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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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



For the quarterly period ended September 30,
2003



Commission File Number: 000-25291



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TUT SYSTEMS, INC.

(Exact name of registrant as specified in its charter)



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|Delaware                                                       |  | 94-2958543                          
|-------------------------------------------------------------- |  | ------------------------------------
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)
|                                                               | 
|5200 Franklin Drive, Suite 100, Pleasanton, California         |  | 94588                               
|(Address of principal executive offices)                       |  | (Zip Code)                          



Registrants
telephone number, including area code: (925) 460-3900



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Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the
Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90
days.    Yes  x    No ̈



Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).    Yes  x    No ̈



As of October 24, 2003,
20,231,366 shares of the Registrants common stock, par value $0.001 per share, were issued and outstanding.



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TUT SYSTEMS, INC.



FORM 10-Q



INDEX



|PART I.    |  | FINANCIAL INFORMATION                                                                                                         |  |   
|---------- |  | ----------------------------------------------------------------------------------------------------------------------------- |  | --
|           |  |                                                                                                                              
|Item 1.    |  | Condensed Consolidated Financial Statements (unaudited):                                                                      |  |   
|           |  |                                                                                                                              
|           |  | Condensed Consolidated Balance Sheets as of September 30, 2003 and December 31, 2002                                          |  | 3 
|           |  |                                                                                                                              
|           |  | Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2003 and September 30, 2002 |  | 4 
|           |  |                                                                                                                              
|           |  | Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2003 and September 30, 2002           |  | 5 
|           |  |                                                                                                                              
|           |  | Notes to Unaudited Condensed Consolidated Financial Statements                                                                |  | 6 
|           |  |                                                                                                                              
|Item 2.    |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                                         |  | 18
|           |  |                                                                                                                              
|Item 3.    |  | Quantitative and Qualitative Disclosures about Market Risk                                                                    |  | 41
|           |  |                                                                                                                              
|Item 4.    |  | Controls and Procedures                                                                                                       |  | 41
|           |  |                                                                                                                              
|PART II.   |  | OTHER INFORMATION                                                                                                             |  |   
|           |  |                                                                                                                              
|Item 1.    |  | Legal Proceedings                                                                                                             |  | 42
|           |  |                                                                                                                              
|Item 2.    |  | Changes in Securities and Use of Proceeds                                                                                     |  | 43
|           |  |                                                                                                                              
|Item 3.    |  | Defaults Upon Senior Securities                                                                                               |  | 43
|           |  |                                                                                                                              
|Item 4.    |  | Submission of Matters to a Vote of Security Holders                                                                           |  | 43
|           |  |                                                                                                                              
|Item 5.    |  | Other Information                                                                                                             |  | 43
|           |  |                                                                                                                              
|Item 6.    |  | Exhibits and Reports on Form 8-K                                                                                              |  | 44
|           | 
|Signatures |  | 47                                                                                                                           



2



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PART I. FINANCIAL INFORMATION



ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS



TUT SYSTEMS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except per share amounts)



|                                                                                                                                          |  | September 30,2003 |          |   | December 31,2002 |  
|----------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------- | -------- | - | ---------------- | -
|                                                                                                                                          |  | (unaudited)       |          |   |                  |  
|ASSETS                                                                                                                                    |  |                   |          |   |                  |  
|Current assets:                                                                                                                           |  |                   |          |   |                  |  
|Cash and cash equivalents                                                                                                                 |  | $                 | 13,956   |   |                  | $
|Accounts receivable, net of allowance for doubtful accounts of $40 and $10 in 2003 and 2002, respectively                                 |  |                   | 7,187    |   |                  |  
|Inventories, net                                                                                                                          |  |                   | 3,822    |   |                  |  
|Prepaid expenses and other                                                                                                                |  |                   | 1,517    |   |                  |  
|                                                                                                                                          |  |                   |          |   |                  |  
|Total current assets                                                                                                                      |  |                   | 26,482   |   |                  |  
|Property and equipment, net                                                                                                               |  |                   | 1,579    |   |                  |  
|Intangibles and other assets                                                                                                              |  |                   | 4,099    |   |                  |  
|                                                                                                                                          |  |                   |          |   |                  |  
|Total assets                                                                                                                              |  | $                 | 32,160   |   |                  | $
|                                                                                                                                          |  |                   |          |   |                  |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                      |  |                   |          |   |                  |  
|Current liabilities:                                                                                                                      |  |                   |          |   |                  |  
|Accounts payable                                                                                                                          |  | $                 | 2,797    |   |                  | $
|Accrued liabilities                                                                                                                       |  |                   | 1,778    |   |                  |  
|Deferred revenue                                                                                                                          |  |                   | 170      |   |                  |  
|                                                                                                                                          |  |                   |          |   |                  |  
|Total current liabilities                                                                                                                 |  |                   | 4,745    |   |                  |  
|Note Payable                                                                                                                              |  |                   | 3,455    |   |                  |  
|Deferred revenue, net of current portion                                                                                                  |  |                   |         |   |                  |  
|Other liabilities                                                                                                                         |  |                   | 56       |   |                  |  
|                                                                                                                                          |  |                   |          |   |                  |  
|Total liabilities                                                                                                                         |  |                   | 8,256    |   |                  |  
|                                                                                                                                          |  |                   |          |   |                  |  
|Commitments and contingencies (Note 7)                                                                                                    |  |                   |          |   |                  |  
|Stockholders equity:                                                                                                                     |  |                   |          |   |                  |  
|Common stock, $0.001 par value, 100,000 shares authorized, 20,188 and 19,796 shares issued and outstanding in 2003 and 2002,
respectively |  |                   | 20       |   |                  |  
|Additional paid-in capital                                                                                                                |  |                   | 305,571  |   |                  |  
|Accumulated other comprehensive loss                                                                                                      |  |                   | (153     | ) |                  |  
|Accumulated deficit                                                                                                                       |  |                   | (281,534 | ) |                  |  
|                                                                                                                                          |  |                   |          |   |                  |  
|Total stockholders equity                                                                                                                |  |                   | 23,904   |   |                  |  
|                                                                                                                                          |  |                   |          |   |                  |  
|Total liabilities and stockholders equity                                                                                                |  | $                 | 32,160   |   |                  | $
|                                                                                                                                          |  |                   |          |   |                  |  



The accompanying
notes are an integral part of these condensed consolidated financial statements.



3



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TUT SYSTEMS, INC.



CONDENSED
CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

(unaudited)



|                                                                        |  | Three Months EndedSeptember 30, |        |   | Nine Months EndedSeptember 30, |  
|----------------------------------------------------------------------- |  | ------------------------------- | ------ | - | ------------------------------ | -
|                                                                        |  | 2003                            |        |   | 2002                           |  
|Revenues:                                                               |  |                                 |        |   |                                |  
|Product                                                                 |  | $                               | 8,283  |   |                                | $
|License and royalty                                                     |  |                                 | 239    |   |                                |  
|                                                                        |  |                                 |        |   |                                |  
|Total revenues                                                          |  |                                 | 8,522  |   |                                |  
|                                                                        |  |                                 |        |   |                                |  
|Cost of goods sold:                                                     |  |                                 |        |   |                                |  
|Product                                                                 |  |                                 | 3,751  |   |                                |  
|                                                                        |  |                                 |        |   |                                |  
|Total cost of goods sold                                                |  |                                 | 3,751  |   |                                |  
|                                                                        |  |                                 |        |   |                                |  
|Gross margin (loss)                                                     |  |                                 | 4,771  |   |                                |  
|                                                                        |  |                                 |        |   |                                |  
|Operating expenses:                                                     |  |                                 |        |   |                                |  
|Sales and marketing                                                     |  |                                 | 1,848  |   |                                |  
|Research and development                                                |  |                                 | 1,887  |   |                                |  
|General and administrative                                              |  |                                 | 1,018  |   |                                |  
|Restructuring Costs                                                     |  |                                 | 292    |   |                                |  
|Impairment of intangible assets                                         |  |                                 |       |   |                                |  
|Amortization of intangible assets                                       |  |                                 | 442    |   |                                |  
|                                                                        |  |                                 |        |   |                                |  
|Total operating expenses                                                |  |                                 | 5,487  |   |                                |  
|                                                                        |  |                                 |        |   |                                |  
|Loss from operations                                                    |  |                                 | (716   | ) |                                |  
|Impairment of certain equity investments                                |  |                                 |       |   |                                |  
|Interest and other (expense) income, net                                |  |                                 | (26    | ) |                                |  
|                                                                        |  |                                 |        |   |                                |  
|Net loss                                                                |  | $                               | (742   | ) |                                | $
|                                                                        |  |                                 |        |   |                                |  
|Net loss per share, basic and diluted (Note 3)                          |  | $                               | (0.04  | ) |                                | $
|                                                                        |  |                                 |        |   |                                |  
|Shares used in computing net loss per share, basic and diluted (Note 3) |  |                                 | 20,040 |   |                                |  
|                                                                        |  |                                 |        |   |                                |  



The accompanying
notes are an integral part of these condensed consolidated financial statements.



4



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TUT SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)



|                                                                                  |  | Nine Months EndedSeptember 30, |        
|--------------------------------------------------------------------------------- |  | ------------------------------ | -------
|                                                                                  |  | 2003                           |        
|Cash flows from operating activities:                                             |  |                                |        
|Net loss                                                                          |  | $                              | (4,998 
|Adjustments to reconcile net loss to net cash used in operating activities:       |  |                                |        
|Depreciation and other                                                            |  |                                | 796    
|Provision (recovery) for doubtful accounts                                        |  |                                | 30     
|Provision for (reduction of) excess and obsolete inventory and abandoned products |  |                                | (775   
|Write off of certain equity investments                                           |  |                                |       
|Impairment of intangible assets                                                   |  |                                | 128    
|Amortization of intangible assets                                                 |  |                                | 1,360  
|Change in operating assets and liabilities, net of businesses acquired:           |  |                                |        
|Accounts receivable                                                               |  |                                | (5,246 
|Inventories                                                                       |  |                                | 841    
|Prepaid expenses and other assets                                                 |  |                                | (447   
|Accounts payable and accrued liabilities                                          |  |                                | (2,649 
|Deferred revenue                                                                  |  |                                | (786   
|                                                                                  |  |                                |        
|Net cash used in operating activities                                             |  |                                | (11,746
|                                                                                  |  |                                |        
|Cash flows from investing activities:                                             |  |                                |        
|Purchase of property and equipment                                                |  |                                | (745   
|Proceeds from maturities of short-term investments                                |  |                                |       
|                                                                                  |  |                                |        
|Net cash (used in) provided by investing activities                               |  |                                | (745   
|                                                                                  |  |                                |        
|Cash flows from financing activities:                                             |  |                                |        
|Proceeds from issuances of common stock, net                                      |  |                                | 683    
|Deferred interest on note payable                                                 |  |                                | 193    
|Repayment of note receivable                                                      |  |                                |       
|                                                                                  |  |                                |        
|Net cash provided by financing activities                                         |  |                                | 876    
|                                                                                  |  |                                |        
|Net decrease in cash and cash equivalents                                         |  |                                | (11,615
|Cash and cash equivalents, beginning of period                                    |  |                                | 25,571 
|                                                                                  |  |                                |        
|Cash and cash equivalents, end of period                                          |  | $                              | 13,956 
|                                                                                  |  |                                |        



The accompanying
notes are an integral part of these condensed consolidated financial statements.



5



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TUT SYSTEMS, INC.



NOTES TO
UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except per share amounts)



NOTE 1DESCRIPTION OF BUSINESS:



Tut Systems, Inc. (the Company) was founded in 1983 and began
operations in August 1991. The Company designs, develops, markets and sells video content processing systems optimized for the provisioning of public broadcast digital TV services across telephone company and cable company facilities, digital video
trunking systems for applications across TV broadcast, government and education facilities, and broadband transmission systems for application over existing private campus or building facilities. Historically, most of the Companys sales were
derived from its broadband data transmission systems. With the Companys November 2002 acquisition of VideoTele.com (VTC), formerly a subsidiary of Tektronix, Inc., the Company extended its product offerings to include video content
processing and video trunking systems.



The Company has
incurred substantial losses and negative cash flows from operations since inception. For the nine months ended September 30, 2003, the Company incurred a net loss of $4,998, and negative cash flows from operating activities of $11,746, and has an
accumulated deficit of $281,534 at September 30, 2003. To the extent the Companys business continues to be affected by poor economic conditions impacting the telecommunications industry, the Company will continue to require cash to fund
operations. The Company will seek additional funding for operations from alternative debt and equity sources if necessary to maintain reasonable operating levels. The Company cannot be assured that such funding efforts will be successful. Failure to
generate positive cash flow in the future could have a material adverse effect on the Companys ability to achieve its intended business objectives.



NOTE 2SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:



Basis of presentation



The accompanying condensed consolidated financial statements as of September 30, 2003 and December 31, 2002 and for the three and nine months ended
September 30, 2003 and 2002 are unaudited. The unaudited interim condensed consolidated financial statements have been prepared on the same basis as the annual financial statements and, in the opinion of management, reflect all adjustments, which
include only normal recurring adjustments, necessary to present fairly the Companys financial position as of September 30, 2003 and December 31, 2002, its results of operations for the three and nine months ended September 30, 2003 and 2002
and its cash flows for the nine months ended September 30, 2003 and 2002. These condensed consolidated financial statements and the accompanying notes are unaudited and should be read in conjunction with the Companys audited financial
statements included in the Companys Annual Report on Form 10-K, filed with the Securities and Exchange Commission on March 31, 2003. The balance sheet as of December 31, 2002 was derived from audited financial statements but does not include
all disclosures required by generally accepted accounting principles. The results for the three and nine months ended September 30, 2003 are not necessarily indicative of the expected results for any other interim period or the year ending December
31, 2003.



Revenue recognition



The Company generates revenue primarily from the sale of hardware products,
including third-party products, through professional services, the licensing of its HomeRun technology and the sale of its software products. The Company sells products through direct sales channels and through distributors.



6



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TUT SYSTEMS, INC.



NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



Product revenues



The Company recognizes product revenue when persuasive evidence of an arrangement exists, delivery has occurred or services
have been provided, the fee is fixed or determinable, and collection is probable. Significant management judgments and estimates must be made in connection with the measurement of revenue in a given period. The Company follows specific and detailed
guidelines for determining the timing of revenue recognition. At the time of the transaction, the Company assesses a number of factors, including specific contract and purchase order terms, completion and timing of delivery to the common carrier,
past transaction history with the customer, the creditworthiness of the customer, evidence of sell-through to the end user, and current payment terms. Based on the results of the assessment, the Company may recognize revenue when the products are
shipped or defer recognition until evidence of sell-through occurs and cash is received. Revenue from service obligations included in product revenues is deferred and recognized ratably over the period of the obligation. The Company also maintains
accruals and allowances for all cooperative marketing and other programs. Estimated sales returns and warranty costs are based on historical experience and are recorded at the time revenue is recognized. The Companys products generally carry a
one-year warranty from the date of purchase. The warranty accrual was not material at September 30, 2003 or December 31, 2002.



Turnkey solution revenues



Revenue on turnkey video solution sales, which typically include the design, manufacture, test, integration and installation of the Companys
equipment to its customers specifications, or equipment acquired from third parties to be integrated with the Companys products, is generally recognized using the percentage-of-completion method. Under the percentage-of-completion
method, revenue recognized reflects the portion of the anticipated contract revenue that has been earned, equal to the ratio of labor costs expended to date, to anticipated total labor costs, based on current estimates of labor costs to complete the
project. If the estimated costs to complete a project exceed the total contract amount, indicating a loss, the entire anticipated loss is recognized immediately. Generally, the terms of turnkey video solution sales provide for billing for products
at the time of delivery and for services at the time of substantial completion of the project.



License and royalty revenues



The Company has entered into non-exclusive technology agreements with various licensees. These agreements give the licensees the right to manufacture, or have manufactured, products which incorporate the Companys proprietary
technology and to receive customer support for specified periods and any changes or improvements to the technology over the term of the agreement.



