer.**

** **

We and our customers are subject to varying degrees of federal, stateand local as well as foreign governmental regulation. Our products must complywith various regulations and standards defined by the Federal CommunicationsCommission, or FCC. The FCC has issued regulations that set installation andequipment standards for communications systems. Our products are also requiredto meet certain safety requirements. For example, Underwriters Laboratoriesmust certify certain of our products in order to meet federal safetyrequirements relating to electrical appliances to be used inside the home. Inaddition, certain products must be Network Equipment Building Standardcertified before certain of our customers may deploy them. Any delay in orfailure to obtain these approvals could harm our business, financial conditionor results of operations. Outside of the United States, our products aresubject to the regulatory requirements of each country in which our products aremanufactured or sold. These requirements are likely to vary widely. If we donot obtain timely domestic or foreign regulatory approvals or certificates, wewould 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 worldwide toadopt new standards, generally following extensive investigation of competingtechnologies. The delays inherent in this governmental approval process maycause the cancellation, postponement or rescheduling of the installation ofcommunications systems by our customers, which in turn may harm our sale ofproducts to these customers. 

 

**If we lose key personnel or are unable 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. 

 

In order to obtain additional financial resources, weentered into an Agreement and Plan of Merger with CoSine Communications, Inc.,(“CoSine”) on January 7, 2005.  Theproposed merger is a stock-for-stock transaction valued at approximately $24.1million, at the time it was entered into. By the terms of the agreement, upon closing, we would issueapproximately 6.0 million shares of our common stock to the stockholders ofCoSine.  The transaction would result innet cash to Tut Systems of approximately 

 

26

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$22.75 million, and the transaction is expected toclose as soon as practicable following approval by the stockholders of bothcompanies. We are proposing to acquire CoSine primarily to provide additionalfinancial liquidity.  Upon closing, wewould plan to honor CoSine’s existing customers’ support agreements, but do notexpect to offer its products for sale to new customers.  We will not have any additional employees orfacilities as a result of the transaction.

 

On February 11, 2005 we entered into an Agreement and Plan ofMerger and Reorganization with Copper Mountain Networks, Inc. (“*Copper Mountain*”). The proposed mergerwill be a stock-for-stock transaction valued at approximately $10 million.Upon closing the Copper Mountain transaction, we will issue approximately2.5 million shares of our common stock to the stockholders of CopperMountain. The Copper Mountain transaction is conditioned upon the approval ofthe merger by the holders of a majority of the shares of Copper Mountain commonstock, and other customary closing conditions. We are acquiring Copper Mountainto expand and upgrade our line of video processing products. We will honorCopper Mountain’s existing customer support agreements, but do not expect tooffer any of Copper Mountain’s existing products for sale after the completionof the transaction. We will have approximately 41 additional employees and willadd a research and development facility in San Diego, California as a result ofthe transaction.

 

We intend to continue to evaluate new acquisition candidates,divestiture and diversification strategies, and if we fail to manage theintegration of acquired companies, it could adversely affect our operations andgrowth strategy. Any acquisition involves numerous risks, includingdifficulties in the assimilation of the acquired company’s employees, operationsand products, uncertainties associated with operating in new markets andworking with new customers, and the potential loss of the acquired company’skey employees. Additionally, we may incur unanticipated expenses, difficultiesand other adverse consequences relating to the integration of technologies,research and development, and administrative and other functions. Any futureacquisitions may also result in potentially dilutive issuances of our equitysecurities, acquisition or divestiture related write-offs and the assumption ofdebt and contingent liabilities. Any of the above factors could adverselyaffect our revenue, profitability, operations or growth strategy. 

 

**Our stock price is volatile, and, if 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 ofour acquisition of VTC, the closing price of our common stock, as traded on TheNasdaq National Market, has fluctuated from a low of $1.23 to a high of $7.49per share. The value of our common stock may decline regardless of ouroperating performance or prospects. Factors affecting our market price include:

 

•              our perceived prospects; 

 

•              variations in our operatingresults and whether we have achieved our key business targets; 

 

•              the limited number of shares ofour common stock available for purchase or sale in the public markets; 

 

•              differences between our reportedresults and those expected by investors and securities analysts; 

 

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

 

•              market reaction to anyacquisitions, joint ventures or strategic investments announced by us or ourcompetitors. 

 

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 themarket price in the future. In the past, securities class action litigation hasbeen instituted against companies following periods of volatility in the marketprice of their securities. Any such litigation, if instituted against us, couldresult in substantial costs and a diversion of management’s attention andresources. 

