**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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**FORM 10-Q**

 
| x          | ** ** | **QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                    |
|------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       | ** ** | ** **                                                                                                                                                                                                     |
| ** ** | ** ** | **For the  three month period ended September 30, 2007**                                                                                                                                                       |
| ** ** | ** ** | ** **                                                                                                                                                                                                     |
| ** ** | ** ** | **OR**                                                                                                                                                                                                         |
| ** ** | ** ** | ** **                                                                                                                                                                                                     |
| o          | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                             |
|       |       |                                                                                                                                                                                                           |
| ** ** | ** ** | **For the  transition period  from              to              ** |

 

**Commissionfile number: 000-33069**

 

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**OCCAM NETWORKS, INC.**

(Exact name of registrant as specified in itscharter)

 

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| **Delaware**                                                     | **77-0442752**                        |
|------------------------------------------------------------------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) | (I.R.S. Employer  Identification No.) |
| ** **                                                       | ** **                            |
| **6868  Cortona Drive  Santa Barbara, California**               | **93117**                             |
| (Address of principal  executive office)                         | (Zip Code)                            |

** **

**(805) 692-2900**

(Registrant’s telephone number, includingarea code)

** **

**N/A**

(Former name, former address and formerfiscal year, if changed since last report)

 

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

 

                Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer,or a non-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (check one).

 

Large accelerated filer o               Acceleratedfiler o               Non-acceleratedfiler x

 

                Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes o No x

 

                As ofSeptember 30, 2007, the number of shares outstanding of the registrant’scommon stock was 19,764,927 shares.

 

 

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**INDEX**

 
| ** **                              | ** **                                                                                  | **Page** |
|-----------------------------------------|---------------------------------------------------------------------------------------------|----------|
| PART I—FINANCIAL  INFORMATION | ** **                                                                                  |
| Item 1.                            | Financial Statements  (unaudited)                                                           | 1        |
|                                    | Consolidated  Balance Sheets                                                                | 1        |
|                                    | Consolidated Statements of Operations                                                       | 2        |
|                                    | Consolidated Statements of Cash Flows                                                       | 3        |
|                                    | Notes to Consolidated Financial Statements                                                  | 4        |
| Item 2.                            | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 12       |
| Item 3.                            | Quantitative  and Qualitative Disclosures about Market Risk                                 | 21       |
| Item 4.                            | Controls  and Procedures                                                                    | 21       |
| PART II—OTHER INFORMATION     |                                                                                        |
| Item 1.                            | Legal  Proceedings                                                                          | 24       |
| Item 1A.                           | Risk Factors                                                                                | 25       |
| Item 2.                            | Unregistered  Sales of Equity Securities and Use of Proceeds                                | 40       |
| Item 3.                            | Defaults  Upon Senior Securities                                                            | 40       |
| Item 4.                            | Submission  of Matters to a Vote of Security Holders                                        | 40       |
| Item 5.                            | Other  Information                                                                          | 40       |
| Item 6.                            | Exhibits                                                                                    | 43       |
| Signatures                              |                                                                                        |
| Exhibit  Index                          |                                                                                        |

 

 

i

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**PART I—FINANCIALINFORMATION**

 

**ITEM 1.FINANCIAL STATEMENTS**

 

**OCCAM NETWORKS, INC. AND SUBSIDIARY**

**CONSOLIDATEDBALANCE SHEETS**

(In thousands, except per share data)

 
| ** **                                                                                                                                                                            | ** ** | **September 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                            | ** ** | **(Unaudited)**         | ** ** | ** **             | ** ** |
| **ASSETS**                                                                                                                                                                            |       |                    |       |                   |       |
| Current assets:                                                                                                                                                                       |       |                    |       |                   |       |
| Cash and cash equivalents                                                                                                                                                             |       | $                       | 43,262     |                   | $          | 59,219 |   |
| Restricted cash                                                                                                                                                                       |       | 9,008                   |       | 4,378                  |       |
| Accounts receivable, net                                                                                                                                                              |       | 13,891                  |       | 10,736                 |       |
| Inventories, net                                                                                                                                                                      |       | 10,870                  |       | 10,435                 |       |
| Prepaid and other current assets                                                                                                                                                      |       | 5,912                   |       | 933                    |       |
| Total current assets                                                                                                                                                                  |       | 82,943                  |       | 85,701                 |       |
| Property and equipment, net                                                                                                                                                           |       | 8,636                   |       | 1,766                  |       |
| Other assets                                                                                                                                                                          |       | 321                     |       | 291                    |       |
| Total assets                                                                                                                                                                          |       | $                       | 91,900     |                   | $          | 87,758 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                         |       |                    |       |                   |       |
| Current liabilities:                                                                                                                                                                  |       |                    |       |                   |       |
| Accounts payable                                                                                                                                                                      |       | $                       | 9,552      |                   | $          | 7,687 |   |
| Accrued expenses                                                                                                                                                                      |       | 8,743                   |       | 3,899                  |       |
| Deferred sales                                                                                                                                                                        |       | 9,288                   |       | 8,029                  |       |
| Current portion of long-term debt                                                                                                                                                     |       | 12                      |       | —                 |       |
| Total current liabilities                                                                                                                                                             |       | 27,595                  |       | 19,615                 |       |
| Long-term debt                                                                                                                                                                        |       | 56                      |       | —                 |       |
| Total liabilities                                                                                                                                                                     |       | 27,651                  |       | 19,615                 |       |
| Commitments and contingencies (note 5)                                                                                                                                                |       |                    |       |                   |       |
| Stockholders’ equity:                                                                                                                                                            |       |                    |       |                   |       |
| Common stock, $0.001 par value, 250,000 shares authorized; 19,765 and  19,713 shares issued and outstanding at September 30, 2007 and  December 31, 2006, respectively |       | 288                     |       | 288                    |       |
| Additional paid-in capital                                                                                                                                                            |       | 178,876                 |       | 176,947                |       |
| Warrants                                                                                                                                                                              |       | 331                     |       | 331                    |       |
| Accumulated deficit                                                                                                                                                                   |       | (115,246                | )          | (109,423               | )          |
| Total stockholders’ equity                                                                                                                                                       |       | 64,249                  |       | 68,143                 |       |
| Total liabilities and stockholders’ equity                                                                                                                                       |       | $                       | 91,900     |                   | $          | 87,758 |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

 

1

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**OCCAM NETWORKS, INC. AND SUBSIDIARY**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

(In thousands, except per share data)