Contract fees for the services provided under these licensing agreements are generally comprised of license fees and non-refundable prepaid royalties that
are recognized when the proprietary technology is delivered if there are no significant vendor obligations. If the licensing agreements contain post-contract customer support, the Company recognizes the contract fees ratably over the period during
which the post-contract customer support is expected to be provided. This period represents the estimated life of the technology. The Company begins to recognize revenue under the contract once it has delivered the implementation package that
contains all information needed to use the Companys proprietary technology in the licensees process. The remaining obligations are primarily to provide the licensee with any changes or improvements to the technology and technical advice
on specifications, testing, debugging and enhancements.



The
Company recognizes royalties upon notification of sale by its licensees. The terms of the royalty agreements generally require licensees to notify the Company and pay royalties within 60 days of the end of the quarter during which the sales occur.



7



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TUT SYSTEMS, INC.



NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



Software license and post-contract support revenues



Currently, the Companys software revenue is derived from two separate
sources, software license fees and post-contract maintenance and support fees. A software license typically grants a perpetual license to the customer. The Company generally recognizes revenue from sales of the software licenses when all criteria
for revenue recognition that are similarly applicable to the Companys hardware product sales have been met. The revenue for post-contract maintenance and support fees is recognized ratably over the term of the separate support contract.



Revenue recognition- Summary



Revenue recognition in each period is dependent on the application of these
accounting policies. If the Company believes that any of the conditions to recognize revenue have not been met, it will defer revenue recognition. For example, if collectibility is not reasonably assured, the Company will defer revenue recognition
until subsequent cash receipt. The Companys application of percentage-of-completion accounting is subject to its estimates of labor cost to complete each turnkey solution project. In the event that actual results differ from these estimates or
the Company adjusts these estimates in future periods, its operating results for a particular period could be adversely affected. Unearned revenue that has been billed but not collected at the end of the period is recorded as a reduction against the
related accounts receivable balance. Unearned revenue recorded as a reduction against the related accounts receivable was $1,718 and $900 at September 30, 2003 and December 31, 2002, respectively.



Inventories



Inventories are stated at the lower of cost or market. Cost is computed
using standard cost, which approximates actual cost on a first-in, first-out basis. The Company records provisions to write down its inventory and related purchase commitments for estimated obsolescence or unmarketable inventory equal to the
difference between the cost of the inventory and the estimated market value based upon assumptions about the future demand and market conditions. If actual future demand or market conditions are less favorable than estimated, additional inventory
provisions may be required.



Allowance for doubtful accounts



The Company maintains an allowance for doubtful accounts
for estimated losses resulting from the inability of its customers to make payments. These estimated allowances are periodically reviewed and take into account customers payment history and information regarding customers
creditworthiness that is known to the Company. If the financial condition of any of its customers were to deteriorate, resulting in their inability to make payments, an additional allowance would be required.



Accounting for long-lived assets



The Company assesses the impairment of long-lived assets periodically. An
impairment review is performed whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors considered important which could trigger an impairment review include, but are not limited to, significant
underperformance relative to expected historical or projected future operating results, significant changes in the manner of use of the acquired assets or the strategy for the overall business, significant negative industry or economic trends, a
significant decline in the stock price for a sustained period, and the market capitalization of the Company relative to its net book value.



When the Company determines that the carrying value may not be recoverable based upon the existence of one or more of the above indicators of impairment,
it records an impairment charge. Any such impairment is calculated based on a projected discounted cash flow method using a discount rate commensurate with the risk inherent in the Companys current business model.



8



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TUT SYSTEMS, INC.



NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



During the nine months ended September 30, 2003, the Company determined that certain of the
technology acquired as part of the purchase of the ViaGate Technologies, Inc. assets in September 2001 had become impaired. As a result, the Company recorded a loss of $128 to write-off the technology.



Future events could cause the Company to conclude that impairment indicators
exist. Any resulting impairment loss could have a material adverse impact on the Companys financial condition and results of operations.



Legal contingencies



The Company is currently involved in certain legal proceedings as discussed in Note 7. Because of uncertainties related to both the potential amount and
range of loss from the pending litigation, management is unable to make a reasonable estimate of the liability that could result if there were an unfavorable outcome in any of these legal proceedings. As additional information becomes available, the
Company will re-assess the potential liability related to this pending litigation and revise its estimates accordingly. Revisions of the Companys estimates of such potential liability could materially impact its results of operations,
financial condition or cashflows.



Accounting for stock based compensation



The Company accounts for stock-based employee
compensation arrangements in accordance with the provisions of Accounting Principles Board Opinion No. 25 (APB No. 25), Accounting for Stock Issued to Employees, Financial Accounting Standard Board Interpretation No. 44
(FIN 44), Accounting for Certain Transactions Involving Stock Compensationan Interpretation of APB 25, and complies with the disclosure provisions of Statement of Financial Accounting Standard No. 148 (SFAS No.
148), Accounting for Stock-Based Compensation, Transition and Disclosure. Under APB No. 25, compensation expense is based on the difference, if any, on the date of the grant, between the fair value of the Companys stock and
the exercise price. The Company accounts for stock issued to non-employees in accordance with 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 other than Employees for Acquiring, or in Conjunction with Selling Goods or Services.



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



9



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TUT SYSTEMS, INC.



NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



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



|                                                                                                                                      |  | Three Months Ended September 30, |        |   | Nine Months Ended September 30, |  
|------------------------------------------------------------------------------------------------------------------------------------- |  | -------------------------------- | ------ | - | ------------------------------- | -
|                                                                                                                                      |  | 2003                             |        |   | 2002                            |  
|Net loss  as reported                                                                                                                |  | $                                | (742   | ) |                                 | $
|                                                                                                                                      |  |                                  |        |   |                                 |  
|Adjustment:                                                                                                                           |  |                                  |        |   |                                 |  
|Total stock-based employee compensation expense determined under a fair value based method for all grants, net of related tax
effects |  |                                  | (816   | ) |                                 |  
|                                                                                                                                      |  |                                  |        |   |                                 |  
|Net loss  pro forma                                                                                                                  |  | $                                | (1,558 | ) |                                 | $
|                                                                                                                                      |  |                                  |        |   |                                 |  
|Basic and diluted net loss per share  as reported                                                                                    |  | $                                | (0.04  | ) |                                 | $
|                                                                                                                                      |  |                                  |        |   |                                 |  
|Basic and diluted net loss per share  pro forma                                                                                      |  | $                                | (0.08  | ) |                                 | $
|                                                                                                                                      |  |                                  |        |   |                                 |  



The fair value of
options and shares issued pursuant to the option plans and at the grant date were estimated using the Black-Scholes model. The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no
vesting restrictions and are fully transferable. Option-pricing models require the input of highly subjective assumptions including the expected stock price volatility. The Company uses projected volatility rates, which are based upon historical
volatility rates trended into future years. Because employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value
estimate, in managements opinion, the existing models do not necessarily provide a reliable single measure of the fair value of options.



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



Prior to the Companys initial public offering, the fair value of each
stock option was estimated using the minimum value method. Volatility and dividend yields were not factors in the Companys minimum value calculation. Subsequent to the offering, the fair value of each stock option has been estimated on the
date of grant using the Black-Scholes option pricing model. The Company has also estimated the fair value of the purchase rights issued from its employee stock purchase plan using the Black-Scholes option pricing model. The Company first issued
purchase rights from the 1998 Employee Stock Purchase Plan in fiscal year 1999.



10



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TUT SYSTEMS, INC.



NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



Recent accounting pronouncements



In April 2003, the Financial Accounting Standards Board (FASB) issued SFAS No. 149, Amendment of Statement
133 on Derivative Instruments and Hedging Activities. SFAS No. 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred
to as derivatives) and for hedging activities under FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS No. 149 is effective for contracts entered into or modified after September 30, 2003, and for
hedging relationships designated after September 30, 2003. The Company believes that the adoption of this standard will not have a material impact on its financial statements.



In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both
Liabilities and Equity. SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument
that is within its scope as a liability (or an asset in some circumstances). Many of those instruments were previously classified as equity. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and
otherwise is effective at the beginning of the first interim period beginning after September 15, 2003. It is to be implemented by reporting the cumulative effect of a change in an accounting principle for financial instruments created before the
issuance date of SFAS No. 150 and still existing at the beginning of the interim period of adoption. Restatement is not permitted. The Company believes that the adoption of this standard will not have a material impact on its financial statements.



Reclassifications



Certain reclassifications have been made to prior period 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
using the weighted average number of common shares outstanding. Options were not included in the computation of diluted net loss per share because the effect would be antidilutive.



11



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TUT SYSTEMS, INC.



NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



The calculation of net loss per share follows:



|                                                                        |  | Three Months Ended September 30, |        |   | Nine Months Ended September 30, |  
|----------------------------------------------------------------------- |  | -------------------------------- | ------ | - | ------------------------------- | -
|                                                                        |  | 2003                             |        |   | 2002                            |  
|Net loss per share, basic and diluted:                                  |  |                                  |        |   |                                 |  
|Net loss                                                                |  | $                                | (742   | ) |                                 | $
|                                                                        |  |                                  |        |   |                                 |  
|Net loss per share, basic and diluted                                   |  | $                                | (0.04  | ) |                                 | $
|                                                                        |  |                                  |        |   |                                 |  
|Shares used in computing net loss per share, basic and diluted          |  |                                  | 20,040 |   |                                 |  
|                                                                        |  |                                  |        |   |                                 |  
|Antidilutive securities not included in net loss per share calculations |  |                                  | 3,132  |   |                                 |  
|                                                                        |  |                                  |        |   |                                 |  



NOTE 4COMPREHENSIVE LOSS:



Comprehensive loss includes net loss, unrealized gains
and losses on investments, and foreign currency translation adjustments that have been previously excluded from net loss and reflected instead in stockholders equity. The following table sets forth the calculation of comprehensive loss:



|                                         |  | Three Months Ended September 30, |      |   | Nine Months Ended September 30, |  
|---------------------------------------- |  | -------------------------------- | ---- | - | ------------------------------- | -
|                                         |  | 2003                             |      |   | 2002                            |  
|Net loss                                 |  | $                                | (742 | ) |                                 | $
|Unrealized gains (losses) on investments |  |                                  |     |   |                                 |  
|Foreign currency translation adjustments |  |                                  | (12  | ) |                                 |  
|                                         |  |                                  |      |   |                                 |  
|Net change in other comprehensive loss   |  |                                  | (12  | ) |                                 |  
|                                         |  |                                  |      |   |                                 |  
|Total comprehensive loss                 |  | $                                | (754 | ) |                                 | $
|                                         |  |                                  |      |   |                                 |  



12



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TUT SYSTEMS, INC.



NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



NOTE 5BALANCE SHEET COMPONENTS:



|                                           |  | September 30, 2003 |        |   | December 31, 2002 |  
|------------------------------------------ |  | ------------------ | ------ | - | ----------------- | -
|Inventories, net:                          |  |                    |        |   |                   |  
|Finished goods                             |  | $                  | 3,601  |   |                   | $
|Raw materials                              |  |                    | 221    |   |                   |  
|                                           |  |                    |        |   |                   |  
|                                           |  | $                  | 3,822  |   |                   | $
|                                           |  |                    |        |   |                   |  
|Property and equipment:                    |  |                    |        |   |                   |  
|Computers and software                     |  | $                  | 1,198  |   |                   | $
|Test equipment                             |  |                    | 1,960  |   |                   |  
|Office equipment                           |  |                    | 46     |   |                   |  
|                                           |  |                    |        |   |                   |  
|                                           |  |                    | 3,204  |   |                   |  
|Less: accumulated depreciation             |  |                    | (1,625 | ) |                   |  
|                                           |  |                    |        |   |                   |  
|                                           |  | $                  | 1,579  |   |                   | $
|                                           |  |                    |        |   |                   |  
|Accrued liabilities:                       |  |                    |        |   |                   |  
|Provision for loss on purchase commitments |  | $                  |       |   |                   | $
|Professional Services                      |  |                    | 228    |   |                   |  
|Compensation                               |  |                    | 799    |   |                   |  
|Restructuring accrual                      |  |                    | 98     |   |                   |  
|Other                                      |  |                    | 653    |   |                   |  
|                                           |  |                    |        |   |                   |  
|                                           |  | $                  | 1,778  |   |                   | $
|                                           |  |                    |        |   |                   |  



|                                 |  | As of September 30, 2003
|-------------------------------- |  | ------------------------
|                                 |  | GrossCarryingAmount     
|Amortized intangibles assets:    |  |                         
|Completed technology and patents |  | $                       
|Contract backlog                 |  |                         
|Customer lists                   |  |                         
|Maintenance contract renewals    |  |                         
|Trademarks                       |  |                         
|                                 |  |                         
|                                 |  | $                       
|                                 |  |                         
|Other non-current assets         |  |                         
|                                 |  |                         
|                                 |  |                         
|                                 |  |                         



13



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TUT SYSTEMS, INC.



NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



|                                 |  | As of December 31, 2002
|-------------------------------- |  | -----------------------
|                                 |  | GrossCarryingAmount    
|Amortized intangibles assets:    |  |                        
|Completed technology and patents |  | $                      
|Contract backlog                 |  |                        
|Customer lists                   |  |                        
|Maintenance contract renewals    |  |                        
|Trademarks                       |  |                        
|                                 |  |                        
|                                 |  | $                      
|                                 |  |                        
|Other non-current assets         |  |                        
|                                 |  |                        
|                                 |  |                        
|                                 |  |                        



The aggregate
amortization expense for the three and nine months ended September 30, 2003 was $442 and $1,360, respectively. The aggregate amortization expense for the three and nine months ended September 30, 2002 was $300 and $899, respectively.



Minimum future amortization expense as of September 30, 2003 is as follows:



|Remainder of 2003 |  | $ | 449  
|----------------- |  | - | -----
|2004              |  |   | 1,586
|2005              |  |   | 955  
|2006              |  |   | 485  
|2007              |  |   | 363  
|Thereafter        |  |   | 106  
|                  |  |   |      
|                  |  | $ | 3,944
|                  |  |   |      



NOTE 6RESTRUCTURING COSTS:



In August 2003, the Company discontinued further
development of one of its products. Accordingly, the Company implemented a restructuring program that included a workforce reduction and relocation. As a result of this restructuring program, the Company recorded restructuring costs of $292. The
workforce reduction was approximately 11% of the Companys employees, resulting in severance and fringe benefit expenses of approximately $192 along with relocation costs of $100. As of September 30, 2003, the Company had a remaining accrual of
$100. The restructuring will be completed by December 31, 2003.



14



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TUT SYSTEMS, INC.



NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



NOTE 7COMMITMENTS AND CONTINGENCIES:



Lease obligations



The Company leases equipment and office, assembly and warehouse space under noncancelable operating leases that expire from 2003 through 2005. In
connection with the acquisition of VideoTele.com (VTC) in November 2002, the Company assumed an operating lease that expires in July 2005.



In August 2002, the Company entered into an agreement to terminate its lease for engineering facilities in Bridgewater Township, New Jersey for $257,
which consisted of forfeiture of a $116 letter of credit and a cash payment of $141. As part of its November 2002 restructuring program, the Company entered into an agreement to terminate its lease for its headquarters facility in Pleasanton,
California for $2,409, which consisted of forfeiture of a $1,350 letter of credit and a cash payment of $1,059. The Company also incurred $327 in legal costs and other professional fees related to this lease termination. These amounts were paid as
of March 31, 2003. In December 2002, the Company entered into a lease agreement for a facility in Pleasanton, California that expires in December 2003.



Minimum future lease payments under operating leases as of September 30, 2003 are as follows:



|Remainder of 2003 |  | $ | 275  
|----------------- |  | - | -----
|2004              |  |   | 806  
|2005              |  |   | 269  
|Thereafter        |  |   |     
|                  |  |   |      
|                  |  | $ | 1,350
|                  |  |   |      



Purchase
commitments



The Company had noncancellable commitments to
purchase finished goods inventory totaling $416 and $421 in aggregate at September 30, 2003 and December 31, 2002, respectively.