 

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

** **

Substantially all of our common stock may be sold without restrictionin the public markets, subject only in the case of shares held by our officersand directors and affiliates to volume and manner of sale restrictions (otherthan as described in the following sentence). The approximately3.3 million shares of common stock that we issued to Tektronix inconnection with our November 2002 acquisition of VTC are restrictedsecurities, as that term is defined in Rule 144 under the Securities Act,and therefore subject to certain restrictions. However, we are contractuallyobligated to file and keep effective a registration statement in order to allowTektronix to sell these shares to the public. Likewise, Tektronix has the right(subject to certain exceptions) to include these shares in certain registrationstatements pursuant to which we may sell shares of our common stock.  On January 25, 2005, Tektronix sold 1.0million shares of

 

27

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common stock.  At March 31, 2005,Tektronix owns 2.3 million shares of common stock.

 

Sales of a substantial number of shares of common stock in the publicmarket, whether or not in connection with this offering, or the perception thatthese sales could occur could materially and adversely affect our stock priceand make it more difficult for us to sell equity securities in the future at atime and price we deem appropriate. 

 

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

** **

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

 

**ITEM 3****.  *QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT 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 31,2005. 

 

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****.  *CONTROLSAND PROCEDURES***

 

*Evaluation of disclosure controls and procedures.* Under the supervision and with theparticipation of our management, including our principal executive officer andprincipal financial officer, we conducted an evaluation of the effectiveness ofthe design and operation of our disclosure controls and procedures, as definedin Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of1934, as amended, as of the end of the period covered by this report (the “EvaluationDate”). Based on this evaluation, our principal executive officer and principalfinancial officer concluded as of the Evaluation Date that our disclosurecontrols and procedures were effective such that the information relating tothe Company, including our consolidated subsidiaries, required to be disclosedin our Securities and Exchange Commission (“SEC”) reports (i) is recorded,processed, summarized and reported within the time periods specified in SECrules and forms, and (ii) is accumulated and communicated to the Company’smanagement, including our principal executive officer and principal financialofficer, as appropriate to allow timely decisions regarding requireddisclosure.

 

*Changes in internal control over financial reporting.* There were no changes in our internalcontrol over financial reporting which occurred during the first quarter offiscal year 2005 and which have materially affected or are reasonably likely tomaterially affect our internal control over financial reporting. 

 

28

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**PART II. OTHER INFORMATION**

 

**ITEM 1.**  ***LEGAL PROCEEDINGS*******

 

***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 the plaintiffsfrom the underwriter-defendants and other non-settling defendants. In the eventthat all or substantially all of the issuer-defendants approve the finalsettlement agreement, the amount that we would be required to pay to theplaintiffs could range from zero to approximately $3.5 million, depending onplaintiffs’ recovery from the underwriter-defendants and from othernon-settling parties. If the plaintiffs recover at least $1 billion from theunderwriter-defendants, we would have no liability for settlement paymentsunder the proposed terms of the settlement. If the plaintiffs recover less than$1 billion, we believe that our insurance will likely cover some or all of ourshare of any payments towards satisfying plaintiffs’ $1 billion recoverydeficit. Management estimates that its range of loss relative to this matter iszero to $3.5 million. Presently there is no more likely point estimate ofloss within this range. As a consequence of the uncertainties described aboveregarding the amount we will ultimately be required to pay, if any, as ofMarch 31, 2005, we have not accrued a liability for this matter. 

 

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.**  ***UNREGISTERED SALES******OFSECURITIES AND USE OF PROCEEDS*******

* *

None 

 

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

 

None 

 

## ***ITEM 4.***  SUBMISSION OF MATTERSTO A VOTE OF SECURITY HOLDERS

 

None 

 

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

## *** ***

None 

 

## ***ITEM 6. ***EXHIBITS

## *** ***

(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.(7) |
|                |       |            |   |
| 2.2                 |       |            | Agreement  and Plan of Merger with CoSine Communications, Inc. (9) |
|                |       |            |   |
| 2.3                 |       |            | Agreement  and plan of Merger and Reorganization with Copper Mountain Networks, Inc.  (10) |
|                |       |            |   |
| 3.1                 |       |            | Second Amended and Restated Certificate of Incorporation of the  Company.(1) |
|                |       |            |   |
| 3.2                 |       |            | Bylaws of the Company, as currently in effect. (4) |
|                |       |            |   |
| 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) |
|                |       |            |   |
| 10.8                |       |            | 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) |
|                |       |            |   |
| 10.12*              |       |            | Executive Retention and Change of Control Plan.(5) |
|                |       |            |   |
| 10.13*              |       |            | Non-Executive Retention and Change of Control Plan and Summary Plan  Description.(5) |
|                |       |            |   |
| 10.14*              |       |            | Non-Qualified Stock Option Agreement issued to Mark Carpenter on  March 3, 2000.(5) |
|                |       |            |   |
| 10.15*              |       |            | 1999 Non-Statutory Stock Option Plan(6) |
|                |       |            |   |
| 10.16               |       |            | Office Lease Agreement between Kruse Way Office Associates Limited  Partnership and VideoTele.com dated April 28, 2000.(8) |