 
| ** **                                                       | ** ** | **Three Months Ended**       | ** ** | **Nine Months Ended**        | ** ** |
|------------------------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                                       | ** ** | **September 30,  2007** | ** ** | **September 24,  2006** | ** ** | **September 30,  2007** | ** ** | **September 24,  2006** | ** ** |
| ** **                                                       | ** ** | ** **                   | ** ** | **Restated(1)**              | ** ** | ** ** | ** ** | **Restated(1)** | ** ** |
| ** **                                                       | ** ** | **(Unaudited)**              | ** ** | **(Unaudited)**              | ** ** |
| Sales                                                            |       | $                            | 15,660     |                         | $          | 20,775 |   | $ | 53,884 |   | $ | 46,028 |   |
| Cost of sales                                                    |       | 9,959                        |       | 12,998                       |       | 34,054 |   | 28,676 |   |
| Gross margin                                                     |       | 5,701                        |       | 7,777                        |       | 19,830 |   | 17,352 |   |
| Operating expenses:                                              |       |                         |       |                         |       |   |   |   |   |
| Research and product development                                 |       | 3,245                        |       | 2,269                        |       | 8,985 |   | 7,147 |   |
| Sales and marketing                                              |       | 3,728                        |       | 2,834                        |       | 10,779 |   | 7,669 |   |
| General and administrative                                       |       | 4,218                        |       | 1,118                        |       | 8,030 |   | 3,031 |   |
| Total operating expenses                                         |       | 11,191                       |       | 6,221                        |       | 27,794 |   | 17,847 |   |
| Income (loss) from operations                                    |       | (5,490                       | )          | 1,556                        |       | (7,964 | ) | (495 | ) |
| Interest income, net                                             |       | 584                          |       | 61                           |       | 2,141 |   | 66 |   |
| Income (loss) before provision for income taxes                  |       | (4,906                       | )          | 1,617                        |       | (5,823 | ) | (429 | ) |
| Provision for income taxes                                       |       | —                       |       | 13                           |       | — |   | 25 |   |
| Net income (loss)                                                |       | (4,906                       | )          | 1,604                        |       | (5,823 | ) | (454 | ) |
| Beneficial conversion feature                                    |       | —                       |       | —                       |       | — |   | (3,437 | ) |
| Net income (loss) attributable to common stockholders            |       | $                            | (4,906     | )                            | $          | 1,604 |   | $ | (5,823 | ) | $ | (3,891 | ) |
| Net income (loss) per share attributable to common stockholders: |       |                         |       |                         |       |   |   |   |   |
| Basic                                                            |       | $                            | (0.25      | )                            | $          | 0.22 |   | $ | (0.29 | ) | $ | (0.55 | ) |
| Diluted                                                          |       | $                            | (0.25      | )                            | $          | 0.09 |   | $ | (0.29 | ) | $ | (0.55 | ) |
| Weighted average shares attributable to common stockholders:     |       |                         |       |                         |       |   |   |   |   |
| Basic                                                            |       | 19,765                       |       | 7,279                        |       | 19,756 |   | 7,104 |   |
| Diluted                                                          |       | 19,765                       |       | 16,909                       |       | 19,756 |   | 7,104 |   |
|                                                             |       |                         |       |                         |       |   |   |   |   |
| Stock-based compensation included in:                            |       |                         |       |                         |       |   |   |   |   |
| Cost of sales                                                    |       | $                            | 71         |                         | $          | 65 |   | $ | 194 |   | $ | 183 |   |
| Research and product development                                 |       | 164                          |       | 198                          |       | 542 |   | 522 |   |
| Sales and marketing                                              |       | 144                          |       | 159                          |       | 422 |   | 316 |   |
| General and administrative                                       |       | 110                          |       | 118                          |       | 407 |   | 243 |   |
| Total stock-based compensation                                   |       | $                            | 489        |                         | $          | 540 |   | $ | 1,565 |   | $ | 1,264 |   |

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(1)                                  SeeNote 2, “Restatement of Consolidated Financial Statements,” of the notesto consolidated financial statements.

 

The accompanying notes are an integral partof these consolidated financial statements.

 

 

2

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**OCCAM NETWORKS, INC. AND SUBSIDIARY**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

(In thousands)

 
| ** **                                                                                 | ** ** | **Nine Months Ended**        | ** ** |
|--------------------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                                 | ** ** | **September 30,  2007** | ** ** | **September 24,  2006** | ** ** |
| ** **                                                                                 | ** ** | ** **                   | ** ** | **Restated(1)** | ** ** |
| ** **                                                                                 | ** ** | **(Unaudited)**              | ** ** |
| **Operating activities**                                                                   |       |                         |       |   |   |
| Net loss                                                                                   |       | $                            | (5,823     | ) | $ | (454 | ) |
| Adjustments to reconcile net loss to net cash provided by (used in)  operating activities: |       |                         |       |   |   |
| Depreciation and amortization                                                              |       | 1,186                        |       | 1,065 |   |
| Stock-based compensation expense                                                           |       | 1,565                        |       | 1,264 |   |
| Provision for excess and obsolete inventory                                                |       | 645                          |       | — |   |
| Changes in operating assets and liabilities:                                               |       |                         |       |   |   |
| Accounts receivable                                                                        |       | (3,155                       | )          | (1,595 | ) |
| Inventories                                                                                |       | (1,080                       | )          | (3,947 | ) |
| Prepaid expenses and other current assets                                                  |       | (3,434                       | )          | (244 | ) |
| Accounts payable and accrued expenses                                                      |       | 6,709                        |       | 1,252 |   |
| Deferred sales                                                                             |       | 1,259                        |       | 2,796 |   |
| Net cash provided by (used in) operating activities                                        |       | (2,128                       | )          | 137 |   |
| **Investing activities**                                                                   |       |                         |       |   |   |
| Purchases of property and equipment                                                        |       | (7,988                       | )          | (730 | ) |
| Restricted cash                                                                            |       | (4,630                       | )          | (907 | ) |
| Purchase of investment                                                                     |       | (1,575                       | )          | — |   |
| Net cash used in investing activities                                                      |       | (14,193                      | )          | (1,637 | ) |
| **Financing activities**                                                                   |       |                         |       |   |   |
| Payments of capital lease obligations and long-term debt                                   |       | —                       |       | (2,557 | ) |
| Proceeds from issuance of series A-2 preferred stock, net of  issuance costs               |       | —                       |       | 2,723 |   |
| Proceeds from employee stock purchase plan                                                 |       | 245                          |       | — |   |
| Proceeds from the exercise of stock options                                                |       | 194                          |       | 420 |   |
| Common stock issuance costs                                                                |       | (75                          | )          | — |   |
| Net cash provided by financing activities                                                  |       | 364                          |       | 586 |   |
| Net decrease in cash and cash equivalents                                                  |       | (15,957                      | )          | (914 | ) |
| Cash and cash equivalents, beginning of period                                             |       | 59,219                       |       | 6,571 |   |
| Cash and cash equivalents, end of period                                                   |       | $                            | 43,262     |   | $ | 5,657 |   |
| **Supplemental disclosure of cash flow  information:**                                     |       |                         |       |   |   |
| Interest paid                                                                              |       | $                            | 3          |   | $ | 66 |   |

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(1)                                  See Note 2, “Restatementof Consolidated Financial Statements,” of the notes to consolidated financialstatements.

 

The accompanying notes are an integral partof these consolidated financial statements.

 

 

3

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**OCCAM NETWORKS, INC. AND SUBSIDIARY**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**Unaudited**

 

**1. Business and Basis of Presentation**

 

                OccamNetworks, Inc. (“Occam” or the “Company”) develops, markets and supportsinnovative broadband access products designed to enable telecom serviceproviders to offer bundled voice, video and data, or Triple Play, services overboth copper and fiber optic networks. The Company’s Broadband Loop Carrier(BLC) is an integrated hardware and software platform that uses Internet Protocol(IP) and Ethernet technologies to increase the capacity of local accessnetworks, enabling the delivery of advanced Triple Play services.

 

                The Company is thesuccessor corporation of the May 2002 merger of Occam Networks, Inc.,a private California corporation, with Accelerated Networks, Inc. (“Accelerated”),a publicly-traded Delaware corporation. Occam Networks was incorporatedin California in July 1999. Accelerated was incorporated in California inOctober 1996 under the name “Accelerated Networks, Inc.” and wasreincorporated in Delaware in June 2000. The May 2002 merger of these twoentities was structured as a reverse merger transaction, in which Acceleratedsucceeded to the business and assets of Occam Networks. In connection with themerger, Accelerated changed its name to Occam Networks, Inc., a Delawarecorporation. Unless the context otherwise requires, references to “OccamNetworks,” “Occam” or the “Company” refer to Occam Networks, Inc. as aDelaware corporation and include the predecessor businesses of Occam, theCalifornia corporation, and Accelerated. As required by applicable accountingrules, financial statements, data, and information for periods prior toMay 2002 are those of Occam, the California corporation. Occam, the Californiacorporation, as a predecessor business or corporation, is sometimes referred toas “Occam CA.”

 

*Basis of Presentation*

 

                Theaccompanying consolidated financial statements are unaudited. The consolidatedbalance sheet at December 31, 2006 is derived from Occam’s auditedconsolidated financial statements included in its Annual Report onForm 10-K filed with the Securities and Exchange Commission onOctober 16, 2007. This financial information reflects all materialadjustments, which are, in the opinion of the Company, of a normal andrecurring nature and necessary to present fairly the consolidated statements offinancial position, results of operations and cash flows for the dates andperiods presented. The results of operations for the interim periods presentedare not necessarily indicative of results to be expected for the entire year.