Contingencies



Beginning July 12, 2001, nine putative stockholder class action lawsuits were filed in the United States District Court for the Northern District of
California against the Company and certain of its current and former officers and directors. The complaints were filed on behalf of a purported class of people who purchased the Companys stock during the period between July 20, 2000 and
January 31, 2001, seeking unspecified damages. The complaints allege that the Company and certain of its current and former officers and directors made false and misleading statements about the Companys business during the putative class
period. Specifically, the complaints allege violations of Section 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended. The complaints have been consolidated under the name In re Tut Systems, Inc. Securities Litigation, Master File No.
C-01-2659-CW (the Securities Litigation Action). Lead plaintiffs and lead counsel for plaintiffs have been appointed. Plaintiffs filed a consolidated class action complaint on February 4, 2002. Defendants filed a Motion to Dismiss on
March 29, 2002. On August 15, 2002, the Court granted in part and denied in part the Motion to Dismiss. On September 23, 2002, plaintiffs filed an amended complaint. Defendants filed a Motion to Dismiss the amended complaint, and on August 6, 2003
the Court granted in part that Motion. On September 24, 2003, Defendants answered the remaining allegations of the amended complaint. Discovery has commenced. Trial is scheduled to begin on March 7, 2005. The Company believes it has meritorious
defenses to the allegations in the complaint and intends to defend the case vigorously. An unfavorable resolution of this litigation could have a material adverse effect on the Companys business, results of operations, financial condition and
cash flows.



15



---

TUT SYSTEMS, INC.



NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



On March 19, 2003, Chesky Lefkowitz, a shareholder of the Company, filed a derivative complaint
entitled Lefkowitz v. DAuria, et al., No. RG03087467, in the Superior Court of the State of California, County of Alameda, against certain of the Companys current and former officers and directors. The complaint alleges causes of action
for breach of fiduciary duty, gross negligence, breach of contract, unjust enrichment and improper insider stock trading, based on the same factual allegations contained in the Securities Litigation Action. The complaint seeks unspecified damages
against the individual defendants on behalf of the Company, equitable relief, and attorneys fees. On May 21, 2003, the Company and the individual defendants filed separate demurrers to the complaint. The demurrers have not yet been heard by
the Court, and no trial date has been established.



On October
30, 2001, the Company and certain of its current and former officers and directors were named as defendants in Whalen v. Tut Systems, Inc. et al., Case No. 01-CV-9563, a purported securities class action lawsuit filed in the United States District
Court for the Southern District of New York. An amended complaint was filed on December 5, 2001. A consolidated amended complaint was filed on April 19, 2002. The consolidated amended complaint asserts that the prospectuses from the Companys
January 29, 1999 initial public offering and its March 23, 2000 secondary offering failed to disclose certain alleged actions by the underwriters for the offerings. The complaint alleges claims against the Company and certain of its current and
former officers and directors under Section 11 of the Securities Act of 1933, as amended, (the 1933 Act) 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 former officers and directors under Sections 15 and 20(a) of the 1933 Act. The complaints also name as defendants the underwriters for the Companys initial public offering and secondary offering. The Court has denied the
Companys motion to dismiss. The Companys Board recently approved a tentative settlement proposal from the plaintiffs. The settlement is subject to a number of conditions, including approval of the Court. If the settlement does not occur,
and the litigation against the Company continues, the Company believes it has meritorious defenses to the allegations in the complaint and intends to defend the case vigorously. An unfavorable resolution of this litigation could have a material
adverse effect on the Companys business, results of operations, financial condition and cash flows.



The Company is subject to other legal proceedings, claims and litigation arising in the ordinary course of business. The Companys management does
not expect that the ultimate costs to resolve these matters will have a material adverse effect on the Companys consolidated financial position, results of operations, or cash flows.



16



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TUT SYSTEMS, INC.



NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)

(in thousands, except per share amounts)



NOTE 8SEGMENT INFORMATION:



The Company currently targets its sales and marketing efforts to both public and private service providers and users across
two related markets. Management evaluates the financial performance of the Company as a single business segment. Revenues are attributed to the following countries based on the location of customers:



|                    |  | Three MonthsEnded September 30, |       | Nine Months Ended September 30,
|------------------- |  | ------------------------------- | ----- | -------------------------------
|                    |  | 2003                            |       | 2002                           
|United States       |  | $                               | 6,999 |                                
|International:      |  |                                 |       |                                
|Canada              |  |                                 | 911   |                                
|Ireland             |  |                                 |       |                                
|China               |  |                                 | 182   |                                
|Mexico              |  |                                 | 49    |                                
|Japan               |  |                                 | 136   |                                
|Great Britain       |  |                                 | 126   |                                
|All other countries |  |                                 | 119   |                                
|                    |  |                                 |       |                                
|                    |  | $                               | 8,522 |                                
|                    |  |                                 |       |                                



It is impracticable
for the Company to compute product revenues by product type for the three and nine months ended September 30, 2003 and 2002.



No individual customer accounted for greater than 10% of the Companys revenue for the nine months ended September 30, 2003. One customer, Oxford
Networks, accounted for 15% of the Companys revenue for the three months ended September 30, 2003. Three customers, Ingram Micro, BTN Internetworking and Kanematsu Computer System Ltd., accounted for 19%, 13% and 12%, respectively, of the
Companys revenue for the three months ended September 30, 2002. Two customers, Ingram Micro and BTN Internetworking, accounted for 12% and 10%, respectively, of the Companys revenue for the nine months ended September 30, 2002.



NOTE 9PRO FORMA INFORMATION:



In accordance with SFAS No. 141, the following unaudited pro forma
information is provided. The total revenues include the consolidated revenues of the Company as reported and the net revenues of VTC as if it had been acquired as of January 1, 2002. The pro forma net loss and net loss per share have been adjusted
to include the additional costs of amortization of intangibles and depreciation based on the actual purchase price of VTC. The unaudited pro forma information is not necessarily indicative of what actual results would have been had the acquisition
been completed by the Company at the beginning of the period.



|                                                               |  | Three Months Ended September 30, 2002 |        |   | Nine Months Ended September 30, 2002 |  
|-------------------------------------------------------------- |  | ------------------------------------- | ------ | - | ------------------------------------ | -
|                                                               |  | Actual                                |        |   | Pro Forma                            |  
|Net Revenue                                                    |  | $                                     | 2,035  |   |                                      | $
|Net Loss                                                       |  | $                                     | (5,867 | ) |                                      | $
|Net loss per share, basic and diluted                          |  | $                                     | (0.36  | ) |                                      | $
|Shares used in computing net loss per share, basic and diluted |  |                                       | 16,482 |   |                                      |  



17



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ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS



The section entitled Managements Discussion and Analysis of Financial Condition and Results of Operations set forth below contains
forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements include, but are not limited to,
statements about (1) our expectation that our U.S. sales will continue to represent most of our aggregate sales for the remainder of 2003 and that international sales will continue to represent a significant portion of our revenue, (2) our
expectation that our foreign sales will continue to be denominated primarily in U.S. dollars, (3) our expectation that we will continue to make significant expenditures on research and development activities as a percentage of overall operating
expenses, (4) our expectation that our research and development activities will represent a significant percentage of our overall operating expenses during the remainder of 2003, (5) our expectation that the amount of cash used to fund operations
will decrease, (6) our anticipation that our working capital expenditures on a period-to-period basis will decrease, (7) our expectation that our cash and cash equivalents will be sufficient to fund our operating activities and capital expenditure
requirements for the next 12 months, (8) our expectation that we will continue to evaluate product line expansion and new product opportunities, engage in research, development and engineering activities and focus on cost-effective design of our
products, (9) our expectation that we will seek additional funding for operations from alternative debt and equity sources, if necessary, to maintain reasonable operation levels, (10) our expectation that we will continue to incur losses for the
remainder of fiscal year 2003, (11) our anticipation that the average selling prices for our products will continue to decrease in the near future due to increased competitive price pressures in certain geographical regions, (12) our expectation
that we will make acquisitions of, or significant investments in, other companies, products or technologies, (13) our expectation that competitors will continue to market and sell inexpensive competitive products in the marketplace, (14) our
anticipation that, in the future, expansion in certain areas of our business may be required to expand our customer base and exploit market opportunities, (15) our expectation that demand for our products that are based on copper telephone wires
will decline, (16) our intention to introduce new products and product enhancements and (17) our revenue sources, our cash flow and cash position, our expense trends, products and standards development, and our plans, objectives, expectations and
intentions and other statements contained herein that are not historical facts. When used herein, the words anticipates, believes, continue, could, estimates, expects,
intends, may, plans, seeks, should, will or the negative of these terms or similar expressions are generally intended to identify forward-looking statements. Because these
forward-looking statements involve risks and uncertainties, there are important factors that could cause actual results to differ materially from those expressed or implied by these forward-looking statements. These factors are discussed under the
caption Additional Risk Factors that Could Affect our Operating Results and the Market Price of Our Stock. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof.
These forward-looking statements reflect current views of our management with respect to future events and are subject to these and other risks, uncertainties and assumptions. As a result, actual results may differ materially from the
forward-looking statements contained herein. All subsequent written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by this paragraph.



Overview



We design, develop, market and sell video content processing systems optimized for the provisioning of public broadcast
digital TV services across telephone company and cable company facilities, digital video trunking systems for applications across TV broadcast, government and education facilities, and broadband data transmission systems for application over
existing private campus or building facilities.



Historically,
most of our sales were derived from our broadband data transmission systems. With our November 2002 acquisition of Video Tele.com (VTC), formerly a subsidiary of Tektronix, Inc. (Tektronix), we extended our product offerings
to include video content processing and video trunking systems. The acquisition of VTC resulted in a significant change in the structure, organization and priorities of the Company, including: (1) changes in our organizational structure and employee
staffing; (2) establishment of significant operations in Lake Oswego, Oregon, the prior headquarters location of VTC;



18



---

(3) an expansion of our sales and marketing efforts to include VTC products; and (4) a reprioritization of our research and development budget to include the
research and development of products acquired by us in our acquisition of VTC.



Sales to customers outside of the United States accounted for approximately 18.0% and 47.7% of revenue for the nine months ended September 30, 2003 and 2002, respectively. With the inclusion of the products associated
with the acquisition of VTC, the geographic distribution of our sales has shifted significantly towards the United States. We expect this trend to continue for the remainder of 2003. However, actual results, both geographically and in absolute
dollars, may vary from quarter to quarter depending on the timing of orders placed by our customers. To date, all international sales have been primarily denominated in U.S. dollars.



We expect to continue to evaluate product line expansion and new product opportunities, engage in research, development and
engineering activities and focus on cost-effective design of our products. Accordingly, we will continue to make significant expenditures on research and development activities as a percentage of overall operating expenses.



In February 2000, we acquired FreeGate Corporation (FreeGate) for
approximately $25.5 million, consisting of 510,931 shares of our common stock, 19,707 options to acquire shares of our common stock, and acquisition related expenses consisting primarily of investment advisory, legal and other professional service
fees and other assumed liabilities. This transaction was treated as a purchase for accounting purposes. FreeGate was located in Sunnyvale, California. FreeGate designed, developed and marketed Internet server appliances combining the functions of IP
routing, firewall security, network address translation, secure remote access via VPN networking, and email and web servers on a compact, PC-based platform.



In April 2000, we acquired certain assets of OneWorld Systems, Inc. for approximately $2.4 million in cash. This transaction was treated as a purchase for
accounting purposes. The acquired assets consisted of $1.0 million for acquired workforce, $1.1 million for goodwill and $0.3 million for property and equipment.



In May 2000, we acquired Xstreamis Limited (Xstreamis), formerly Xstreamis, PLC, for $19.6 million, consisting
of 439,137 shares of our common stock, 10,863 options to acquire shares of our common stock, $0.1 million in cash and $0.6 million in acquisition related expenses consisting primarily of legal and other professional fees. This transaction was
treated as a purchase for accounting purposes. Xstreamis was located in the United Kingdom. Xstreamis provided policy-driven traffic management for high-performance, multimedia networking solutions including routing, switching and bridging
functions.



In January 2001, we acquired ActiveTelco, Inc.
(ActiveTelco) for approximately $4.9 million, consisting of 321,343 shares of our common stock, 18,657 options to acquire shares of our common stock, acquisition related expenses consisting primarily of legal and other professional fees,
assumed ActiveTelco convertible notes in the amount of $0.7 million plus accrued interest and other assumed liabilities of approximately $1.1 million. This transaction was treated as a purchase for accounting purposes. ActiveTelco was located in
Fremont, California. ActiveTelco provided an Internet telephony platform that enabled Internet and telecommunications service providers to integrate and deliver Web-based telephony applications such as unified messaging, long-distance service,
voicemail and fax delivery, call forwarding, call conferencing and callback services.



In September 2001, we acquired certain assets, including some intellectual property rights, from ViaGate Technologies, Inc. (ViaGate) for approximately $0.6 million in cash. This transaction was treated as
a purchase of assets for accounting purposes. The acquired patents and technology of ViaGate provide a highly scalable, carrier-class, full service gateway built on standards-based asynchronous transfer mode, or ATM, IP and VDSL technology.



In November 2002, we acquired VTC from Tektronix for
approximately $7.2 million, consisting of 3.3 million shares of our common stock valued at $3.6 million, acquisition related expenses consisting primarily of legal and other professional fees of $0.3 million, and a note payable to Tektronix in the
amount of $3.3 million. This transaction was treated as a purchase for accounting purposes. VTC was located in Lake Oswego, Oregon. VTC offers digital head-end solutions enabling home entertainment delivery via the broadband Internet.



19



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In connection with our acquisition of VTC, we registered on a Form S-3 pursuant to Rule 415(a)(1)(i)
under the Securities Act of 1933, as amended, on a continuous or delayed offering the 3.3 million shares of common stock issued to Tektronix, in order that Tektronix may sell such shares on or after December 1, 2003.



As of September 30, 2003, our net intangible assets remaining to be amortized
were $3.9 million, related to the acquisitions of the ViaGate assets, Xstreamis and VTC.



Results of Operations



The following table sets forth items from our statements of operations as a percentage of total revenues for the periods indicated:



|                                         |  | Three Months Ended September 30, |    |  | Nine Months Ended September 30, |   
|---------------------------------------- |  | -------------------------------- | -- |  | ------------------------------- | --
|                                         |  | 2003                             |    |  | 2002                            |   
|Total revenues                           |  | 100.0                            | %  |  | 100.0                           | % 
|Total cost of goods sold                 |  | 44.0                             |    |  | 61.4                            |   
|                                         |  |                                  |    |  |                                 |   
|Gross margin (loss)                      |  | 56.0                             |    |  | 38.6                            |   
|                                         |  |                                  |    |  |                                 |   
|Operating expenses:                      |  |                                  |    |  |                                 |   
|Sales and marketing                      |  | 21.7                             |    |  | 89.9                            |   
|Research and development                 |  | 22.2                             |    |  | 155.9                           |   
|General and administrative               |  | 11.9                             |    |  | 31.5                            |   
|Restructuring Costs                      |  | 3.4                              |    |  | 42.8                            |   
|Impairment of intangible assets          |  |                                 |    |  |                                |   
|Amortization of intangible assets        |  | 5.2                              |    |  | 14.7                            |   
|                                         |  |                                  |    |  |                                 |   
|Total operating expenses                 |  | 64.4                             |    |  | 334.8                           |   
|                                         |  |                                  |    |  |                                 |   
|Loss from operations                     |  | (8.4                             | )  |  | (296.2                          | ) 
|Impairment of certain equity investments |  |                                 |    |  |                                |   
|Interest and other (expense) income, net |  | (0.3                             | )  |  | 7.9                             |   
|                                         |  |                                  |    |  |                                 |   
|Net loss                                 |  | (8.7                             | )% |  | (288.3                          | )%
|                                         |  |                                  |    |  |                                 |   



Three and Nine Months Ended
September 30, 2003 and 2002



Revenue. Since our acquisition of VTC
in November 2002, we generate revenues primarily from turnkey video solutions, which are comprised of digital head-end and video trunking equipment. We also generate revenue from the sale of hardware products, which includes both our proprietary
products and third-party products, and professional services through the licensing of our HomeRun technology. Our total product revenue increased to $8.3 million and $22.4 million for the three and nine months ended September 30, 2003, respectively,
when compared to total product revenues of $1.8 million and $6.3 million for the same periods in 2002. The increase of $6.4 million or 350.2% and $16.1 million or 254.4 % for the three and



20



---

nine months ended September 30, 2003, respectively, compared with the same periods in the prior year is due primarily to the additional revenue resulting
from our sales of products acquired in our acquisition of VTC. For the nine months ended September 30, 2003, the increase in product revenue attributable to products acquired with the VTC acquisition offset declines in sales of our other products.