 

30

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| **Exhibit  Number** | ** ** | **Description** |
|---------------------|------------|-----------------|
|                |       |            |   |
|                |       |            |   |
| 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.(8) |
|                |       |            |   |
| 11.1                |       |            | Calculation of net loss per share (contained in Note 3 of Notes  to Unaudited Condensed Consolidated Financial Statements). |
|                |       |            |   |
| 31.1                |       |            | Certification of Chief Executive Officer Pursuant to Section 302(a)  of the Sarbanes-Oxley Act of 2002. |
|                |       |            |   |
| 31.2                |       |            | Certification of Chief Financial Officer Pursuant to Section 302(a)  of the Sarbanes-Oxley Act of 2002. |
|                |       |            |   |
| 32.1                |       |            | Certification of Chief Executive Officer Pursuant to 18 U.S.C. 1350,  as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
|                |       |            |   |
| 32.2                |       |            | Certification of Chief Financial Officer Pursuant to 18 U.S.C. 1350,  as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

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(1) Incorporated by reference to ourRegistration Statement on Form S-1 (File No. 333-60419) as declaredeffective by the Securities and Exchange Commission on January 28, 1999. 

 

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

 

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

 

(4) Incorporated by reference to ourQuarterly Report on Form 10-Q for the quarter ended March 31, 2004. 

 

(5) Incorporated by reference to ourQuarterly Report on Form 10-Q for the quarter ended June 30, 2000. 

 

(6) Incorporated by reference to our ScheduleTO (File No. 005-58093) filed May 11, 2001. 

 

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

 

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

 

(9) Incorporated by reference to our CurrentReport on Form 8-K dated January 10, 2005.

 

(10) Incorporated by reference to our CurrentReport on Form 8-K dated February 14, 2005.

 

*Indicates management contracts orcompensatory plans and arrangements.

 

31

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**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 12,  2005 |              | ** ** |

 

32

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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.(7) |
|                |       |            |   |
| 2.2                 |       |            | Agreement  and Plan of Merger with CoSine Communications, Inc. (9) |
|                |       |            |   |
| 2.3                 |       |            | Agreement  and plan of Merger and Reorganization with Copper Mountain Networks, Inc.  (10) |
|                |       |            |   |
| 3.1                 |       |            | Second Amended and Restated Certificate of Incorporation of the  Company.(1) |
|                |       |            |   |
| 3.2                 |       |            | Bylaws of the Company, as currently in effect. (4) |
|                |       |            |   |
| 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) |
|                |       |            |   |
| 10.8                |       |            | 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) |
|                |       |            |   |
| 10.12*              |       |            | Executive Retention and Change of Control Plan.(5) |
|                |       |            |   |
| 10.13*              |       |            | Non-Executive Retention and Change of Control Plan and Summary Plan  Description.(5) |
|                |       |            |   |
| 10.14*              |       |            | Non-Qualified Stock Option Agreement issued to Mark Carpenter on  March 3, 2000.(5) |
|                |       |            |   |
| 10.15*              |       |            | 1999 Non-Statutory Stock Option Plan(6) |
|                |       |            |   |
| 10.16               |       |            | Office Lease Agreement between Kruse Way Office Associates Limited  Partnership and VideoTele.com dated April 28, 2000.(8) |
|                |       |            |   |
| 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.(8) |

 

33

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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. |

 

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(1) Incorporated by reference to ourRegistration Statement on Form S-1 (File No. 333-60419) as declaredeffective by the Securities and Exchange Commission on January 28, 1999. 

 

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

 

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

 

(4) Incorporated by reference to ourQuarterly Report on Form 10-Q for the quarter ended March 31, 2005. 

 

(5) Incorporated by reference to ourQuarterly Report on Form 10-Q for the quarter ended June 30, 2000. 

 

(6) Incorporated by reference to our ScheduleTO (File No. 005-58093) filed May 11, 2001. 

 

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

 

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

 

(9) Incorporated by reference to our CurrentReport on Form 8-K dated January 10, 2005.

 

(10) Incorporated by reference to our CurrentReport on Form 8-K dated February 14, 2005.

 

*Indicates management contracts orcompensatory plans and arrangements.

 

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