 

                These consolidatedfinancial statements have been prepared in accordance with the rules andregulations of the U.S. Securities and Exchange Commission. Certain informationand footnote disclosures normally included in financial statements prepared inaccordance with accounting principles generally accepted in the United Statesof America have been condensed or omitted pursuant to such rules andregulations. These consolidated financial statements should be read inconjunction with the consolidated financial statements and the notes theretoincluded in our Annual Report on Form 10-K for the year endedDecember 31, 2006.

 

                Prior toJanuary 1, 2007, Occam prepared its financial statements with the end ofeach quarter falling on the last Sunday of each calendar quarter. As a result,Occam’s accounting quarters did not necessarily coincide with the last day ofthe calendar month. The quarter-end dates for fiscal 2006 were March 26,June 25, September 24, and December 31. Effective January 1,2007, Occam adopted a fiscal reporting schedule based on calendar quarter andyear ends.

 

                OnFebruary 23, 2006, Occam announced a 1-for-40 reverse stock split whichwas previously authorized at its annual meeting of stockholders held on June21, 2005. The record date for the reverse split was March 10, 2006 andOccam began trading on the NASD Electronic Bulletin Board (OTCBB) on a split-adjustedbasis on Monday, March 13, 2006 under the new symbol “OCNW.OB.” The shareinformation in the accompanying consolidated financial statements reflects thisreverse stock split.

 

*Use of Estimates*

 

                The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the amounts reported in the consolidated financialstatements and the accompanying notes. Actual results could differ from thoseestimates and such differences may be material to the consolidated financialstatements.

 

 

4

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*Revenue Recognition*

 

                Occam recognizessales revenue when persuasive evidence of sales arrangements exist, deliveryhas occurred or services have been rendered, the buyer’s price is fixed ordeterminable and collection is reasonably assured. Occam allows credit forproducts returned within its policy terms.

 

                In addition to theaforementioned general policy, Occam enters into transactions that representmultiple-element arrangements, which may include training and post-salestechnical support and maintenance to our customers as needed to assist them ininstallation or use of our products, and make provisions for these costs in theperiods of sale. Multiple-element arrangements are assessed to determinewhether they can be separated into more than one unit of accounting. A multiple-elementarrangement is separated into more than one unit of accounting if all of thefollowing criteria are met:

 

•                  the delivereditem(s) has value to the customer on a stand-alone basis;

 

•                  there isobjective and reliable evidence of the fair value of the undelivered item(s);and

 

•                  the arrangementincludes a general right of return relative to the delivered item(s), deliveryor performance of the undelivered item(s) is considered probable andsubstantially in Occam’s control.

 

                If these criteriaare not met, then sales revenue is deferred until such criteria are met oruntil the period(s) over which the last undelivered element is delivered. Ifthere is objective and reliable evidence of fair value for all units ofaccounting in an arrangement, the arrangement consideration is allocated to theseparate units of accounting based on each unit’s relative fair value.

 

                In certain circumstances,Occam enters into arrangements with customers who receive financing support inthe form of long-term low interest rate loans from the United States Departmentof Agriculture’s Rural Utilities Service (“RUS”). The terms of the RUScontracts provide that in certain instances transfer of title of Occam’sproducts does not occur until customer acceptance. In these cases, Occam doesnot recognize revenue until payment has been received, assuming the remainingrevenue recognition criteria are met. Occam believes payment, whichcontractually occurs after written customer acceptance, provides superiorassurance for revenue recognition purposes.

 

                Occam furtherwarrants its products for periods up to five years and records an estimatedwarranty accrual when sales revenue is recognized.

 

**2. Restatement of Consolidated Financial Statements**

 

                InMarch 2007, the Company’s chief financial officer notified its auditcommittee and independent registered public accounting firm that the financedepartment had discovered a letter, in which the Company had committed toprovide a customer with a free third-party product as well as extendedsoftware maintenance and free training. In response, the audit committeeinitiated a review of the transaction, with the assistance of outside legalcounsel and a forensic accounting and technology service firm. Subsequently,the audit committee obtained independent legal counsel to review the conduct ofpersons involved. Upon determining that other similar transactions existed, theaudit committee expanded the scope of its investigation to cover numeroustransactions from 2003 through the first quarter of fiscal 2007. Among othermatters, during the course of the investigation, the audit committee, assistedby its independent forensic accountants and legal advisors, reviewed theCompany’s practices relating to the following:

 

•                  commitments toprovide customers with software, hardware and software maintenance, hardwareand software upgrades, training and other services in connection with customers’purchases of the Company’s network equipment;

 

•                  sales to valueadded resellers; and

 

•                  use ofintermediate shipping vendors in connection with shipments of products at theend of quarters falling on weekends.

 

                OnSeptember 9, 2007, the Company’s board of directors, based on arecommendation of the audit committee, concluded that the Company shouldrestate its financial statements for fiscal years 2004 and 2005, thecorresponding interim quarterly periods of fiscal years 2004 and 2005, and thefirst, second, and third quarters of fiscal year 2006. The board of directorsalso determined that the Company’s previously filed financial statements forthese periods should not be relied on. 

 

 

5

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On October 16, 2007, the Company filed its Annual Report onForm 10-K with the restated financial statements and issued a pressrelease announcing the final restated financial information and conclusions ofthe audit committee investigation. The adjustments resulting from therestatement related solely to revenue recognition matters. The restatementadjustments did not affect the Company’s reported cash and cash equivalents balancesas of the end of any fiscal period.

 

                The principalaccounting issues resulting in the need to restate the Company’s financialstatements were derived from (i) commitments to certain customers inconnection with sales for features or deliverables that were not available atthe time revenue was originally recognized, including commitments toprospectively provide free product, software, training, and installationservices; (ii) sales to value-added resellers where the resellersdid not have the ability to pay the Company for these sales independent ofpayment to them by the end-user; and (iii) for certain quarters ending onweekends, the Company’s use of a shipping vendor who picked up product forsubsequent delivery to another shipping company where the terms and conditionsof the shipments did not appropriately transfer title or risk of loss at thetime of shipment.

 

                In determiningthat a restatement was required, the Company accounted for hardware sales andrelated cost of sales in accordance with Staff Accounting Bulletin 104 (*Revenue Recognition*). The Companyaccounted for software sales in accordance with AICPA Statement of PositionNo. 97-2 (*Software Revenue Recognition*).The Company accounted for sales with multiple deliverables in accordance withEmerging Issues Task Force 00-21 (*Accountingfor Revenue Arrangements with Multiple Deliverables*).

 

**Summary of the Restatement Adjustments**

 

                The followingtables set forth summary restated financial data for the three and nine monthsended September 24, 2006 as originally reported and as restated (in thousands,except per share data):

 
| ** **                                                                           | ** ** | **Three Months Ended**       | ** ** | **Nine Months Ended**        | ** ** |
|--------------------------------------------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                                                           | ** ** | **September 24,  2006** | ** ** | **September 24,  2006** | ** ** | **September 24,  2006** | ** ** | **September 24,  2006** | ** ** |
| ** **                                                                           | ** ** | **(As reported)**            | ** ** | **(As restated)**            | ** ** | **(As reported)** | ** ** | **(As restated)** | ** ** |
| Sales                                                                                |       | $18,066                      |       | $20,775                      |       | $48,525 |   | $46,028 |   |
| Cost of sales                                                                        |       | 11,690                       |       | 12,998                       |       | 30,068 |   | 28,676 |   |
| Net income (loss)                                                                    |       | 203                          |       | 1,604                        |       | 649 |   | (454 | ) |
| Basic net income (loss) per share attributable to common  stockholders(1)            |       | $0.03                        |       | $0.22                        |       | $(0.39 | ) | $(0.55 | ) |
| Diluted net income (loss) per share attributable to common  stockholders(1)          |       | $0.01                        |       | $0.09                        |       | $(0.39 | ) | $(0.55 | ) |
| Increase in net income (loss) attributable to common stockholders                    |       | —                       |       | 1,401                        |       | — |   | (1,103 | ) |
| Increase in basic net income (loss) per share attributable to common  stockholders   |       | $—                      |       | $0.19                        |       | $— |   | $(0.16 | ) |
| Increase in diluted net income (loss) per share attributable to  common stockholders |       | $—                      |       | $0.08                        |       | $— |   | $(0.16 | ) |

----

(1)          Per-share amounts computedafter consideration of beneficial conversion feature charges to commonstockholders. See Note 8 of Notes to Consolidated Financial Statementscontained in the Company’s Annual Report on Form 10-K filed onOctober 16, 2007.