License and royalty revenue was $0.2 million and $0.6 million
for the three and nine months ended September 30, 2003, respectively, and was unchanged from license and royalty revenue for the same periods in 2002. We did not enter into any new license or royalty agreements during the first nine months of 2003
or 2002.



Cost of Goods Sold/Gross Margin. Cost of goods sold consists
primarily of costs related to raw materials, contract manufacturing, personnel, overhead, test and quality assurance, and the cost of licensed technology included in our products. Cost of goods sold increased by $2.5 million to $3.8 million during
the three months ended September 30, 2003, from $1.2 million during the same period in 2002. Cost of goods sold during the third quarter of 2003 included a reduction of reserves for excess and obsolete inventories of $0.8 million due to sales of
products for which we had set aside reserves. Excluding the effect from changes in inventory reserves, the increase in cost of goods sold was primarily due to increased product sales and related costs, particularly from product sales related to our
VTC acquisition. Historically, as a percentage of revenue, the VTC products generally have had a lower cost of goods sold than our other products.



For the nine months ended September 30, 2003, cost of goods sold increased by $1.7 million to $11.0 million compared with $9.3 million in 2002. Included
in cost of goods sold for the nine months ended September 30, 2003, was a reduction of reserves for excess and obsolete inventories of $0.8 million due to the sales of previously fully reserved products, compared to an increase of $5.2 million in
the prior year period. Excluding the effects of changes in reserves for excess and obsolete inventory, the increase in cost of goods sold was primarily due to increased product sales, particularly from product sales related to our VTC acquisition
and, consequently, increased product costs.



Gross margin as a
percentage of revenue increased to 56.0% and 52.0% for the three and nine months ended September 30, 2003, respectively, from 38.6% and (35.2%) for the three and nine months ended September 30, 2002, respectively, including the effect of reserves
for excess and obsolete inventory. The increase in our aggregate gross margin is the result of sales of previously fully reserved product sales and higher gross margins associated with the VTC product line. These VTC products were not included in
our 2002 financials.



Sales and Marketing. Sales and marketing expense
primarily consists of personnel costs, including commissions and costs related to customer support facilities, travel, trade shows, promotions and outside services. Our sales and marketing expenses were $1.9 million and $5.7 million for the three
and nine months ended September 30, 2003, respectively, compared with $1.8 million and $6.6 million for the three and nine months ended September 30, 2002, respectively. As a percentage of revenue, sales and marketing expense decreased to 21.7% and
24.8% for the three and nine months ended September 30, 2003, respectively, from 89.9% and 95.7% for the same periods in 2002. The decreases in sales and marketing expense as a percentage of revenue for the three and nine months ended September 30,
2003, compared with the same periods in 2002, were primarily due to our restructuring efforts, which have enabled us to support increasing revenue with a lower cost structure.



Research and Development. Research and development expense consists primarily of personnel and facilities costs related to
engineering and technical support, contract consultants, outside testing services, equipment and supplies associated with developing new products and enhancing existing products. Research and development costs are expensed as incurred. Our research
and development expense decreased to $1.9 million and $6.2 million for the three and nine months ended September 30, 2003, respectively, from $3.2 million and $10.0 million for the three and nine months ended September 30, 2002, respectively. The
decreases for the three and nine months ended September 30, 2003, when compared with the same periods in 2002, of $1.3 million, or 40.5%, and $3.7 million, or 37.5%, respectively, was primarily a result of our continued focus on cost saving measures
and restructurings in current and prior periods, including the reduction, postponement or abandonment of research and development efforts on certain product lines. These cost savings resulted in decreases of $0.3 million in personnel costs and $0.5
million in facilities, supplies and other expenses in the third quarter of 2003 when compared with the same periods in 2002. In addition, included in research and development expense during the third quarter



21



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of 2002 was $0.5 million in expenditures for prototypes of our IntelliPOP 8000 series of products. For the nine months ended September 30, 2003, personnel
costs declined by $1.5 million and facilities, prototypes, supplies and other costs declined by $2.3 million. Even though our research and development costs decreased in total during the first nine months of 2003 compared with the first nine months
of 2002, we expect research and development activities to continue to represent a significant percentage of our overall operating expenses.



General and Administrative. General and administrative expense consists primarily of personnel costs for executive and administrative officers and support
personnel, professional services and insurance. Our general and administrative expense increased to $1.0 million from $0.6 million for the three months ended September 30, 2003 and 2002, respectively. For the three months ended September 30, 2003,
professional fees and insurance declined $0.6 million and personnel and other costs declined $0.3 million compared with the same period in 2002. Included in general and administrative expense during the third quarter of 2002 was the recovery of $1.3
million of debt that we had previously classified as bad debt. General and administrative expense decreased to $3.3 million for the nine months ended September 30, 2003, from $3.8 million for the nine months ended September 30, 2002. The decrease of
$0.5 million for the nine months ended September 30, 2003, when compared with the same period in 2002 included reductions of $1.2 million in professional fees and insurance and reductions in personnel and other costs of $1.3 million. Included in
general and administrative expense during the first nine months of 2002 was the recovery of $2.0 million of debt that we had previously classified as bad debt.



Impairment of Intangibles. We recognized a loss of $0.1 million during the nine months ended September 30, 2003, for the impairment of certain technology
acquired as part of the acquisition of the assets of ViaGate. There were no such write-offs during the three and nine months ended September 30, 2002.



Restructuring. In August 2003, we implemented a restructuring program that included a workforce reduction and relocation. This restructuring program resulted in
restructuring costs of $0.3 million in the third quarter of 2003. The restructuring costs consisted of $0.2 million in workforce reduction charges relating primarily to severance and fringe benefits and $0.1 million in relocation expenses. In the
third quarter of 2002, we announced a restructuring program that included a workforce reduction, closure of our New Jersey research and development facility, and disposal of certain of our fixed assets. As a result of this restructuring program, we
recorded restructuring costs of $0.9 million in the third quarter of 2002. These restructuring costs consisted of $0.5 million in workforce reduction charges relating primarily to severance and fringe benefits and $0.4 million relating to closure of
our New Jersey facility.



Amortization of Intangibles. Amortization of
intangibles is comprised of technology and patents related to acquisitions and is amortized over their estimated useful lives of five years. Amortization of intangibles increased to $0.4 million and $1.4 million for the three and nine months ended
September 30, 2003, respectively, from $0.3 million and $0.9 million for the three and nine months ended September 30, 2002, respectively. The increase was primarily due to the intangibles acquired when we purchased VTC in November 2002. As of
September 30, 2003, net intangible assets of $3.9 million consist primarily of completed technology and patents, which remain to be amortized.



Impairment of Certain Equity Investments. Impairment of certain equity investments for the nine months ended September 30, 2002, consisted of the recognition of
expense related to the write-off of $0.6 million invested in a privately-held company. The value of this investment was impaired due to uncertainty about the continued viability of the company. As of September 30, 2002, we had no remaining
investments in privately held companies.



Interest and Other (Expense)
Income, Net. Interest and other (expense) income, net consists primarily of interest income and expense and foreign currency exchange gains and losses. Our interest income and other (expense) income, net decreased during the three months ended
September 30, 2003 as a result of interest expense on a note payable exceeding interest income. Interest and other (expense) income, net was $0.2 million of income for the nine months ended September 30, 2003, compared with income of $0.6 million
for the nine months ended September 30, 2002. The decreases for the three and nine months ended September 30, 2003 were due to lower interest rates on lower average invested cash balances and to increased interest expense associated with the
long-term note payable to Tektronix, Inc. related to the acquisition of VTC. The reduction in interest and other income, net during the first nine months of 2003 was partially offset by a foreign currency exchange gain of $0.1 million.



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Liquidity and Capital Resources



Historically, our principal source of liquidity has been through equity funding. From our inception through January 1999, we
financed our operations primarily through the sale of preferred equity securities for an aggregate of $46.2 million, net of offering costs. In January 1999, we completed our initial public offering and issued 2,875,000 shares of our common stock at
a price of $18.00 per share. From that January 1999 offering, we received approximately $46.9 million in cash, net of underwriting discounts, commissions and other offering costs. We also received approximately $6.7 million as a result of the
exercise of a warrant to purchase 666,836 shares of Series G convertible preferred stock at a price of $10.00 per share. In March 2000, we completed our secondary offering and issued 2,500,000 shares of our common stock at a price of $60.00 per
share, and we received approximately $141.7 million in cash, net of underwriting discounts, commissions and other offering costs. In the future, we cannot be certain that similar equity funding will be available to us. If we are unable to obtain
additional equity financing on terms acceptable to us, our business, operating results and financial condition could be negatively impacted.



Cash and cash equivalents totaled $14.0 million at September 30, 2003, a decrease of $11.6 million, or 45.4%, from cash and cash equivalents of $25.6
million at December 31, 2002.



The net decrease in cash and
cash equivalents of $11.6 million during the nine months ended September 30, 2003, resulted primarily from our use of $11.7 million in cash for operating activities and purchase of property and equipment of $0.7 million. Included in cash used for
operating activities was the payment of $3.7 million towards our remaining purchase commitments to a former vendor for raw material components and an increase in accounts receivable of $5.2 million. The increase in accounts receivable is primarily
due to increased sales volume. Also included in cash used for operating activities during the nine months ended September 30, 2003, were cash payments of $0.2 million associated with our restructuring activities in the three months ended September
30, 2003.



In future periods, we generally anticipate a
decrease in working capital expenditures on a period-to-period basis primarily as a result of completing substantial payments for purchase commitments for inventory and decreases in our operational costs due to our restructuring and prior workforce
reductions.



We have entered into certain contractual
obligations including inventory purchase commitments of $0.4 million at September 30, 2003, that could result in cash outflows.



Our future minimum lease payments under operating leases at September 30, 2003, are as follows:



|Remainder of 2003 |  | $ | 275,000  
|----------------- |  | - | ---------
|2004              |  |   | 806,000  
|2005              |  |   | 269,000  
|Thereafter        |  |   |         
|                  |  |   |          
|                  |  | $ | 1,350,000
|                  |  |   |          



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 in ninety months, or November 2007. The interest rate on this note is 8% and is compounded annually. Through January 31, 2006,
the accrued interest is added to the principal balance of the note. Thereafter, we will pay accrued interest on this note commencing on January 31, 2006 and on each April 30, July 31 and October 31 thereafter until the principal balance is paid in
full.



We have incurred substantial losses and negative cash
flows from operating activities since inception. For the nine months ended September 30, 2003, we incurred a net loss of $5.0 million, negative cash flows from operating activities of $11.7 million, and have an accumulated deficit of $281.5 million.
We believe that the cash and cash equivalents as of September 30, 2003 are sufficient to fund our operating activities and capital expenditure requirements for the next twelve months. We expect the amount of cash necessary to fund operations to
decrease throughout the remainder of 2003. However, to the extent our business



23



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continues to be affected by poor economic conditions impacting the telecommunications industry, we will continue to require cash to fund operations. We will
seek additional funding for operations from alternative debt and equity sources, if necessary, to maintain reasonable operating levels. We cannot assure that such funding efforts will be successful. Failure to generate positive cash flow in the
future could have a material adverse effect on our ability to achieve our intended business objectives.



Critical Accounting Policies and Estimates



The discussion and analysis of our financial condition and results of operations is based upon our unaudited condensed consolidated financial statements, which have been prepared in accordance with accounting
principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and
related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to revenue recognition, bad debts, investments, intangible assets and income taxes. Our estimates are based on
historical experience and on various other assumptions we believe are reasonable under the circumstances. Actual results may differ from these estimates.



The accounting policies described below are those that most frequently require us to make estimates and judgments, and are therefore critical to
understanding our results of operations.



Revenue
recognition



We generate revenue primarily from the sale
of hardware products, including third-party products, through professional services, the licensing of our HomeRun technology and the sale of our software products. We sell products through direct sales channels and through distributors.



Product revenues



We recognize product revenue when persuasive evidence of an arrangement
exists, delivery has occurred or services have been provided, the fee is fixed or determinable, and collection is probable. Significant management judgments and estimates must be made in connection with the measurement of revenue in a given period.
We follow specific and detailed guidelines for determining the timing of revenue recognition. At the time of the transaction, we assess a number of factors, including specific contract and purchase order terms, completion and timing of delivery to
the common carrier, past transaction history with the customer, the creditworthiness of the customer, evidence of sell-through to the end user, and current payment terms. Based on the results of our assessment, we may recognize revenue when the
products are shipped or defer recognition until evidence of sell-through occurs and cash is received. Revenue from service obligations included in product revenues is deferred and recognized ratably over the period of the obligation. We also
maintain accruals and allowances for all cooperative marketing and other programs. Estimated sales returns and warranty costs are based on historical experience and are recorded at the time revenue is recognized. Our products generally carry a
one-year warranty from the date of purchase. The warranty accrual was not material at September 30, 2003 or December 31, 2002.



Turnkey solution revenues



Revenue on turnkey video solution sales, which typically include the design, manufacture, test, integration and installation of our equipment to our
customers specifications, or equipment acquired from third parties to be integrated with our products, is generally recognized using the percentage-of-completion method. Under the percentage-of-completion method, revenue recognized reflects
the portion of the anticipated contract revenue that has been earned, equal to the ratio of labor costs expended to date, to anticipated total labor costs, based on current estimates of labor costs to complete the project. If the estimated costs to
complete a project exceed the total contract amount, indicating a loss, the entire anticipated loss is recognized immediately. Generally, the terms of turnkey video solution sales provide for billing for products at the time of delivery and for
services at the time of substantial completion of the project.



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License and royalty revenues



We have entered into non-exclusive technology agreements with various licensees. These agreements provide the licensees the
right to manufacture, or have manufactured, products which incorporate the Companys proprietary technology and to receive customer support for specified periods and any changes or improvement to the technology over the term of the agreement.



Contract fees for the services provided under these licensing
agreements are generally comprised of license fees and non-refundable, prepaid royalties that are recognized when the proprietary technology is delivered if there are no significant vendor obligations. If the licensing agreements contain
post-contract customer support, we recognize the contract fees ratably over the period during which the post-contract customer support is expected to be provided. This period represents the estimated life of the technology. We begin to recognize
revenue under the contract once it has delivered the implementation package that contains all information needed to use our proprietary technology in the licensees process. The remaining obligations are primarily to provide the licensee with
any changes or improvements to the technology and technical advice on specifications, testing, debugging and enhancements.



We recognize royalties upon notification of sale by our licensees. The terms of the royalty agreements generally require licensees to notify us and pay
royalties within 60 days of the end of the quarter during which the sales occur.



Software license and post contract support revenues



Currently, our software revenue is derived from two separate sources, software license fees and post-contract maintenance and support fees. A software license typically grants a perpetual license to the customer. We
generally recognize revenue from the sales of software licenses when all criteria for revenue recognition that are similarly applicable to our hardware product sales have been met. The revenue for post-contract maintenance and support fees is
recognized ratably over the term of the separate support contract.



Revenue recognitionSummary



Revenue
recognition in each period is dependant on our application of these accounting policies. If we believe that any of the conditions to recognize revenue have not been met, we will defer revenue recognition. For example, if collectibility is not
reasonably assured, we will defer revenue recognition until subsequent cash receipt. Our application of percentage-of-completion accounting is subject to our estimates of labor cost to complete each turnkey solution project. In the event that actual
results differ from these estimates or we adjust these estimates in future periods, our operating results for a particular period could be adversely affected. Unearned revenue that has been billed but not collected at the end of the period is
recorded as a reduction against the related accounts receivable balance. Unearned revenue recorded as a reduction against the related accounts receivable was $1.7 million and $0.9 million at September 30, 2003 and December 31, 2002, respectively.