 

**3. Inventories**

 

                Inventoriesconsist of the following (in thousands):

 

| ** **      | ** ** | **September 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|-----------------|------------|------------------------------|------------|-----------------------------|------------|
| Raw materials   |       | $                            | —     |                        | $          | 4 |   |
| Work-in-process |       | 7                            |       | 19                          |       |
| Finished goods  |       | 10,863                       |       | 10,412                      |       |
|            |       | $                            | 10,870     |                        | $          | 10,435 |   |

 

 

6

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**4. Net Income (Loss) Per Share**

 

                The followingtable sets forth the computation of basic and diluted net income (loss) pershare (in thousands, except per share data):

 
| ** **                                                                                           | ** ** | **Three Months Ended**       | ** ** | **Nine Months Ended**        | ** ** |
|------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                                                                           | ** ** | **September 30,  2007** | ** ** | **September 24,  2006** | ** ** | **September 30,  2007** | ** ** | **September 24,  2006** | ** ** |
| ** **                                                                                           | ** ** | ** **                   | ** ** | **(Restated)**               | ** ** | ** ** | ** ** | **(Restated)** | ** ** |
| Net income (loss) attributable to common stockholders                                                |       | $                            | (4,906     | )                            | $          | 1,604 |   | $ | (5,823 | ) | $ | (3,891 | ) |
| **Shares used in computation:**                                                                      |       |                         |       |                         |       |   |   |   |   |
| Weighted average common shares outstanding used in computation of  basic net income (loss) per share |       | 19,765                       |       | 7,279                        |       | 19,756 |   | 7,104 |   |
| Dilutive effect of conversion of Series A-2 Preferred Shares                                         |       | —                       |       | 8,590                        |       | — |   | — |   |
| Dilutive effect of stock options                                                                     |       | —                       |       | 1,027                        |       | — |   | — |   |
| Dilutive effect of common stock warrants                                                             |       | —                       |       | 13                           |       | — |   | — |   |
| Shares used in computation of diluted net income (loss) per share                                    |       | 19,765                       |       | 16,909                       |       | 19,756 |   | 7,104 |   |
| Basic net income (loss) per share                                                                    |       | $                            | (0.25      | )                            | $          | 0.22 |   | $ | (0.29 | ) | $ | (0.55 | ) |
| Diluted net income (loss) per share                                                                  |       | $                            | (0.25      | )                            | $          | 0.09 |   | $ | (0.29 | ) | $ | (0.55 | ) |

 

                The followingtable presents common stock equivalents (potential common stock) that are notincluded in the diluted net loss per share calculation above because theireffect on net loss would be antidilutive for the periods indicated (shares inthousands):

 
| ** **                                                           | ** ** | **Three Months Ended**       | ** ** | **Nine Months Ended**        | ** ** |
|----------------------------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                                           | ** ** | **September 30,  2007** | ** ** | **September 24,  2006** | ** ** | **September 30,  2007** | ** ** | **September 24,  2006** | ** ** |
| ** **                                                           | ** ** | ** **                   | ** ** | **(Restated)**               | ** ** | ** ** | ** ** | **(Restated)** | ** ** |
| Common stock warrants                                                |       | 13                           |       | —                       |       | 13 |   | 13 |   |
| Common stock equivalents of convertible preferred stock and warrants |       | —                       |       | —                       |       | — |   | 8,590 |   |
| Stock options                                                        |       | 673                          |       | —                       |       | 770 |   | 1,027 |   |
| Common stock equivalents                                             |       | 686                          |       | —                       |       | 783 |   | 9,630 |   |

 

**5. Commitments and Contingencies**

 

                At September 30, 2007, the Companyhad open purchase orders related to our contract manufacturers and othercontractual obligations of approximately $8.5 million primarily related toinventory purchases.  The Companyleases its office facilities and certain equipment under non-cancelableoperating lease agreements, which expire at various dates through 2014. Certainoperating leases contain escalation clauses with annual base rent adjustmentsor a cost of living adjustment. Total rent expense for the nine months endedSeptember 30, 2007 and September 24, 2006, was $769,000 and $588,000,respectively. Ourcontractual obligations as of September 30, 2007 are as follows (inthousands):

 

| **Twelve Months Ending September 30,** | ** ** | **Minimum  Lease  Payments** | ** ** | **Purchase  Commitments** | ** ** |
|----------------------------------------|------------|------------------------------|------------|---------------------------|------------|
| 2008                                   |       | $                            | 947        |                      | $          | 8,491 |   |
| 2009                                   |       | 862                          |       | —                    |       |
| 2010                                   |       | 884                          |       | —                    |       |
| 2011                                   |       | 899                          |       | —                    |       |
| 2012                                   |       | 905                          |       | —                    |       |
| Thereafter                             |       | 1,240                        |       | —                    |       |
| Total Payments                         |       | $                            | 5,737      |                      | $          | 8,491 |   |

 

 

7

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***                Royalties***

 

                From time to time,the Company may license certain technology for incorporation into its products.Under the terms of these agreements, royalty payments will be made based onper-unit sales of certain of the Company’s products. The Company incurred$98,000 and $109,000 of royalty expenses for the nine months ended September30, 2007 and September 24, 2006, respectively.

 

***                LegalProceedings***

 

*                2007Class Action Litigation*

 

                On April 26,2007 and May 16, 2007, two putative class action complaints were filed inthe United States District Court for the Central District of California againstthe Company and certain of its officers. The complaints alleged that thedefendants violated sections 10(b) and 20(a) of the Securities Exchange Act of1934, or the Exchange Act, and SEC Rule 10b-5 by making false andmisleading statements and omissions relating to the Company’s financialstatements and internal controls with respect to revenue recognition. Thecomplaints seek, on behalf of persons who purchased our common stock during theperiod from May 2, 2006 to April 17, 2007, damages of an unspecifiedamount.

 

                On July 30,2007, Judge Christina A. Snyder consolidated these actions into a singleaction, appointed NECA-IBEW Pension Fund (The Decatur Plan) as lead plaintiff,and approved its selection of lead counsel. The lead plaintiff must file aconsolidated complaint no later than November 16, 2007.

 

                Occam believes ithas meritorious defenses in this action and intends to defend itself and itsofficers vigorously. Failure by the Company to obtain a favorable resolution ofthe claims set forth in the current complaints or the consolidated complaintdue November 16, 2007 could have a material adverse effect on the Company’sbusiness, results of operations and financial condition. Currently, the amountof such material adverse effect cannot be reasonably estimated.

 

*                IPOAllocation Litigation*

 

                In June 2001,three putative stockholder class action lawsuits were filed against AcceleratedNetworks, certain of its then officers and directors and several investmentbanks that were underwriters of Accelerated Networks’ initial public offering.The cases, which have since been consolidated, were filed in the United StatesDistrict Court for the Southern District of New York. The court appointed alead plaintiff on April 16, 2002, and plaintiffs filed a consolidatedamended class action complaint, or consolidated complaint, on April 19,2002. The consolidated complaint was filed on behalf of investors who purchasedAccelerated Networks’ stock between June 22, 2000 and December 6, 2000 andalleged violations of Sections 11 and 15 of the Securities Act of 1933 andSections 10(b) and 20(a) and Rule 10b-5 of the Exchange Act against one orboth of Accelerated Networks and the individual defendants. The claims werebased on allegations that the underwriter defendants agreed to allocate stockin Accelerated Networks’ initial public offering to certain investors inexchange for excessive and undisclosed commissions and agreements by thoseinvestors to make additional purchases in the aftermarket at pre-determinedprices. Plaintiffs alleged that the prospectus for Accelerated Networks’initial public offering was false and misleading in violation of the securitieslaws because it did not disclose these arrangements. These lawsuits are part ofthe massive “IPO allocation” litigation involving the conduct of underwritersin allocating shares of successful initial public offerings. The Company believesthat over three hundred other companies have been named in more than onethousand similar lawsuits that have been filed by some of the same plaintiffs’law firms. In October 2002, the plaintiffs voluntarily dismissed theindividual defendants without prejudice. On February 1, 2003, a motion todismiss filed by the issuer defendants was heard, and the court dismissed the10(b), 20(a) and Rule 10b-5 claims against the Company.

 

                OnOctober 13, 2004 the court certified a class in six of the approximately300 other nearly identical actions (the “focus” cases) and noted that thedecision was intended to provide guidance to all parties regarding classcertification in the remaining cases. The underwriter defendants appealed thedecision and the Second Circuit Court of Appeals vacated the district court’sdecision granting class certification in those six cases on December 5,2006. Plaintiffs filed a motion for rehearing. On April 6, 2007, theSecond Circuit denied the petition but noted that plaintiffs could ask theDistrict Court to certify a more narrow class than the one that was rejected.On October 3, 2007, Plaintiff filed a motion to certify a new class. Anopposition brief is due on December 21, 2007, and a reply brief is due onFebruary 15, 2008.

 

                Prior to the SecondCircuit’s December 5, 2006 ruling, the Company agreed, together with overthree hundred other companies similarly situated, to settle with theplaintiffs. A settlement agreement and related agreements were submitted to thecourt for approval. The settlement would have provided, among other things, fora release of the Company and the individual defendants for the conduct allegedto be wrongful in the complaint in exchange for a guarantee from the defendants’insurers regarding recovery from the underwriter defendants and otherconsideration from defendants regarding the underwriters. In light of theSecond Circuit opinion, liaison counsel for the issuers informed the DistrictCourt that the settlement cannot be approved because the defined settlement class,like the litigation class, cannot be certified. The Company cannot predictwhether it will be able to renegotiate a settlement that complies with theSecond Circuit’s mandate.

 

 

8

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                Due to theinherent uncertainties of litigation, the Company cannot accurately predict theultimate outcome of the matter. The Company has not recorded any accrualrelated to this proposed settlement because it expects any settlement amountsto be covered by its insurance policies.

 

*Other Matters*

 

                From time to time,the Company is subject to threats of litigation or actual litigation in theordinary course of business, some of which may be material. The Companybelieves that there are no currently pending matters that, if determinedadversely to it, would have a material effect on its business or that would notbe covered by its existing liability insurance maintained by the Company.

 

*Indemnifications and Guarantees*

 

                Occam enters intoindemnification provisions under its agreements with other companies in theordinary course of business, typically with its contractors, customers andlandlords. Under these provisions, Occam generally indemnifies and holdsharmless the indemnified party for losses suffered or incurred by theindemnified party as a result of Occam’s activities or, in some cases, as aresult of the indemnified party’s activities under the agreement. Theseindemnification provisions generally survive termination of the underlyingagreement. In addition, Occam has entered into indemnification agreements withits officers and directors that indemnify such persons for certain liabilitiesthey may incur in connection with their services as an officer or director, andOccam has agreed to indemnify certain investors for liabilities they may incurin connection with the exercise of registration rights. The maximum potentialamount of future payments Occam could be required to make under theseindemnification provisions is generally unlimited. As of September 30, 2007,Occam has not incurred material costs to defend lawsuits or settle claimsrelated to these indemnification agreements. Occam had no liabilities recordedfor these agreements as of September 30, 2007 and December 31, 2006.

 

*Purchase Orders*

 

                Under the terms ofOccam’s contract manufacturer agreements, Occam is required to place orderswith its contract manufacturers to meet its estimated sales demand. Certaincontract manufacturer agreements include lead-time and cancellation provisions.At September 30, 2007, open purchase orders with contract manufacturers were$8.5 million.

 

*Warranties*

 

                Occam providesstandard warranties with the sale of products generally for up to five yearsfrom date of shipment. The estimated cost of providing the product warranty isrecorded at the time revenue is recognized. Occam maintains product qualityprograms and processes including actively monitoring and evaluating the qualityof its suppliers. Occam quantifies and records an estimate for warranty relatedcosts based on Occam’s history, projected return and failure rates and currentrepair costs. The following table summarizes changes in Occam’s accruedwarranty liability that is included in accrued expenses (in thousands):

 

| ** **                                | ** ** | **Three Months Ended**  | ** ** | **Nine Months Ended**   | ** ** |
|-------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                | ** ** | **September 30,  2007** | ** ** | **September 24,  2006** | ** ** | **September 30,  2007** | ** ** | **September 24,  2006** | ** ** |
| ** **                                | ** ** | ** **              | ** ** | **(Restated)**          | ** ** | ** ** | ** ** | **(Restated)** | ** ** |
| Balance at beginning of period            |       | $                       | 2,772      |                    | $          | 1,412 |   | $ | 1,862 |   | $ | 1,093 |   |
| Warranty provision expensed during period |       | 837                     |       | 460                     |       | 2,658 |   | 1,488 |   |
| Warranty utilization                      |       | (612                    | )          | (233                    | )          | (1,523 | ) | (942 | ) |
| Balance at end of period                  |       | $                       | 2,997      |                    | $          | 1,639 |   | $ | 2,997 |   | $ | 1,639 |   |

 

**6. Accrued expenses**

 

                Accrued expensesconsist of the following (in thousands):

 

| ** **           | ** ** | **September 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|----------------------|------------|-------------------------|------------|------------------------|------------|
| Accrued expenses     |       | $                       | 2,821      |                   | $          | 1,830 |   |
| Warranty obligations |       | 2,997                   |       | 1,862                  |       |
| Deferred rent        |       | 2,556                   |       | 17                     |       |
| Accrued other        |       | 369                     |       | 190                    |       |
|                 |       | $                       | 8,743      |                   | $          | 3,899 |   |

 

 

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**7. Stock Options—Fair Value Disclosures**

 

| ** **                         | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted-  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|------------------------------------|------------|------------|------------|-----------------------------------------|------------|------------------------------------------------------|------------|---------------------------------|------------|
| Outstanding at June 30, 2007       |       | 1,990      |       | $                                       | 9.55       |                                                 |       |                            |       |   |
| Granted                            |       | —     |       | —                                  |       |                                                 |       |                            |       |
| Exercised                          |       | —     |       | —                                  |       |                                                 |       |                            |       |
| Forfeited or expired               |       | (39        | )          | 14.14                                   |       |                                                 |       |                            |       |
| Outstanding at September 30, 2007  |       | 1,951      |       | 9.45                                    |       | 7.14                                                 |       | $                               | 6,496      |   |
| Exerciseable at September 30, 2007 |       | 1,266      |       | $                                       | 7.29       |                                                 | 6.59       |                            | $          | 5,327 |   |

 

***Stock-Based Compensation***

 

                Effectivebeginning the first fiscal quarter of 2006, the Company adopted SFAS No. 123(R)using the modified prospective method. Under this method, compensation costsfor all awards granted after the date of adoption and the unvested portion ofpreviously granted awards outstanding at the date of adoption are measured atestimated fair value and included in cost of sales and operating expenses overthe vesting period during which an employee provides service in exchange forthe award. Accordingly, prior period amounts presented herein have not beenrestated to reflect the adoption of SFAS No. 123(R).