Inventories



Inventories are stated at the lower of cost or market. Cost is computed
using standard cost, which approximates actual cost on a first-in, first-out basis. We record provisions to write down our inventory and related purchase commitments for estimated obsolescence or unmarketable inventory equal to the difference
between the cost of the inventory and the estimated market value based upon assumptions about the future demand and market conditions. If actual future demand or market conditions are less favorable than we estimate, additional inventory provisions
may be required.



Allowance for doubtful accounts



We maintain allowances for doubtful accounts for
estimated losses resulting from the inability of our customers to make payments. These estimated allowances are periodically reviewed and take into account the customers payment history and information regarding the customers
creditworthiness that is known to us. If the financial condition of any of our customers were to deteriorate, resulting in their inability to make payments, an additional allowance would be required.



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Accounting for long-lived assets



We assess the impairment of long-lived assets periodically. An impairment review is performed whenever events or changes in
circumstances indicate that the carrying value may not be recoverable. Factors considered important which could trigger an impairment review include, but are not limited to, significant underperformance relative to expected historical or projected
future operating results, significant changes in the manner of use of the acquired assets or the strategy for the overall business, significant negative industry or economic trends, a significant decline in the stock price for a sustained period,
and the market capitalization relative to net book value.



When
our management determines that the carrying value may not be recoverable based upon the existence of one or more of the above indicators of impairment, any impairment is based on a projected discounted cash flow method using a discount rate
commensurate with the risk inherent in our current business model.



During the nine months ended September 30, 2003, we determined that certain of the technology acquired as part of our purchase of the ViaGate assets in September 2001 had become impaired. As a result, we recorded a loss of $0.1 million to
write off the technology.



Future events could cause us to
conclude that impairment indicators exist. Any resulting impairment loss could have a material adverse impact on our financial condition and results of operations.



Legal contingencies



We are currently involved in certain legal proceedings as discussed in Note 7 of our unaudited condensed consolidated financial statements. Because of
uncertainties related to both the potential amount and range of loss from the pending litigation, management is unable to make a reasonable estimate of the liability that could result if there were an unfavorable outcome in any of these legal
proceedings. As additional information becomes available, we will re-assess the potential liability related to this pending litigation and revise our estimates accordingly. Revisions of our estimates of such potential liability could materially
impact our results of operations, financial condition or cashflows.



Accounting for stock based compensation



We account for stock-based employee compensation arrangements in accordance with the provisions of Accounting Principles Board Opinion No. 25 (APB No. 25), Accounting for Stock Issued to
Employees, Financial Accounting Standard Board Interpretation No. 44 (FIN 44), Accounting for Certain Transactions Involving Stock Compensationan Interpretation of APB 25, and comply with the disclosure provisions
of Statement of Financial Accounting Standard No. 148 (SFAS No. 148), Accounting for Stock-Based Compensation, Transition and Disclosure. Under APB No. 25, compensation expense is based on the difference, if any, on the date
of the grant, between the fair value of the Companys stock and the exercise price. We account for stock issued to non-employees in accordance with 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 other than Employees for Acquiring, or in Conjunction with Selling Goods or Services.



We amortize stock-based compensation using the straight-line method over the remaining vesting periods of the related options, which is generally four
years. Pro forma information regarding net loss and earnings per share is required. This information is required to be determined as if we had accounted for employee stock options under the fair value method of SFAS No. 123, as amended by SFAS No.
148.



26



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The following table illustrates the effect on net loss and earnings per share if we had applied the fair
value recognition provisions of SFAS No. 123, as amended by SFAS No. 148, to stock-based employee compensation (unaudited, in thousands except per share amounts):



|                                                                                                                                      |  | Three Months Ended September 30, |        |   | Nine Months Ended September 30, |  
|------------------------------------------------------------------------------------------------------------------------------------- |  | -------------------------------- | ------ | - | ------------------------------- | -
|                                                                                                                                      |  | 2003                             |        |   | 2002                            |  
|Net lossas reported                                                                                                                  |  | $                                | (742   | ) |                                 | $
|                                                                                                                                      |  |                                  |        |   |                                 |  
|Adjustment:                                                                                                                           |  |                                  |        |   |                                 |  
|Total stock-based employee compensation expense determined under a fair value based method for all grants, net of related tax
effects |  |                                  | (816   | ) |                                 |  
|                                                                                                                                      |  |                                  |        |   |                                 |  
|Net losspro forma                                                                                                                    |  | $                                | (1,558 | ) |                                 | $
|                                                                                                                                      |  |                                  |        |   |                                 |  
|Basic and diluted net loss per shareas reported                                                                                      |  | $                                | (0.04  | ) |                                 | $
|                                                                                                                                      |  |                                  |        |   |                                 |  
|Basic and diluted net loss per sharepro forma                                                                                        |  | $                                | (0.08  | ) |                                 | $
|                                                                                                                                      |  |                                  |        |   |                                 |  



The fair value of
options and shares issued pursuant to the option plans and at the grant date were estimated using the Black-Scholes model. The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no
vesting restrictions and are fully transferable. Option-pricing models require the input of highly subjective assumptions including the expected stock price volatility. We use projected volatility rates, which are based upon historical volatility
rates trended into future years. Because employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in
managements opinion, the existing models do not necessarily provide a reliable single measure of the fair value of options.



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



Prior to our initial public offering, the fair value of each stock option was
estimated using the minimum value method. Volatility and dividend yields were not factors in the Companys minimum value calculation. Subsequent to the offering, the fair value of each stock option has been estimated on the date of grant using
the Black-Scholes option pricing model. We have also estimated the fair value of the purchase rights issued from our employee stock purchase plan using the Black-Scholes option pricing model. We first issued purchase rights from the 1998 Employee
Stock Purchase Plan in fiscal year 1999.



Recent Accounting Pronouncements



In April 2003, the Financial Accounting Standards Board
(FASB) issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. SFAS No. 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain
derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS No. 149 is effective for
contracts entered into or modified after September 30, 2003, and for hedging relationships designated after September 30, 2003. We believe that the adoption of this standard will not have a material impact on our financial statements.



In May 2003, the FASB issued SFAS No. 150, Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity. SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It
requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments were previously classified as equity. SFAS No. 150 is effective for financial instruments
entered into or modified after May 31, 2003, and otherwise is effective at



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the beginning of the first interim period beginning after September 15, 2003. It is to be implemented by reporting the cumulative effect of a change in an
accounting principle for financial instruments created before the issuance date of SFAS No. 150 and still existing at the beginning of the interim period of adoption. Restatement is not permitted. We believe that the adoption of this standard will
not have a material impact on our financial statements.



Non-Audit Services
of Independent Auditors



In accordance with Section
10(A)(i)(2) of the Securities Exchange Act of 1934, as amended, as added by Section 202 of the Sarbanes-Oxley Act of 2002, we are required to disclose the non-audit services approved by our Audit Committee to be provided by PricewaterhouseCoopers
LLP, our independent auditor. The Audit Committee has approved fees of $10,000 for the engagement of PricewaterhouseCoopers LLP for merger and acquisition consulting services.



ADDITIONAL RISK FACTORS THAT COULD AFFECT OUR OPERATING RESULTS AND THE MARKET PRICE OF OUR STOCK



We have a history of losses and expect to continue to incur losses in the future.



We have incurred substantial net losses and experienced
negative cash flow for each quarter since our inception. We incurred a net loss of $5.0 million for the nine months ended September 30, 2003, and a net loss of $41.6 million for the year ended December 31, 2002. As of September 30, 2003, we had an
accumulated deficit of $281.5 million. We expect that we will continue to incur losses for the remainder of fiscal year 2003.



We may never achieve profitability and, if we do so, we may not be able to maintain profitability. We have spent substantial amounts of money on the
development of our Expresso products, HomeRun and LongRun technology, IntelliPOP products and software products. In November 2002, we acquired VideoTele.com (VTC) and certain products of VTC that are generating incremental revenue beyond
our Expresso, Home Run, Long Run and IntelliPOP products and that we anticipate will continue to bring us such incremental value. During fiscal years 2001, 2002 and 2003, we significantly reduced our workforce in an effort to decrease certain of our
operating expenditures, including our sales and marketing, research and development and general and administrative expenditures. However, we may not be able to generate a sufficient level of revenue (even with our VTC products) to offset our current
level of expenditures. Additionally, we may be unable to adjust our spending in a timely manner to respond to any unanticipated decline in revenue due to the fact that our expenditures for sales and marketing, research and development, and general
and administrative functions are relatively fixed in the short term. Our ability to achieve and maintain profitability in the future will primarily depend on our ability to do the following:



| |  | increase the level of sales of our Expresso products, including existing Expresso inventories;
| | - | ----------------------------------------------------------------------------------------------



| |  | increase our sales of VTC products;
| | - | -----------------------------------



| |  | successfully penetrate new markets for our IntelliPOP products;
| | - | ---------------------------------------------------------------



| |  | reduce manufacturing costs;
| | - | ---------------------------



| |  | reduce operating expenses as a percentage of sales;
| | - | ---------------------------------------------------



| |  | sell excess component parts obtained as a result of canceled purchase commitments; and
| | - | --------------------------------------------------------------------------------------



| |  | successfully introduce and sell enhanced versions of our existing and new products.
| | - | -----------------------------------------------------------------------------------



Our operating results may fluctuate significantly, which could cause our stock price to decline.



A number of factors could cause our quarterly and annual financial results
to be worse than expected, which could result in a decline in our stock price. Our annual and quarterly operating results have fluctuated in the past and may fluctuate significantly in the future as a result of numerous factors, some of which are
outside of our control. These factors include:



| |  | availability of capital in the network infrastructure industry;
| | - | ---------------------------------------------------------------



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| |  | management of inventory levels;
| | - | -------------------------------



| |  | market acceptance of our products;
| | - | ----------------------------------



| |  | competitive pressures, including pricing pressures from our partners and competitors, particularly in light of past announcements from competitors that they have written down
significant amounts of inventory, which could lead to a general excess of competitive products in the marketplace;
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | the timing or cancellation of orders from, or shipments to, existing and new customers;
| | - | ---------------------------------------------------------------------------------------



| |  | the timing of our new product and service introductions as well as introductions by our customers, our partners or our competitors;
| | - | -----------------------------------------------------------------------------------------------------------------------------------



| |  | variations in our sales or distribution channels;
| | - | -------------------------------------------------



| |  | variations in the mix of products that we offer;
| | - | ------------------------------------------------



| |  | changes in the pricing policies of our suppliers;
| | - | -------------------------------------------------



| |  | the availability and cost of key components; and
| | - | ------------------------------------------------



| |  | the timing of personnel hiring.
| | - | -------------------------------



We anticipate that average selling prices for our products will continue to decrease in the near future due to increased competitive price pressures in
certain geographical regions. In addition, we may also experience substantial period-to-period fluctuations in future operating results and declines in gross margins as a result of the erosion of average selling prices for our VTC products,
high-speed data access products and services due to a number of factors, including increased competition and rapid technological change. Decreasing the average selling prices of our products could cause us to experience decreased revenue despite an
increase in the number of units sold. We may be unable to sustain our gross margins, even at the anticipated reduced levels, improve our gross margins by offering new products or increased product functionality or offset future price declines with
proportionate reductions in our cost structure.



As a result of
these and other factors, our operating results for future periods may be below the expectations of securities analysts and investors. In that event, the price of our common stock would further decline.



We continue to be affected by poor general economic conditions that have resulted in
significantly reduced sales levels and, if such adverse economic conditions continue or worsen, our business, operating results and financial condition will be further negatively impacted.



The continued poor economic conditions in the world economy, and the
continued industry-wide slowdown in the telecommunications market have materially and adversely affected, and continue to materially and adversely affect, our sales. As a result, we have experienced, and will likely continue to experience, a
material adverse impact on our business, operating results and financial condition. Comparatively lower sales for each of our fiscal years from 2000 through 2002 have resulted in operating expenses increasing as a percentage of revenue for 2002 and
2001 compared to 2000. Although we took actions throughout 2001, 2002 and the first nine months of 2003 to create revenue opportunities and reduce operating expenses, including our acquisition of VTC, a prolonged continuation or worsening of sales
trends that we faced in 2001 and 2002 would force us to take additional actions and charges in order to reduce our operating expenses further. If we are unable to reduce operating expenses at a rate and level



29



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consistent with anticipated future adverse sales trends or if we continue to incur significant special charges associated with such expense reductions that
are disproportionate to our sales, our business, operating results and financial condition will be even further negatively impacted.



We depend on a limited number of large customers for a substantial portion of our revenue during any given period, and the loss of a key customer or loss or delay of a
key order could substantially reduce our revenue in a given period.



We derive a significant portion of our revenue in each period from a limited number of customers. No individual customer accounted for greater than 10% of our revenue for the nine months ended September 30, 2003. Two customers, Ingram Micro
and BTN Internetworking, accounted for 12% and 10%, respectively, of our revenue for the nine months ended September 30, 2002. Many of our customers have limited or, in some cases, no access to capital and continue to experience significant
financial difficulties, including bankruptcy. In order to meet our revenue targets, we must continue to acquire new customers and increase sales to our existing customers. In addition, our strategy of targeting larger, more established customers may
result in longer sales cycles and delayed revenue. Sales to larger accounts could also result in increased competition from larger and more established competitors. If sales to our largest customers decrease materially below current levels or if we
are unable to establish a new base of customers, such decreases or failures would materially and adversely affect our business, results of operations and financial condition.



We have in the past and may in the future acquire other companies. If we fail to integrate successfully these acquisitions into our
Company, our business, results of operations and financial condition could be materially harmed.



Since February 2000, we have completed six acquisitions of other companies or their assets. As a part of our business strategy, we expect to make
additional acquisitions of, or significant investments in, complementary companies, products or technologies. We may need to overcome significant issues in order to realize any benefits from our past transactions, and any future acquisitions would
be accompanied by similar risks. These risks include, but are not limited to:



| |  | combining product offerings and preventing customers and distributors from deferring purchasing decisions or switching to other suppliers due to uncertainty about the direction of
our product offerings and our willingness to support and service existing products, which could result in our incurring additional obligations in order to address customer uncertainty;
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | demonstrating to customers and distributors that the transaction will not result in adverse changes in client service standards or business focus and helping customers conduct
business easily;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | consolidating and rationalizing corporate IT infrastructure, including implementing information management and system processes that enable increased customer satisfaction, improved
productivity, lower costs, more direct sales and improved inventory management;
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | consolidating administrative infrastructure and manufacturing operations and maintaining adequate controls throughout the integration of an acquired company into our organization;
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | coordinating sales and marketing efforts to communicate our offerings and capabilities effectively;
| | - | ---------------------------------------------------------------------------------------------------



| |  | coordinating and rationalizing research and development activities to enhance introduction of new products and technologies with reduced cost;
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------



| |  | preserving distribution, marketing and other important relationships and resolving potential conflicts that may arise;
| | - | ----------------------------------------------------------------------------------------------------------------------



| |  | minimizing the diversion of management attention from ongoing business concerns;
| | - | --------------------------------------------------------------------------------



| |  | maintaining employee morale and retaining key employees while implementing restructuring programs;
| | - | --------------------------------------------------------------------------------------------------



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| |  | coordinating and combining operations, subsidiaries and affiliated entities, relationships and facilities, which may be subject to additional constraints imposed by local laws and
regulations and may also result in contract terminations or renegotiations and labor and tax law implications; and
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | managing integration issues shortly after or pending the completion of other independent reorganizations.
| | - | ---------------------------------------------------------------------------------------------------------



On November 7, 2002, we completed our acquisition of VTC, a leading provider
of video content processing and video trunking, and we are in the process of integrating VTC into our company. We evaluate and enter into other acquisition and alliance transactions on an ongoing basis. The size and scope of the acquisition of VTC
relative to our overall size increases both the scope and consequence of ongoing integration risks. We may not successfully address the integration challenges in a timely manner, or at all, and we may not fully realize all of the anticipated
benefits or synergies of the VTC acquisition (which principally entail restructuring our organization through workforce reductions, identification of procurement synergies and other such operational efficiencies) or any other acquisition to the
extent, or in the timeframe, anticipated. Moreover, the timeframe for achieving benefits of any such acquisition may depend partially on the actions of employees, suppliers or other third parties.