 

                The followingtable summarizes the impact of the adoption of SFAS 123(R) on stock-basedcompensation costs for employees on our Consolidated Statements of Operationsfor the three and nine months ended September 30, 2007 and September 24, 2006(in thousands):

 
| ** **                                                            | ** ** | **Three Months Ended**  | ** ** | **Nine Months Ended**   | ** ** |
|-----------------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                                            | ** ** | **September 30,  2007** | ** ** | **September 24,  2006** | ** ** | **September 30,  2007** | ** ** | **September 24,  2006** | ** ** |
| ** **                                                            | ** ** | ** **              | ** ** | **(Restated)**          | ** ** | ** ** | ** ** | **(Restated)** | ** ** |
| **Employee stock-based compensation in:**                             |       |                    |       |                    |       |   |   |   |   |
| Cost of sales                                                         |       | $                       | 71         |                    | $          | 65 |   | $ | 194 |   | $ | 183 |   |
| Research and product development expense                              |       | 164                     |       | 198                     |       | 542 |   | 522 |   |
| Sales and marketing expense                                           |       | 144                     |       | 159                     |       | 422 |   | 316 |   |
| General and administrative expense                                    |       | 110                     |       | 118                     |       | 407 |   | 243 |   |
| Total SFAS 123(R) stock-based compensation in operating expenses |       | 418                     |       | 475                     |       | 1,371 |   | 1,081 |   |
| Total SFAS 123(R) stock-based compensation                            |       | $                       | 489        |                    | $          | 540 |   | $ | 1,565 |   | $ | 1,264 |   |
|                                                                       |            |                         |            |                         |            |  |  |  |  |  |  |  |  |  |

 

                As of September30, 2007, total unamortized stock-based compensation costs related tonon-vested stock options was $4.8 million, which is expected to berecognized over the remaining vesting period of each grant, up to48 months.

 

Upon adoption of SFAS 123(R), we selected the Black-Scholes optionpricing model for determining the estimated fair value for stock-basedawards. The use of the Black-Scholes model requires the use of extensiveactual employee exercise behavior data and the use of a number of complexassumptions including expected volatility, risk-free interest rate,forfeitures, and expected dividends. The assumptions used to value optionsgranted are as follows:

 

| ** **              | ** ** | **Nine Months Ended**   | ** ** |
|-------------------------|------------|-------------------------|------------|
| ** **              | ** ** | **September 30,  2007** | ** ** | **September 24,  2006** | ** ** |
| Risk-free interest rate |       | 4                       | %          | 5 | % |
| Expected term (years)   |       | 4.9                     |       | 4.9 |   |
| Dividend yield          |       | 0                       | %          | 0 | % |
| Expected volatility     |       | 51                      | %          | 74 | % |

 

 

10

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                The risk-freeinterest rate is based on the U.S. Treasury yield curve in effect at the timeof grant. We do not anticipate declaring dividends in the foreseeable future.Expected volatility is based on the annualized weekly historical volatility ofour stock price and we believe it is indicative of future volatility. Weestimate the expected life of options granted based on historical exercise andpost-vesting cancellation patterns with consideration of our industrypeers of similar size with similar option vesting periods. Our analysis ofstock price volatility and option lives involves management’s best estimates atthe time of determination. SFAS 123(R) also requires that we recognizecompensation expense for only the portion of options or stock units that areexpected to vest. Therefore, we apply an estimated forfeiture rate that isderived from historical employee termination behavior. If the actual number offorfeitures differs from those estimated by management, additional adjustmentsto compensation expense may be required in future periods.

 

**8. Series A-2 Convertible Preferred Stock**

 

                OnFebruary 1, 2006, the Company concluded a rights offering to eligiblestockholders of record as of December 26, 2005. Each subscription rightentitled the stockholder to subscribe for and purchase one share ofSeries A-2 preferred stock for each 2.27275 shares of common stock held onthe record date. Each share of Series A-2 preferred stock had a purchase priceof $10.00 and was convertible into shares of Occam’s common stock at aconversion price of $4.40, subject to adjustment, representing a conversionratio of 2.27275 shares of common stock for each share of Series A-2preferred stock issued. In response to the rights offering, Occam receivedsubscriptions to purchase 343,741 shares of Series A-2 preferred stock foran aggregate purchase price of $3.4 million and net proceeds of$2.7 million

 

                The Companyrecorded beneficial conversion feature (“BCF”) charges to net loss attributableto common stockholders of $3.4 million relating to the issuance of theSeries A-2 preferred stock in February 2006. The BCF was calculatedusing the fair value of the common stock on the dates of issuance, subtractingthe accounting conversion price and then multiplying the resulting amount bythe number of shares of common stock into which the Series A-2 preferredstock was convertible.

 

                OnNovember 6, 2006, pursuant to an action by written consent signed byholders of greater than 66.67% of the outstanding shares of Series A-2preferred stock of Occam, all outstanding shares of Series A-2 preferredstock of the Company were converted to shares of common stock of the Company.The rate of conversion was one share of Series A-2 preferred stock for2.27275 shares of common stock.

 

**9. Subsequent Event**

 

*Terawave Asset Purchase*

 

On October 25, 2007, the Company completed its acquisition ofsubstantially all assets of Terawave Communications, Inc., or Terawave,including its patents, patent applications, trademarks and other intellectualproperty, certain license agreements and other contracts, equipment, supplies,inventories, work in process, cash and accounts receivable.  Terawave’s products include a portfolio ofbroadband access solutions, incorporating gigabit passive optical network, orGPON, and other technologies. The acquisition was completed pursuant to anasset purchase agreement between the Company and Terawave entered into onSeptember 27, 2007.  Pursuant to theasset purchase agreement, the Company assumed certain liabilities of Terawaveincluding liabilities under certain assigned contracts, inventory purchasecommitments of approximately $0.4 million, $0.2 million in Terawave’stransaction expenses and one half of the transfer taxes associated with the sale.The purchase price for the acquisition was $5.3 million andincluded $3.2 million in cash and the assumption of certain liabilities andpurchase commitments of Terawave, the cancellation of bridge financing of $1.9million and payment of Terawave’s legal fees of $0.2 million . Of the $1.9 million in loans cancelled in connection with this purchase,$1.6 million in aggregate principal amount of loans were funded to Terawave inthe three months ended September 30, 2007. The Company will also incur transaction and integration-relatedexpenses in connection with the acquisition. In connectionwith the acquisition of assets from Terawave, the Company hired 29 formeremployees of Terawave, including 22 in engineering, 3 in operations and 1 insales and marketing.

 

*SEC Matter*

 

In advance of the Company’s announcement ofthe audit committee investigation and pending restatement described under Note2, the Company advised the staff of the Enforcement Division of the UnitedStates Securities and Exchange Commission (“SEC”) of these developments.  After the conclusion of the investigation,the Company met with the SEC staff.  OnNovember 13, 2007, the Company received a letter from the SEC staffstating that the investigation as to Occam Networks, Inc. has been completedand that the SEC staff does not intend to recommend any enforcement action bythe SEC.

 

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**ITEM 2.****              ****MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF OPERATIONS**

 

*                Youshould read the following discussion and analysis in conjunction with ourcondensed consolidated financial statements and the related notes theretoincluded in this Report on Form 10-Q and with Management’s Discussion andAnalysis of Financial Condition and Results of Operations contained in theCompany’s Annual Report on Form 10-K for the year ended December 31,2006. The discussion in this Report contains both historical information andforward-looking statements. A number of factors affect our operatingresults and could cause our actual future results to differ materially from anyforward-looking results discussed below. In some cases, you can identifyforward-looking statements by terminology such as “anticipates,” “appears,”“believes,” “continue,” “could,” “estimates,” “expects,” “feels,” “goal,” “hope,”“intends,” “may,” “our future success depends,” “plans,” “potential,” “predicts,”“projects,” “reasonably,” “seek to continue,” “should,” “thinks,” “will” or thenegative of these terms or other comparable terminology. These statements areonly predictions. Actual events or results may differ materially. In addition,historical information should not be considered an indicator of futureperformance. Factors that could cause or contribute to these differences include,but are not limited to, the risks discussed in Part II, Item 1A underthe caption “Risk Factors.” These factors may cause our actual results todiffer materially from any forward-looking statements.*

 

*                Althoughwe believe that the expectations reflected in the forward-lookingstatements are reasonable, we cannot guarantee future results, levels ofactivity, performance or achievements. Moreover, we are under no duty to updateany of the forward-looking statements after the date of this Report onForm 10-Q to conform these statements to actual results. These forward-lookingstatements are made in reliance upon the safe harbor provision of The PrivateSecurities Litigation Reform Act of 1995.*

 

**Restatement of Consolidated Financial Statements**

 

                On October 16,2007, we announced that the audit committee of our board of directors hadcompleted its previously announced internal review of our revenue recognitionpractices. As a result of the review, we determined that our previously filedfinancial statements for the following periods required restatement:(i) our fiscal years ended December 25, 2005 and December 26,2004; (ii) each of the interim quarterly periods in our fiscal years endedDecember 25, 2005 and December 26, 2004; and (iii) each of theinterim quarterly periods ended March 26, June 25 and September 24,2006. The adjustments resulting from the restatement relate solely to revenuerecognition matters. The restatement adjustments did not affect our reportedcash and cash equivalent balances as of the end of any fiscal period.

 

                Specifically, wedetermined that a restatement was required because we incorrectly accounted forthe following categories of transactions: (i) transactions involvingcommitments to certain customers in connection with sales for features ordeliverables that were not available at the time revenue was originallyrecognized, including commitments to prospectively provide free product,software, training, and installation services, for which we prematurelyrecognized approximately $9.3 million in revenue from fiscal 2004 tofiscal 2006; (ii) sales to value-added resellers where the resellersdid not have the ability to pay us for these sales independent of payment tothem by the end-user, for which we prematurely recognized approximately$20.2 million in revenue from fiscal 2004 to fiscal 2006; and(iii) for certain quarters ending on weekends, transactions involving ouruse of a shipping vendor who picked up product for subsequent delivery toanother shipping company where the terms and conditions of the shipments didnot appropriately transfer title or risk of loss at the time of shipment, forwhich we prematurely recognized approximately $2.3 million in revenue fromfiscal 2004 to fiscal 2006. In addition, we prematurely recognizedapproximately $1.1 million of revenue from fiscal 2004 through fiscal 2006relating principally to errors in accounting for software and softwaremaintenance, customer credits, and undelivered free product.

 

                In determiningthat a restatement was required, we accounted for hardware sales and relatedcost of sales in accordance with Staff Accounting Bulletin 104, *Revenue Recognition*, or SAB 104. Weaccounted for software sales in accordance with AICPA Statement of PositionNo. 97-2, *Software Revenue Recognition*,or SOP 97-2. We accounted for sales with multiple deliverables in accordancewith Emerging Issues Task Force 00-21, *Accountingfor Revenue Arrangements with Multiple Deliverables,*or EITF 00-21.

 

**Overview**

 

                We develop, marketand support innovative broadband access products designed to enable telecomservice providers to offer bundled voice, video and data, or Triple Play,services over both copper and fiber optic networks. Our Broadband Loop Carrier,or BLC, is an integrated hardware and software platform that uses InternetProtocol, or IP, and Ethernet technologies to increase the capacity of localaccess networks, enabling our customers to deliver advanced services, includingvoice-over-IP, or VoIP, IP-based television, or IPTV, and high-definitiontelevision, or HDTV. Our platform simultaneously supports traditional voiceservices, enabling our customers to leverage their existing networks andmigrate to IP without disruption. In addition to providing our customers withincreased bandwidth, our products provide incremental value by offeringsoftware-based features to improve the quality, resiliency and securityof Triple Play services. We market our products through a combination of directand indirect channels. Our direct sales efforts are focused on the independentoperating company, or IOC, segment of the telecom service provider market. Wealso target larger telecom service providers through strategic resellerrelationships. As of September 30, 2007, we had shipped our BLC platform to 258customers.

 

                From our inceptionthrough September 30, 2007, we have incurred cumulative net losses ofapproximately $115.2 million. We realized income from operations and wereprofitable on a net income basis during the quarters ended March 26, 2006,September 24, 2006 and December 31, 2006 and for the year endedDecember 31, 2006. Previously, we had not been profitable on a quarterlyor annual basis. We have experienced operating losses for each of thefirst three quarters of

 

 

12

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2007 and net losses for the second and third quarters of 2007 andcurrently expect to experience operating and net losses for the fourth quarterand full year.  For the ninemonths ended September 30, 2007, we recorded a net loss of $5.8 million, withan operating loss for this period of $8.0 million. Beginning in the secondquarter of 2007, we began to experience a softening in our business. We believethis softening is attributable in part to adverse trends affecting our targetcustomer markets, in part to delays associated with our customers’ evaluationsof strategic investment decisions concerning their movement from copper wire tofiber, and in part to uncertainty surrounding our financial reporting.

 

                Prior toJanuary 1, 2007, when we adopted a calendar year end for fiscal reportingpurposes, we prepared our financial statements with the end of each quarterfalling on the last Sunday of each calendar quarter. As a result, ouraccounting quarters did not necessarily coincide with the last day of thecalendar quarter. Effective January 1, 2007, we adopted a calendar fiscal-yearand quarter-end. The quarter-end dates for fiscal 2006 wereMarch 26, June 25, September 24, and December 31.

 

                On October 25, 2007, wecompleted our acquisition of substantially all assets of TerawaveCommunications, Inc., or Terawave, including its patents, patent applications,trademarks and other intellectual property, certain license agreements andother contracts, equipment, supplies, inventories, work in process, cash andaccounts receivable.  Terawave’s productsinclude a portfolio of broadband access solutions, incorporating gigabitpassive optical network, or GPON, and other technologies. The acquisition wascompleted pursuant to an asset purchase agreement between us and Terawaveentered into on September 27, 2007. Pursuant to the asset purchase agreement, we assumed certain liabilitiesof Terawave including liabilities under certain assigned contracts, inventorypurchase commitments of approximately $0.4 million, $0.2 million in Terawave’stransaction expenses and one half of the transfer taxes associated with thesale. The purchase price for the acquisition was $5.3 million andincluded $3.2 million in cash and the assumption of certain liabilities and purchasecommitments of Terawave, the cancellation of bridge financing of $1.9 millionand payment of Terawave’s legal fees of $0.2 million. Of the $1.9 million in loans cancelled in connection with this purchase,$1.6 million in aggregate principal amount of loans were funded to Terawave inthe three months ended September 30, 2007. We will also incur transaction and integration-related expenses inconnection with the acquisition.  In connection with the acquisition ofassets from Terawave, we hired 29 former employees of Terawave, including 22 inengineering, 3 in operations and 1 in sales and marketing.  We expect this acquisition to result inadditional transition costs over the next several quarters and our financialperformance in future periods will depend in part on our ability to incorporateTerawave’s products into our business.

 

 

**Critical Accounting Policies and Estimates**

 

                Management’sDiscussion and Analysis of Financial Condition and Results of Operationsdiscusses our consolidated financial statements, which have been prepared inaccordance with accounting principles generally accepted in the United Statesof America. The preparation of these consolidated financial statements requiresus to make estimates and assumptions that affect the reported amounts of assetsand liabilities and the disclosure of contingent assets and liabilities at thedate of the consolidated financial statements and the reported amounts of salesand expenses during the reporting period. On an ongoing basis, we evaluate our estimatesand judgments, including those related to revenue recognition, inventories,litigation, warranty reserve and valuation of deferred income tax assets. Webase our estimates and judgments on historical experience and on various otherfactors that are believed to be reasonable under the circumstances, the resultsof which form the basis for making judgments about the carrying values ofassets and liabilities that are not readily apparent from other sources.

 

                We included in ourAnnual Report on Form 10-K for the year ended December 31, 2006a discussion of our most critical accounting policies, which are those that aremost important to the portrayal of our financial condition and results ofoperations and require management’s most difficult, subjective and complexjudgments, often as a result of the need to make estimates about the effect ofmatters that are inherently uncertain. We did not make changes to such criticalaccounting policies for the three and nine months ended September 30, 2007.

 

 

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**Results of Operations**

 

***                Three-monthsended September 30, 2007 and September 24, 2006***

 

*                Sales*

 

| ** ** | ** ** | **Three Months Ended**  | ** ** |
|------------|------------|-------------------------|------------|
| ** ** | ** ** | **September 30,  2007** | ** ** | **September 24,  2006** | ** ** |
| ** ** | ** ** | ** **              | ** ** | **Restated(1)** | ** ** |
| Sales      |       | $                       | 15,660     |   | $ | 20,775 |   |
|            |            |                         |            |  |  |  |  |

----

(1)          See Note 2, “Restatement ofConsolidated Financial Statements,” in Notes to Consolidated FinancialStatements, beginning on page 5.