As a result of the foregoing, if we are unable to integrate successfully any
completed, pending or future acquisitions, our business, operating results and financial condition could be materially harmed.



We are currently engaged in three securities lawsuits, two of which are class action lawsuits, any of which, if they were to result in an unfavorable resolution, could
adversely affect our business, results of operations or financial condition.



Beginning July 12, 2001, nine putative stockholder class action lawsuits were filed in the United States District Court for the Northern District of California against the Company and certain of its current and former
officers and directors. The complaints were filed on behalf of a purported class of people who purchased the Companys stock during the period between July 20, 2000 and January 31, 2001, seeking unspecified damages. The complaints allege that
the Company and certain of its current and former officers and directors made false and misleading statements about the Companys business during the putative class period. Specifically, the complaints allege violations of Section 10(b) and
20(a) of the Securities Exchange Act of 1934, as amended. The complaints have been consolidated under the name In re Tut Systems, Inc. Securities Litigation, Master File No. C-01-2659-CW (the Securities Litigation Action). Lead
plaintiffs and lead counsel for plaintiffs have been appointed. Plaintiffs filed a consolidated class action complaint on February 4, 2002. Defendants filed a Motion to Dismiss on March 29, 2002. On August 15, 2002, the Court granted in part and
denied in part the Motion to Dismiss. On September 23, 2002, plaintiffs filed an amended complaint. Defendants filed a Motion to Dismiss the amended complaint, and on August 6, 2003 the Court granted in part that Motion. On September 24, 2003,
Defendants answered the remaining allegations of the amended complaint. Discovery has commenced. Trial is scheduled to begin on March 7, 2005. The Company believes it has meritorious defenses to the allegations in the complaint and intends to defend
the case vigorously. An unfavorable resolution of this litigation could have a material adverse effect on the Companys business, results of operations, financial condition and cash flows.



On March 19, 2003, Chesky Lefkowitz, a shareholder of the Company, filed a
derivative complaint entitled Lefkowitz v. DAuria, et al., No. RG03087467, in the Superior Court of the State of California, County of Alameda, against certain of the Companys current and former officers and directors. The complaint
alleges causes of action for breach of fiduciary duty, gross negligence, breach of contract, unjust enrichment and improper insider stock trading, based on the same factual allegations contained in the Securities Litigation Action. The complaint
seeks unspecified damages against the individual defendants on behalf of the Company, equitable relief, and attorneys fees. On May 21, 2003, the Company and the individual defendants filed separate demurrers to the complaint. The demurrers
have not yet been heard by the Court, and no trial date has been established.



On October 30, 2001, Tut Systems and certain of its current and former officers and directors were named as defendants in Whalen v. Tut Systems, Inc. et al., Case No. 01-CV-9563, a purported securities class action
lawsuit filed in the United States District Court for the Southern District of New York. An



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amended complaint was filed on December 5, 2001. A consolidated amended complaint was filed on April 19, 2002. The consolidated amended complaint asserts
that the prospectuses from Tut Systems January 29, 1999 initial public offering and its March 23, 2000 secondary offering failed to disclose certain alleged actions by the underwriters for the offerings. The complaint alleges claims against
Tut Systems and certain of its current and former officers and directors under Section 11 of the Securities Act of 1933, as amended, (the 1933 Act) 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 former officers and directors under Sections 15 and 20(a) of the 1933 Act. The complaints also name as defendants the underwriters for Tut Systems initial public offering and
secondary offering. The Court has denied the Companys motion to dismiss. The Companys Board recently approved a tentative settlement proposal from the plaintiffs. The settlement is subject to a number of conditions, including approval of
the Court. If the settlement does not occur, and the litigation against the Company continues, the Company believes it has meritorious defenses to the allegations in the complaint and intends to defend the case vigorously. An unfavorable resolution
of this litigation could have a material adverse effect on the Companys business, results of operations, financial condition and cash flows.



If our Expresso and IntelliPOP products do not gain broader acceptance in the market, our business, financial condition and results of operations will be further
harmed.



We launched our IntelliPOP 5000 product series in
the first half of 2001 and have still not been successful in generating widespread customer interest in this product. Similarly, our sales of Expresso units have been below what we had anticipated. We must devote a substantial amount of human and
capital resources in order to broaden commercial acceptance of our Expresso products and to gain commercial acceptance of our IntelliPOP products and expand our offerings of these products in the multi-dwelling unit, or MDU, and the multi-tenant
commercial unit, or MCU, markets. However, to date, this commitment of resources to these product lines has not generated the commercial acceptance that we have sought for these products. Historically, the majority of our Expresso products have been
sold into the MDU market. Our future success depends on our ability to continue to penetrate this market and to expand our penetration into the MCU market. Our success also depends on our ability to educate existing and potential customers and
end-users about the benefits of our Fast Copper and Signature Switch technologies, our LongRun and IntelliPOP products, and about the development of new products to meet changing and expanding demands of service providers, MCU owners and corporate
customers, including our new product offerings based on our acquisition of VTC. The future success of our Expresso and IntelliPOP products will also depend on the ability of our service provider customers to market and sell high-speed data services
to end-users. If our IntelliPOP or Expresso products do not achieve broader commercial acceptance within the MDU market, MCU market, or in any other markets we may enter, our business, financial condition and results of operations will be further
materially and adversely affected.



The market in which we operate is highly
competitive, and we may not be able to compete effectively.



The market for video and broadband data systems is intensely competitive, and we expect that this market will continue to become more competitive in the future. Our immediate competitors include, or are expected to include, Cisco Systems,
Inc., Harmonic Inc., Tandberg Television and a number of other public and private companies. Many of these competitors offer or may in the future offer technologies and services that directly compete with some or all of our high-speed access
products and related software products. Also, many of these competitors continue to announce significant changes in their business plans and operations, some of which, such as major write downs of inventory, could result in lower priced products
flooding the market, which would have a negative impact on our ability to sustain our current pricing and sell our inventory. In addition, the market in which we compete is characterized by increasing consolidation, and we cannot predict with
certainty how industry consolidation will affect us or our competitors.



Our competitors and potential competitors may have substantially greater name recognition and technical, financial and marketing resources than we do, and we can give you no assurance that we will be able to compete effectively in our
target markets. These competitors may be able to undertake more extensive marketing campaigns, adopt more aggressive pricing policies and devote substantially more resources to developing new products than we can. In addition, our HomeRun licensees
may sell products based on our HomeRun technology to our competitors or potential competitors. This licensing may cause an erosion in the potential market for our Expresso products. We cannot assure you that we will have the financial resources,
technical expertise or marketing, manufacturing, distribution and support capabilities to compete successfully. This competition could result in price reductions, reduced profit margins and loss of market share, which could harm our business,
financial condition and results of operations.



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Our copper-wire based solutions face severe competition from other technologies, and the commercial acceptance of any
competing solutions could harm our ability to compete and thus materially and adversely impact our business, financial condition and results of operations.



The market for high-speed data access products and services is characterized by several competing technologies, including fiber optic cables, coaxial
cables, satellites and other wireless facilities. These competing solutions provide fast access, high reliability and cost-effective solutions for some users. Many of our products are based on the use of copper telephone wire. Because there are
physical limits to the speed and distance over which data can be transmitted over copper wire, our products may not be a viable solution for customers requiring service at performance levels beyond the current limits of copper telephone wire. To the
extent that telecommunications service providers choose to install fiber optic cable or other transmission media in the last mile, or to the extent that homes and businesses install other transmission media within buildings, we expect that demand
for our products that are based on copper telephone wires will decline. Commercial acceptance of any one of these competing solutions or any technological advancement or product introduction that provides faster access, greater reliability,
increased cost-effectiveness or other advantages over technologies that utilize existing copper telephone wires could decrease the demand for our products and reduce average selling prices and gross margins associated with our products. The
occurrence of any one or more of these events could harm our business, financial condition and results of operations.



If we fail to manage our operations in light of our changing revenue base, our ability to increase our revenues and improve our results of operations could be harmed.



Our operations have changed significantly due to
volatility in our business. In the past, we rapidly and significantly expanded our operations. However, in fiscal years 2001 and 2002, we reduced our workforce significantly to control overall operating expenses in response to dramatic declines in,
and the expectation of continued slowing of, our sales growth. In 2003, we reduced our workforce significantly to further control operating expenses. We anticipate that, in the future, expansion in certain areas of our business may be required to
expand our customer base and exploit market opportunities. In particular, we expect to face numerous challenges in the implementation of our business strategy to focus on selling our products to the larger, more established customers, such as ILECs
and PTTs, in both domestic and international markets.



To
exploit the market for our products, we must develop new and enhanced products while implementing and managing effective planning and operating processes. To manage our operations, we must, among other things, continue to implement and improve our
operational, financial and management information systems, hire and train additional qualified personnel, continue to expand and upgrade core technologies and effectively manage multiple relationships with various customers, suppliers and other
third parties. We cannot assure you that our systems, procedures or controls will be adequate to support our operations or that our management will be able to achieve the rapid execution necessary to exploit fully the market for our products or
systems. If we are unable to manage our operations effectively, our business, financial condition and results of operations could be harmed.



We depend on international sales for a significant portion of our revenue, which subjects our business to a number of risks. If we are unable to generate significant
international sales, our business, financial condition and results of operations could be materially and adversely affected.



Sales to customers outside of the United States accounted for approximately 18.0% and 47.7% of revenue for the nine months ended September 30, 2003 and
2002, respectively. There are a number of risks arising from the operation of our international business, including, but not limited to:



| |  | longer receivables collection periods;
| | - | --------------------------------------



| |  | increased exposure to bad debt write-offs;
| | - | ------------------------------------------



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| |  | risk of political and economic instability;
| | - | -------------------------------------------



| |  | difficulties in enforcing agreements through foreign legal systems;
| | - | -------------------------------------------------------------------



| |  | unexpected changes in regulatory requirements;
| | - | ----------------------------------------------



| |  | import or export licensing requirements;
| | - | ----------------------------------------



| |  | reduced protection for intellectual property rights in some countries; and
| | - | --------------------------------------------------------------------------



| |  | currency fluctuations.
| | - | ----------------------



We expect sales to customers outside of the United States to continue to represent a significant portion of our revenue. However, we cannot assure you
that foreign markets for our products will develop at the rate or to the extent currently anticipated. If we fail to generate significant international sales, our business, financial condition and results of operations could be materially and
adversely affected.



Our ability to attract and retain qualified personnel
has been and may continue to be materially and adversely affected by our low stock price.



Our continued low stock price means that most of our outstanding employee stock options are under water or priced substantially above the current market price of our common stock. Our employees may have
felt, and may continue to feel, that they are receiving inadequate compensation. Further, the continued adverse market conditions mean that our stock option offerings and our stock option plans may not offer current and potential future employees
sufficient incentive to work for us. If adverse market conditions persist, our stock option offerings and employee stock plans will further diminish our ability to attract and/or retain qualified personnel, which will further materially and
adversely impact our business, financial condition, results of operations, or cash flows.



Some of our customers have not been able to meet their financial obligations to us due to changes in the capital markets and these customers own precarious financial situations. If more of our customers
experience similar financial difficulties, our revenue will decrease further, which would materially and adversely affect our business, operating results and financial condition.



Due to increased volatility in equity markets and tightening of lending in the credit markets, we are exposed to a
significant risk that customers will not pay us the amounts that they owe us in order to conserve their capital. This would lead to increases in our outstanding accounts receivable as a percentage of revenue, extended payback periods and increased
risk of customer default. For example, during the latter part of the fourth quarter of 2000, several key customers experienced a rapid deterioration in their ability to obtain additional capital to fund their businesses and eventually declared
bankruptcy. As of December 31, 2002, all of these bankruptcies were finalized, and we had to write off the amounts owed to us by these customers.



We factor the increased risk of non-payment into our assessment of our customers ability to pay, and, in some instances, these considerations will
result in longer revenue deferrals than we had anticipated at the time that we booked the sales to those customers. We also believe that certain of our customers will alter their plans to deploy products to meet the constraints imposed on them by
changes in the capital markets. If we are not able to increase sales to other customers, or if our sales are otherwise delayed or revenue written off, our sales will continue to decline, which would further harm our business, operating results and
financial condition.



If we inaccurately estimate customer demand, our
business, results of operations and financial condition could be harmed.



We plan our expense levels in part based on our expectations about future revenue. These expense levels are relatively fixed in the short-term. However, the number of orders for our products may vary from



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quarter to quarter. In some circumstances, customers may delay purchasing our current products in favor of next-generation products. In addition, our new
products are generally subject to technical evaluations by potential customers that typically last 60 to 90 days. In the case of IntelliPOP and our turnkey video solutions, those evaluations may take up to several months or longer. If orders
forecasted for a specific customer for a particular quarter are delayed or cancelled, our revenue for that quarter may be less than our forecast. Currently, we have minimal risk of loss associated with long-term customer commitments or penalties for
delayed and/or cancelled orders. However, we may be unable to reduce our spending accordingly in the short-term if such a loss occurred, and any such revenue shortfall would have a direct and adverse impact on our results of operations for that
quarter. Further, we outsource the manufacturing of our products based on forecasts of sales. If orders for our products exceed our forecasts, we may have difficulty meeting customers orders in a timely manner, which could damage our
reputation or result in lost sales. Conversely, if our forecasts exceed the orders we actually receive and we are unable to cancel future purchase and manufacturing commitments in a timely manner, our inventory levels would increase. This could
expose us to losses related to slow moving and obsolete inventory, which would have a material adverse effect on our business, operating results and financial condition.



We depend on contract manufacturers to manufacture all of our products and rely on them to deliver high-quality products in a timely
manner. The failure of these manufacturers to continue to deliver quality products in a timely manner could have a materially adverse effect on our business, results of operations and financial condition.



We do not manufacture our products. We rely on contract manufacturers to
assemble, test and package our products. We cannot assure you that these contract manufacturers and suppliers will be able to meet our future requirements for manufactured products, components and subassemblies. In addition, we believe that current
market conditions have placed additional financial strain on our contract manufacturers. Any interruption in the operations of one or more of these contract manufacturers would harm our ability to meet our scheduled product deliveries to customers.
We also intend to introduce new products and product enhancements, which will require that we rapidly achieve volume production by coordinating our efforts with those of our suppliers and contract manufacturers. The inability of our contract
manufacturers to provide us with adequate supplies of high-quality products or the loss of a current contract manufacturer would cause a delay in our ability to fulfill customer orders while we obtain a replacement manufacturer and would harm our
business, operating results and financial condition. In addition, we have canceled certain finished goods and component orders, which may harm our relationship with certain contract manufacturers. Moreover, if we do not accurately forecast the
actual demand for our products, we may face supply, manufacturing or testing capacity constraints. These constraints could result in delays in the delivery of our products or the loss of existing or potential customers, either of which could harm
our business, operating results or financial condition.



Based on our
manufacturing specifications, several key components are purchased from single or limited source suppliers, and if our contract manufacturers fail to obtain the raw materials and component products we require in a timely manner we could lose sales.
If we lose sales, our business, financial condition and results of operations would be materially and adversely affected.



We currently purchase most of our raw materials and components used in our products through our contract manufacturers. In procuring components for our
products, we and our contract manufacturers rely on some suppliers that are the sole source of those components, and we are dependent upon supplies from these sources to meet our needs. We also depend on various sole source offerings from Broadcom,
Metalink US, IBM and Motorola for certain of our products. Components are purchased pursuant to purchase orders based on forecasts, but neither we nor our contract manufacturers have any guaranteed supply arrangements with these suppliers. The
availability of many of these components depends in part on our ability to provide our contract manufacturers and their suppliers with accurate forecasts of our future needs. If we or our manufacturers are unable to obtain a sufficient supply of key
components from current sources or if there is any interruption in the supply of any of the key components currently obtained from a single or limited source, we could experience difficulties in obtaining alternative sources at reasonable prices, if
at all, or in altering product designs to use alternative components. Resulting delays and reductions in product shipments could damage customer relationships, disrupt our operations and harm our business, financial condition or results of
operations. In addition, any increases in component costs that are passed on to our customers could reduce demand for our products.



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We rely on third parties to test substantially all of our products. If, for any reason, these third parties were
unable to or did not adequately assist us in controlling the quality of our products, this lack of quality control could harm our business, financial condition and results of operations.



Substantially all of our products are assembled and tested by our contract
manufacturers. Although we perform random spot testing on manufactured products, we rely on our contract manufacturers for assembly and primary testing of our products. Any quality assurance problems could increase the cost of manufacturing,
assembling or testing our products and could harm our business, financial condition and results of operation. Moreover, defects in products that are not discovered in the quality assurance process could damage customer relationships and result in
product returns or product liability claims, each of which could harm our business, financial condition and results of operations.



Our business relies on the continued growth of the Internet and any slowdown in or reversal of the growth of Internet use could materially and adversely impact our
business.



The market for high-speed data access products
depends in large part on the continued use and popularity of the Internet. Issues concerning the use of the Internet, including security, lost or delayed packets, and quality of service may negatively affect the development of the market for our
products, which could materially and adversely impact our business.



Our
industry is characterized by rapid technological change. We must continually introduce new products that achieve broad market acceptance in order to address this change and remain competitive.



The markets for high-speed data access products 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 remain competitive, we must continually improve the performance, features and
reliability of our products, particularly in response to competitive product offerings. We must introduce products that incorporate or are compatible with these new technologies as they emerge and must do so in a timely manner. We cannot assure you
that we will be able to respond quickly and effectively to technological change. We may have only limited time to penetrate certain markets, and we cannot assure you that we will be successful in achieving widespread acceptance of our products
before competitors offer products and services similar or superior to our products. Any failure to introduce new products addressing technological changes or any delay in our product introductions could adversely affect our ability to compete and
cause our operating results to be below our expectations or the expectations of public market analysts or investors. In addition, when we announce new products or product enhancements that have the potential to replace or shorten the life cycle of
our existing products, customers may defer purchasing our existing products. These actions could harm our business, financial condition and operating results by unexpectedly decreasing sales, increasing our inventory levels of older products and
exposing us to greater risk of product obsolescence.



Manufacturing or
design defects in our products could harm our reputation and our business, financial condition and results of operations.



Any defect or deficiency in our products could reduce the functionality, effectiveness or marketability of our products. These defects or deficiencies
could cause orders for our products to be canceled or delayed, reduce our revenue, or render our product designs obsolete. In that event, we would be required to devote substantial financial and other resources for a significant period of time to
the development of new product designs. We cannot assure you that we would be successful in addressing any manufacturing or design defects in our products 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 business, financial condition, results of operations, or cash flows.



Changing industry standards may reduce the demand for our products, which would harm our business, financial condition and results of operations.



We will not be competitive unless we continually introduce new products and
product enhancements that meet constantly changing industry standards. The emergence of new industry standards, whether through adoption by official standards committees or through widespread use of such standards by



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telephone companies or other service providers, could require that we redesign our products. If these standards become widespread and our products do not
comply with these standards, our customers and potential customers may not purchase our products, which would harm our business, financial condition and results of operations. The rapid development of new standards increases the risk that
competitors could develop products that make our products obsolete. Any failure by us to develop and introduce new products or enhancements directed at new industry standards could harm our business, financial condition and results of operations. In
addition, selection of competing technologies as standards by standards setting bodies such as the HomePNA technology could negatively affect our reputation in the market, regardless of whether our products are standards-compliant or demand for our
products does not decline. This selection could be interpreted by the press and others as having a negative impact on our business, which would negatively impact our stock price.



Further, the marketplaces anticipation of an emerging standard, such as MPEG-4, Part 10 (H.264), could delay customers
from making decisions to purchase or deploy existing products that we offer, which could materially and adversely affect our sales.



Fluctuations in currency exchange rates may harm our business.



A majority of our foreign sales are invoiced in U.S. dollars. As a result, fluctuations in currency exchange rates could cause our products to become
relatively more expensive for international customers, thereby reducing demand for our products. We anticipate that foreign sales will generally continue to be invoiced in U.S. dollars. Accordingly, we do not currently engage in foreign currency
hedging transactions. However, as we expand our current international operations, we may allow payment in foreign currencies and, as a result, our exposure to foreign currency transaction losses may increase. To reduce this exposure, we may purchase
forward foreign exchange contracts or use other hedging strategies. However, we cannot assure you that any currency hedging strategy would be successful in avoiding exchange-related losses.



If we fail to protect our intellectual property or if others use our proprietary
technology without our authorization, our competitive position may suffer.



Our future success and ability to compete depends in part on our proprietary technology. We rely on a combination of copyright, patent, trademark and trade secrets laws and nondisclosure agreements to establish and
protect our proprietary technology. We currently hold 46 United States patents and have 28 United States patent applications pending. However, we cannot assure you that patents will be issued with respect to pending or future patent applications
that we have filed or plan to file or that our patents will be upheld as valid or will prevent the development of competitive products or that any actions we have taken will adequately protect our intellectual property rights.



We generally enter into confidentiality agreements with our employees,
consultants, resellers, customers and potential customers in which we strictly limit access to and distribution of our software and further limit the disclosure and use of our proprietary information. Despite our efforts to protect our proprietary
rights, unauthorized parties may attempt to copy or otherwise obtain or use our products or technology. Our competitors may also independently develop technologies that are substantially equivalent or superior to our technology. In addition, the
laws of some foreign countries do not protect our proprietary rights to the same extent as the laws of the United States.



We may be subject to intellectual property infringement claims that are costly to defend and could harm our business and ability to compete.



Our industry is characterized by vigorous protection and pursuit of
intellectual property rights. We are subject to the risk of adverse claims and litigation alleging infringement of the intellectual property rights of others. From time to time, third parties may assert infringement claims with respect to our
current or future products. Any such assertion, regardless of its merit, could require us to pay damages or settlement amounts and could require us to develop non-infringing technology or acquire licenses to the technology that is the subject of the
asserted infringement. This litigation or potential litigation could result in product delays, increased costs or both. In addition, the cost of any litigation and the resulting distraction of our management resources to address such litigation
could harm our business, results of operations or financial condition. We also cannot assure you that any licenses of technology necessary for our business will be available or that, if available, these licenses can be obtained on commercially
reasonable terms. Our failure to obtain these licenses could harm our business, results of operations and financial condition.



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If our products do not comply with complex government regulations, our products may not be sold, preventing us from
increasing our revenue or achieving profitability.



We and
our customers are subject to varying degrees of federal, state and local regulation. Our products must comply with various regulations and standards defined by the Federal Communications Commission, or FCC. The FCC has issued regulations that set
installation and equipment standards for communications systems. Our products are also required to meet certain safety requirements. For example, certain of our products must be certified by Underwriters Laboratories in order to meet federal safety
requirements relating to electrical appliances to be used inside the home. In addition, certain products must be Network Equipment Building Standard certified before they may be deployed by certain of our customers. Any delay in or failure to obtain
these approvals could harm our business, financial condition or results of operations. Outside of the United States, our products are subject to the regulatory requirements of each country in which our products are manufactured or sold. These
requirements are likely to vary widely. If we do not obtain timely domestic or foreign regulatory approvals or certificates, we would not be able to sell our products where these regulations apply, which may prevent us from sustaining our revenue or
achieving profitability.



In addition, regulation of our
customers may adversely impact our business, operating results and financial condition. For example, FCC regulatory policies affecting the availability of data and Internet services and other terms on which telecommunications companies conduct their
business may impede our penetration of certain markets. In addition, the increasing demand for communications systems has exerted pressure on regulatory bodies worldwide to adopt new standards, generally following extensive investigation of
competing technologies. The delays inherent in this governmental approval process may cause the cancellation, postponement or rescheduling of the installation of communications systems by our customers, which in turn may harm our sale of products to
these customers.



If our customers do not receive adequate and timely
customer support from us or our third-party providers, our relationships with our customers could be damaged, which would harm our business, financial condition and results of operations.



Our ability to achieve our planned sales growth and retain customers will
depend in part on the quality of our customer support operations. Our customers generally require significant support and training with respect to our products, particularly in the initial deployment and implementation stage. As our systems and
products become more complex, we believe our ability to provide adequate customer support will be increasingly important to our success. Moreover, we believe that our IntelliPOP products will add a significant layer of complexity to the demands
placed on our customer support organizations. We have limited experience with widespread deployment of our products to a diverse customer base, and we cannot assure you that we will have adequate personnel to provide the levels of support that our
customers may require during initial product deployment or on an ongoing basis. In addition, we rely on a third party for a substantial portion of our customer support functions, and therefore, we may have limited control over the level of support
that is provided. Our failure to provide sufficient support to our customers could delay or prevent the successful deployment of our products. Failure to provide adequate support could also have an adverse impact on our reputation and relationship
with our customers, could prevent us from gaining new customers and could harm our business, financial condition or results of operations.



If we lose key personnel or are unable to hire additional qualified personnel as necessary, we may not be able to manage our business successfully, which could
materially and adversely affect our business, financial condition and results of operations.



We depend on the performance of Salvatore DAuria, our President, Chief Executive Officer and Chairman of the Board, and on other senior management
and technical personnel with experience in the data communications, telecommunications and high-speed data access industries. The loss of any one of them could harm our ability to execute our business strategy. Additionally, we do not have
employment contracts with any of our executive officers. We believe that our future success will depend in large part on our continued ability to identify, hire, retain and motivate highly skilled employees who are in great demand. We cannot assure
you that we will be able to do so.



38



---

Our stock price has fluctuated and is likely to continue to fluctuate, and you may not be able to resell your shares
at or above their purchase price.



The price of our common
stock has been and is likely to continue to be highly volatile. Our stock price could continue to fluctuate widely in response to many factors, including, but not limited to, the following:



| |  | actual or anticipated variations in operating results;
| | - | ------------------------------------------------------



| |  | announcements of technological innovations, new products or new services by us or by our partners, competitors or customers;
| | - | ----------------------------------------------------------------------------------------------------------------------------



| |  | changes in financial estimates or recommendations by stock market analysts regarding us or our competitors;
| | - | -----------------------------------------------------------------------------------------------------------



| |  | conditions or trends in the telecommunications industry, including regulatory developments;
| | - | -------------------------------------------------------------------------------------------



| |  | our announcement of a significant acquisition, strategic partnership, joint venture or capital commitment;
| | - | ----------------------------------------------------------------------------------------------------------



| |  | additions or departures of key personnel;
| | - | -----------------------------------------



| |  | future equity or debt offerings or our announcements of these offerings; and
| | - | ----------------------------------------------------------------------------



| |  | general market and economic conditions.
| | - | ---------------------------------------



In addition, in recent years, the stock market in general, and the Nasdaq National Market and the securities of Internet and technology companies in
particular, have experienced extreme price and volume fluctuations with severe drops. These fluctuations have often been unrelated or disproportionate to the operating performance of these technology companies. These market and industry factors may
harm our stock price, regardless of our operating results.



Our stock may be
delisted from the Nasdaq National Market.



Nasdaq corporate
governance rules require that all shares listed on the Nasdaq National Market maintain a minimum bid price at closing of $1.00 per share. Our failure to maintain such a minimum bid price for a period of thirty or more consecutive trading days could
result in the Nasdaq governing board taking action to remove our shares from the Nasdaq National Market. In the second half of 2002, the minimum closing bid price of our common stock was consistently below $1.00 per share. On September 9, 2002, we
received a Nasdaq delisting notice because our common stock had closed below $1.00 per share for 30 consecutive trading days. If the bid price of our common stock had not closed at $1.00 per share or more for a minimum of 10 consecutive trading days
before December 9, 2002, our stock would have been delisted from the Nasdaq National Market. On November 15, 2002, we received a notice from the Nasdaq that our stock price had traded above $1.00 per share for the required 10 consecutive days. Since
that time, our stock has not traded below the required minimum bid price at closing of $1.00 per share. However, based on the various risks noted elsewhere in this Quarterly Report on Form 10Q, we nevertheless continue to face the risk of our stock
price falling below the $1.00 listing threshold, which could result in the delisting of our stock from the Nasdaq National Market. The delisting of our common stock as well as the threat of delisting of our common stock may negatively impact the
value of our shares because shares that trade on the over-the-counter market, rather than the Nasdaq National Market, are typically less liquid and, therefore, trade with larger variations between the bid and asking price.



39



---

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



Certain provisions of our
charter and bylaws and our retention and change of control plans, the Plans, may have the effect of making it more difficult for a third party to acquire, or of discouraging a third party from attempting to acquire, control of us. The
provisions of the charter and bylaws and the Plans could limit the price that certain investors may be willing to pay in the future for shares of our common stock. Our charter and bylaws provide for a classified board of directors, eliminate
cumulative voting in the election of directors, restrict our stockholders from acting by written consent and calling special meetings, and provide for procedures for advance notification of stockholder nominations and proposals. In addition, our
board of directors has the authority to issue up to 5,000,000 shares of preferred stock and to determine the price, rights, preferences, privileges and restrictions, including voting rights, of those shares without any further vote or action by the
stockholders. The issuance of preferred stock, while providing flexibility in connection with possible financings or acquisitions or other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority
of our outstanding voting stock. The Plans provide for severance payments and accelerated stock option vesting in the event of termination of employment following a change of control. The provisions of the charter and bylaws, and the Plans, as well
as Section 203 of the Delaware General Corporation Law, to which we are subject, could discourage potential acquisition proposals, delay or prevent a change of control and prevent changes in our management.



Future sales of our common stock could depress our stock price.



Sales of a substantial number of shares of our common stock in the public
market, or the appearance that these shares are available for sale, could harm the market price of our common stock. Also, we may from time to time need to register shares of our common stock for resale, which registration and resale may increase
the number of our shares that are publicly-traded, thereby adversely impacting the per share price of our common stock. In connection with our acquisition of VTC, in May 2003 we registered on a Form S-3 pursuant to Rule 415(a)(1)(i) under the
Securities Act of 1933, as amended, on a continuous or delayed offering the 3.3 million shares of common stock issued to Tektronix, in order that Tektronix may sell such shares on or after December 1, 2003. These sales also may make it more
difficult for us to sell equity securities or equity-related securities in the future at a time and price that we deem appropriate. As of September 30, 2003, we had 20,187,786 shares outstanding. Of these shares, 16,904,189 shares of our common
stock are currently available for sale in the public market, some of which are subject to volume and other limitations under securities laws.



Our Pleasanton, California facility is located near known earthquake fault zones, and the occurrence of an earthquake or other natural disaster could cause damage to
our facility and equipment, which could require us to curtail or cease operations.



Our Pleasanton, California facility is located in the San Francisco Bay Area near known earthquake fault zones and is vulnerable to damage from earthquakes. In October 1989, a major earthquake that caused significant
property damage and a number of fatalities struck this area. We are also vulnerable to damage from other types of disasters, including fire, floods, power loss, communications failures and similar events. If any disaster were to occur, our ability
to operate our business at our Pleasanton, California facility could be seriously, or completely, impaired. The insurance we maintain may not be adequate to cover our losses resulting from disasters or other business interruptions.



We rely on a continuous power supply to conduct our operations, and a statewide energy
crisis could disrupt our operations and increase our expenses.



In the fourth quarter of 2000 and the first quarter of 2001, California suffered an energy crisis that could have disrupted our operations and increased our expenses. In the event of an acute power shortage which occurs when power reserves
for the State of California fall below 1.5%, California has on some occasions implemented, and may in the future implement, rolling blackouts throughout the state. We currently do not have backup generators or alternate sources of power in the event
of a blackout, and our current insurance does not provide coverage for any damages we or our customers may suffer as a result of any interruption in our power supply. If California were to suffer a similar energy crisis in the future and blackouts
interrupt our power supply, we would be temporarily unable to continue operations at our Pleasanton, California facility. Any such interruption in our ability to continue operations at our facilities could damage our reputation, harm our ability to
retain existing customers and to obtain new customers, and could result in lost revenue, any of which could substantially harm our business and results of operations.



40



---

ITEM 3.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK



We are exposed to changes in interest rates primarily from our investments in certain cash equivalents. Under our current policies, we do not use interest
rate derivative instruments to manage exposure to interest rate changes. A hypothetical 100 basis point adverse move in interest rates along the entire interest rate yield curve would not materially affect the fair value of our interest-sensitive
financial instruments at September 30, 2003.



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 in the value of the U.S. dollar relative to foreign
currencies could make our products more expensive and, therefore, reduce the demand for our products.



ITEM 4.CONTROLS AND PROCEDURES



(a) Evaluation of Disclosure Controls and Procedures. The Company carried out an evaluation under the supervision and with the participation of the
Companys management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Companys disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and
15d-15(e) under the Securities Exchange Act of 1934, as amended (the Exchange Act)), as of the end of the period covered by this report. There are inherent limitations to the effectiveness of any system of disclosure controls and
procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control
objectives. Notwithstanding these limitations, as of the end of the period covered by this report, based upon the Companys evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the disclosure controls and
procedures are effective in all material respects to ensure that information required to be disclosed in the reports the Company files and submits under the Exchange Act is recorded, processed, summarized and reported as and when required.



41



---

(b) Changes in Internal Control Over Financial Reporting. There has not been any change in the
Companys internal control over financial reporting that occurred during the Companys last fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Companys internal control over financial
reporting that was identified in connection with the Companys evaluation of its internal control over financial reporting.



PART II. OTHER INFORMATION



ITEM 1.LEGAL PROCEEDINGS



Beginning July 12, 2001, nine putative stockholder class action lawsuits were filed in the United States District Court for the Northern District of
California against the Company and certain of its current and former officers and directors. The complaints were filed on behalf of a purported class of people who purchased the Companys stock during the period between July 20, 2000 and
January 31, 2001, seeking unspecified damages. The complaints allege that the Company and certain of its current and former officers and directors made false and misleading statements about the Companys business during the putative class
period. Specifically, the complaints allege violations of Section 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended. The complaints have been consolidated under the name In re Tut Systems, Inc. Securities Litigation, Master File No.
C-01-2659-CW (the Securities Litigation Action). Lead plaintiffs and lead counsel for plaintiffs have been appointed. Plaintiffs filed a consolidated class action complaint on February 4, 2002. Defendants filed a Motion to Dismiss on
March 29, 2002. On August 15, 2002, the Court granted in part and denied in part the Motion to Dismiss. On September 23, 2002, plaintiffs filed an amended complaint. Defendants filed a Motion to Dismiss the amended complaint, and on August 6, 2003
the Court granted in part that Motion. On September 24, 2003, Defendants answered the remaining allegations of the amended complaint. Discovery has commenced. Trial is scheduled to begin on March 7, 2005. The Company believes it has meritorious
defenses to the allegations in the complaint and intends to defend the case vigorously. An unfavorable resolution of this litigation could have a material adverse effect on the Companys business, results of operations, financial condition and
cash flows



On March 19, 2003, Chesky Lefkowitz, a shareholder
of the Company, filed a derivative complaint entitled Lefkowitz v. DAuria, et al., No. RG03087467, in the Superior Court of the State of California, County of Alameda, against certain of the Companys current and former officers and
directors. The complaint alleges causes of action for breach of fiduciary duty, gross negligence, breach of contract, unjust enrichment and improper insider stock trading, based on the same factual allegations contained in the Securities Litigation
Action. The complaint seeks unspecified damages against the individual defendants on behalf of the Company, equitable relief, and attorneys fees. On May 21, 2003, the Company and the individual defendants filed separate demurrers to the
complaint. The demurrers have not yet been heard by the Court, and no trial date has been established.



On October 30, 2001, the Company and certain of its current and former officers and directors were named as defendants in Whalen v. Tut Systems, Inc. et
al., Case No. 01-CV-9563, a purported securities class action lawsuit filed in the United States District Court for the Southern District of New York. An amended complaint was filed on December 5, 2001. A consolidated amended complaint was filed on
April 19, 2002. The consolidated amended complaint asserts that the prospectuses from the Companys January 29, 1999 initial public offering and its March 23, 2000 secondary offering failed to disclose certain alleged actions by the
underwriters for the offerings. The complaint alleges claims against the Company and certain of its current and former officers and directors under Section 11 of the Securities Act of 1933, as amended, (the 1933 Act) 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 former officers and directors under Sections 15 and 20(a) of the 1933 Act. The complaints also name as defendants the
underwriters for the Companys initial public offering and secondary offering. The Court has denied the Companys motion to dismiss. The Companys Board recently approved a tentative settlement proposal from the plaintiffs. The
settlement is subject to a number of conditions, including approval of the Court. If the settlement does not occur, and the litigation against the Company continues, the Company believes it has meritorious defenses to the allegations in the
complaint and intends to defend the case vigorously. An unfavorable resolution of this litigation could have a material adverse effect on the Companys business, results of operations, financial condition and cash flows.



42



---

The Company is subject to other legal proceedings, claims and litigation arising in the ordinary course
of business. The Companys management does not expect that the ultimate costs to resolve these matters will have a material adverse effect on the Companys consolidated financial position, results of operations, or cash flows.



ITEM 2.CHANGES IN SECURITIES AND USE OF PROCEEDS



None



ITEM 3.DEFAULTS UPON SENIOR SECURITIES



None



ITEM 4.SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS



None



ITEM 5.OTHER INFORMATION



None



43



---

ITEM 6.EXHIBITS AND REPORTS ON FORM 8-K



(a) Exhibits



|Exhibit Number |  | Description                                                                                                                                                                                                                                                                             
|-------------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|               | 
|2.1            |  | Agreement and Plan of Reorganization dated as of October 15, 1999, by and among the Company, Vintel Acquisition Corp., and Vintel Communications, Inc.(4)                                                                                                                               
|               | 
|2.2            |  | Agreement and Plan of Reorganization dated as of September 8, 1999, by and among the Company, Public Port Acquisition Corporation, and Public Port, Inc.(3)                                                                                                                             
|               | 
|2.3            |  | Agreement and Plan of Reorganization dated as of November 16, 1999, as amended, by and among the Company, Fortress Acquisition Corporation and FreeGate
Corporation.(5)                                                                                                                 
|               | 
|2.4            |  | Asset Purchase Agreement by and between the Company and OneWorld Systems, Inc. dated as of February 3, 2000.(6)                                                                                                                                                                         
|               | 
|2.5            |  | Amendment No. 1 to Asset Purchase Agreement by and between the Company and OneWorld Systems, Inc. dated as of February 17, 2000.(6)                                                                                                                                                     
|               | 
|2.6            |  | Agreement for the sale and purchase of the entire share capital of Xstreamis plc, by and among the Company, the shareholders of Xstreamis plc and Philip
Corbishley.(8)                                                                                                                 
|               | 
|2.7            |  | Agreement and Plan of Reorganization dated as of December 21, 2000, by and among the Company, ActiveTelco Incorporated, ActiveTelco Acquisition Corporation, and, with respect to
Article VII only, Azeem Butt, as shareholder representative, and U.S. Bank Trust, as escrow agent.(10)
|               | 
|2.8            |  | Agreement and Plan of Merger by and among Tut System, Inc., Tiger Acquisition Corporation, Textronix, Inc. and Video Tele.com, Inc. dated as of October 28,
2002.(12)                                                                                                                   
|               | 
|3.1            |  | Second Amended and Restated Certificate of Incorporation of the Company.(1)                                                                                                                                                                                                             
|               | 
|3.2            |  | Bylaws of the Company, as currently in effect.(1)                                                                                                                                                                                                                                       
|               | 
|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.(6)                                                                                                                                                                                                                      
|               | 
|10.5           |  | American Capital Marketing, Inc. 401(k) Plan.(1)                                                                                                                                                                                                                                        
|               | 
|10.6           |  | Fourth Amended and Restated Shareholders Rights Agreement, dated December 16, 1997, between the Company and certain stockholders.(1)                                                                                                                                                   
|               | 
|10.7           |  | Lease by and between Pleasant Hill Industrial Park Associates, a California Limited Partnership, and the Company dated April 4, 1995, as amended.(1)                                                                                                                                    
|               | 
|10.8           |  | Office Building Lease between Petula Associates, Ltd., an Iowa corporation, and Principal Mutual Life Insurance Co., an Iowa corporation, doing business as RC Creekside Phase VI
and the Company dated April 25, 1997.(1)                                                              



44



---

|      | 
|----- | 
|10.9  | 
|      | 
|10.10 | 
|      | 
|10.11 | 
|      | 
|10.12 | 
|      | 
|10.13 | 
|      | 
|10.14 | 
|      | 
|10.15 | 
|      | 
|10.16 | 
|      | 
|10.17 | 
|      | 
|10.18 | 
|      | 
|10.19 | 
|      | 
|10.20 | 
|      | 
|10.21 | 
|      | 
|10.22 | 
|      | 
|10.23 | 
|      | 
|10.24 | 
|      | 
|10.25 | 
|      | 
|10.26 | 
|      | 
|10.27 | 
|      | 
|10.28 | 
|      | 
|10.29 | 
|      | 
|11.1  | 



45



---

|     | 
|---- | 
|31.1 | 
|     | 
|31.2 | 
|     | 
|32.1 | 
|     | 
|32.2 | 

---

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

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

|(3) | Incorporated by reference to our Quarterly Report on Form 10-Q for the quarter ended September 30, 1999.
|--- | --------------------------------------------------------------------------------------------------------

|(4) | Incorporated by reference to our Quarterly Report on Form 10-Q for the quarter ended September 30, 1999.
|--- | --------------------------------------------------------------------------------------------------------

|(5) | Incorporated by reference to our Current Report on Form 8-K dated February 14, 2000.
|--- | ------------------------------------------------------------------------------------

|(6) | Incorporated by reference to our Annual Report on Form 10-K for the year ended December 31, 1999.
|--- | -------------------------------------------------------------------------------------------------

|(7) | Incorporated by reference to our Registration Statement on Form S-1 (File No. 333-31446) as declared effective by the Securities and Exchange Commission on March 23, 2000.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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

|(9) | Incorporated by reference to our Quarterly Report on Form 10-Q for the quarter ended September 30, 2000.
|--- | --------------------------------------------------------------------------------------------------------

|(10) | Incorporated by reference to our Current Report on Form 8-K dated January 18, 2001.
|---- | -----------------------------------------------------------------------------------

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

|(12) | Incorporated by reference to our Current Report on Form 8-K dated October 29, 2002.
|---- | -----------------------------------------------------------------------------------

|(13) | Incorporated by reference to our Annual Report on Form 10-K for the year ended December 31, 2002.
|---- | -------------------------------------------------------------------------------------------------



(b) Reports on Form 8-K.



The Company filed the following Current Report on Forms 8-K during the quarter ended September 30, 2003:



On July 31, 2003, the Company filed a Report on Form 8-K regarding the
Companys issuance of a press release stating its earnings for the quarter ended June 30, 2003.



46



---

SIGNATURE



Pursuant to the
requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.



TUT SYSTEMS, INC.By:

/s/    RANDALL K. GAUSMANRandall K. Gausman Vice-President, Finance and Administration, Chief Financial Officer and Secretary (Principal
Financial and Accounting Officer and Duly Authorized Officer)




Date: October 30, 2003



47



---

INDEX TO EXHIBITS



|ExhibitNumber |  | Description                                                                                                                                                                                                                                                                              
|------------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|              | 
|2.1           |  | Agreement and Plan of Reorganization dated as of October 15, 1999, by and among the Company, Vintel Acquisition Corp., and Vintel Communications, Inc.(4)                                                                                                                                
|              | 
|2.2           |  | Agreement and Plan of Reorganization dated as of September 8, 1999, by and among the Company, Public Port Acquisition Corporation, and Public Port, Inc.(3)                                                                                                                              
|              | 
|2.3           |  | Agreement and Plan of Reorganization dated as of November 16, 1999, as amended, by and among the Company, Fortress Acquisition Corporation and FreeGate
Corporation.(5)                                                                                                                  
|              | 
|2.4           |  | Asset Purchase Agreement by and between the Company and OneWorld Systems, Inc. dated as of February 3, 2000.(6)                                                                                                                                                                          
|              | 
|2.5           |  | Amendment No. 1 to Asset Purchase Agreement by and between the Company and OneWorld Systems, Inc. dated as of February 17, 2000.(6)                                                                                                                                                      
|              | 
|2.6           |  | Agreement for the sale and purchase of the entire share capital of Xstreamis plc, by and among the Company, the shareholders of Xstreamis plc and Philip
Corbishley.(8)                                                                                                                  
|              | 
|2.7           |  | Agreement and Plan of Reorganization dated as of December 21, 2000, by and among the Company, ActiveTelco Incorporated, ActiveTelco Acquisition Corporation, and, with respect to
Article VII only, Azeem Butt, as shareholder representative, and U.S. Bank Trust, as escrow agent. (10)
|              | 
|2.8           |  | 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.
(12)                                                                                                                   
|              | 
|3.1           |  | Second Amended and Restated Certificate of Incorporation of the Company. (1)                                                                                                                                                                                                             
|              | 
|3.2           |  | Bylaws of the Company, as currently in effect. (1)                                                                                                                                                                                                                                       
|              | 
|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. (6)                                                                                                                                                                                                                      
|              | 
|10.5          |  | American Capital Marketing, Inc. 401(k) Plan. (1)                                                                                                                                                                                                                                        
|              | 
|10.6          |  | Fourth Amended and Restated Shareholders Rights Agreement, dated December 16, 1997, between the Company and certain stockholders. (1)                                                                                                                                                   





48



---

|      | 
|----- | 
|10.7  | 
|      | 
|10.8  | 
|      | 
|10.9  | 
|      | 
|10.10 | 
|      | 
|10.11 | 
|      | 
|10.12 | 
|      | 
|10.13 | 
|      | 
|10.14 | 
|      | 
|10.15 | 
|      | 
|10.16 | 
|      | 
|10.17 | 
|      | 
|10.18 | 
|      | 
|10.19 | 
|      | 
|10.20 | 
|      | 
|10.21 | 
|      | 
|10.22 | 



49



---

|      | 
|----- | 
|10.23 | 
|      | 
|10.24 | 
|      | 
|10.25 | 
|      | 
|10.26 | 
|      | 
|10.27 | 
|      | 
|10.28 | 
|      | 
|10.29 | 
|      | 
|11.1  | 
|      | 
|31.1  | 
|      | 
|31.2  | 
|      | 
|32.1  | 
|      | 
|32.2  | 

---

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

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

|(3) | Incorporated by reference to our Quarterly Report on Form 10-Q for the quarter ended September 30, 1999.
|--- | --------------------------------------------------------------------------------------------------------

|(4) | Incorporated by reference to our Quarterly Report on Form 10-Q for the quarter ended September 30, 1999.
|--- | --------------------------------------------------------------------------------------------------------

|(5) | Incorporated by reference to our Current Report on Form 8-K dated February 14, 2000.
|--- | ------------------------------------------------------------------------------------

|(6) | Incorporated by reference to our Annual Report on Form 10-K for the year ended December 31, 1999.
|--- | -------------------------------------------------------------------------------------------------

|(7) | Incorporated by reference to our Registration Statement on Form S-1 (File No. 333-31446) as declared effective by the Securities and Exchange Commission on March 23, 2000.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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

|(9) | Incorporated by reference to our Quarterly Report on Form 10-Q for the quarter ended September 30, 2000.
|--- | --------------------------------------------------------------------------------------------------------

|(10) | Incorporated by reference to our Current Report on Form 8-K dated January 18, 2001.
|---- | -----------------------------------------------------------------------------------

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

|(12) | Incorporated by reference to our Current Report on Form 8-K dated October 29, 2002.
|---- | -----------------------------------------------------------------------------------

|(13) | Incorporated by reference to our Annual Report on Form 10-K for the year ended December 31, 2002.
|---- | -------------------------------------------------------------------------------------------------



50