 

                Our sales areprincipally comprised of sales of our BLC 6000 system product line, cabinetsand related accessories. Sales decreased by $5.1 million or 25% to$15.7 million for the three months ended September 30, 2007 as compared tosales of $20.8 million for the three months ended September 24, 2006. Webelieve this decrease in our sales for the three months ended September 30,2007 was due to a softening in our business attributable to delays associatedwith our customers’ evaluations of strategic investment decisions concerningtheir movement from copper wire to fiber, a shift in our customer base towardlonger term loan projects funded by the United States Departmentof Agriculture’s Rural Utilities Service, or RUS, and uncertaintyconcerning our financial reporting while we were delinquent in our filings withthe SEC and subject to a delisting proceeding by the NASDAQ Global Market. Dueto these factors, we do not expect our revenues in upcoming periods to grow atthe same rates they have grown in past periods and expect revenues in futurequarters to grow, if at all, only modestly relative to prior years.

 

*                Costof sales and gross margin*

 

| ** **    | ** ** | **Three Months Ended**  | ** ** |
|---------------|------------|-------------------------|------------|
| ** **    | ** ** | **September 30,  2007** | ** ** | **September 24,  2006** | ** ** |
| ** **    | ** ** | ** **              | ** ** | **Restated(1)** | ** ** |
| Cost of sales |       | $                       | 9,959      |   | $ | 12,998 |   |
| Gross profit  |       | $                       | 5,701      |   | $ | 7,777 |   |
| Gross margin  |       | 36                      | %          | 37 | % |

----

(1)          See Note 2, “Restatement ofConsolidated Financial Statements,” in Notes to Consolidated FinancialStatements, beginning on page 5.

 

                Cost of salesincludes the cost of products shipped for which sales were recognized, warrantycosts, costs of any manufacturing yield problems, field replacements, re-workcosts, manufacturing overhead, provisions for obsolete inventory and the costof post-sales support. Cost of sales decreased by $3.0 million or 23% to$10.0 million for the three months ended September 30, 2007 as compared to$13.0 million for the three months ended September 24, 2006. The decreasein cost of sales during the three months ended September 30, 2007 wasattributable primarily to decreased sales of our products.

 

                Gross profits were36% of sales for three months ended September 30, 2007 compared to grossprofits of 37% of sales for the three months ended September 24, 2006. Cost ofsales and gross margin in both periods were adversely affected by additionalcosts arising from repair costs on certain new products. As of September 30,2007 and September 24, 2006, we had accruals of $3.0 million and$1.6 million, respectively, to cover estimated repair costs of fieldunits. These accruals were based upon our experience with failures of certainparts and estimated repair costs.

 

                We expect that ourgross margin will vary from quarter-to-quarter due in part to variations inproduct mix. To the extent that cabinets and other lower-margin productsrepresent an increased percentage of our total sales in any period, it willtend to reduce our gross margin.

 

 

14

----

 

*                Researchand product development expenses*

 

| ** **                                | ** ** | **Three Months Ended**  | ** ** |
|-------------------------------------------|------------|-------------------------|------------|
| ** **                                | ** ** | **September 30,  2007** | ** ** | **September 24,  2006** | ** ** |
| ** **                                | ** ** | ** **              | ** ** | **Restated(1)** | ** ** |
| Research and product development expenses |       | $                       | 3,245      |   | $ | 2,269 |   |
| Percentage of sales                       |       | 21                      | %          | 11 | % |
|                                           |            |                         |            |  |  |  |  |

----

(1)          See Note 2, “Restatement ofConsolidated Financial Statements,” in Notes to Consolidated FinancialStatements, beginning on page 5.

 

                Research andproduct-development expenses consist primarily of salaries and otherpersonnel-related costs, prototype component and assembly costs, third-partydesign services and consulting costs, and other costs related to the design,development, and testing of our products. Research and product developmentcosts are expensed as incurred, except for capital expenditures, which arecapitalized and depreciated over their estimated useful lives, generally two tofive years. Research and product development expenses increased by$1.0 million or 43% to $3.2 million for the three months ended September30, 2007 as compared to $2.3 million for the three months ended September24, 2006. The increase in research and product development expenses wasattributable to increased salary and personnel-related costs and third-partydesign costs recorded as non-recurring engineering expenses. We expectresearch and product development expenses to continue to increase in futureperiods as a result of our hiring certain former Terawave engineers in October2007 and continued investments in our products and technologies.

 

*                Salesand marketing expenses*

 

| ** **                   | ** ** | **Three Months Ended**  | ** ** |
|------------------------------|------------|-------------------------|------------|
| ** **                   | ** ** | **September 30,  2007** | ** ** | **September24,  2006** | ** ** |
| ** **                   | ** ** | ** **              | ** ** | **Restated(1)** | ** ** |
| Sales and marketing expenses |       | $                       | 3,728      |   | $ | 2,834 |   |
| Percentage of sales          |       | 24                      | %          | 14 | % |
|                              |            |                         |            |  |  |  |  |

----

(1)          See Note 2, “Restatement ofConsolidated Financial Statements,” in Notes to Consolidated FinancialStatements, beginning on page 5.

 

                Sales andmarketing expenses consist primarily of salaries, sales commissions, and otherpersonnel-related costs, development and distribution of promotionalmaterials, and other costs related to generating sales and conducting corporatemarketing activities. Sales and marketing expenses increased by$0.9 million or 32% to $3.7 million for the three months endedSeptember 30, 2007 as compared to $2.8 million for the three months endedSeptember 24, 2006. This increase was primarily due to increased headcount,commissions and marketing event expenses. We expect sales and marketing coststo increase as a result of our hiring of certain former Terawave sales andmarketing employees in October 2007, increasing our domestic sales coverage andestablishing an international sales presence.

 

*                Generaland administrative expenses*

 

| ** **                          | ** ** | **Three Months Ended**  | ** ** |
|-------------------------------------|------------|-------------------------|------------|
| ** **                          | ** ** | **September 30,  2007** | ** ** | **September 24,  2006** | ** ** |
| ** **                          | ** ** | ** **              | ** ** | **Restated(1)** | ** ** |
| General and administrative expenses |       | $                       | 4,218      |   | $ | 1,118 |   |
| Percentage of sales                 |       | 27                      | %          | 5 | % |
|                                     |            |                         |            |  |  |  |  |

----

(1)          See Note 2, “Restatement ofConsolidated Financial Statements,” in Notes to Consolidated FinancialStatements, beginning on page 5.

 

                Generaland administrative expenses consist primarily of salaries and other personnel-relatedcosts for executive, finance, human resources, and administrative personnel.Additionally, general and administrative expenses include professional fees,liability insurance and other general corporate costs. General andadministrative expenses increased by $3.1 million or 277% to approximately$4.2 million for the three months ended September 30, 2007 as compared to$1.1 million for the three months ended September 24, 2006. General andadministrative expenses increased primarily due to professional fees andexpenses resulting from the audit committee review of our revenue recognitionpractices, increased headcount, and the cost of remediating internal controldeficiencies identified in connection with the audit committee review. In thethird quarter of 2007, we incurred approximately $2.6 million ofprofessional fees related to the audit committee review. We expect to continueto incur significant general and administrative expenses for the remainder of2007 as we concluded the audit committee investigation in October 2007 andwill incur additional expenses associated with remediation of internal controldeficiencies and developing the necessary documentation and testing proceduresrequired by Section 404 of the Sarbanes-Oxley Act. We also expect toincur significant business and system integration expenses related to our purchase ofsubstantially all assets of Terawave.

 

 

15

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*                Stock-basedcompensation*

 

| ** **                                           | ** ** | **Three Months Ended**  | ** ** |
|------------------------------------------------------|------------|-------------------------|------------|
| ** **                                           | ** ** | **September 30,  2007** | ** ** | **September 24,  2006** | ** ** |
| ** **                                           | ** ** | ** **              | ** ** | **Restated(1)** | ** ** |
| Cost of sales                                        |       | $                       | 71         |   | $ | 65 |   |
| Research and product development                     |       | 164                     |       | 198 |   |
| Sales and marketing                                  |       | 144                     |       | 159 |   |
| General and administrative                           |       | 110                     |       | 118 |   |
| Total stock-based compensation in operating expenses |       | 418                     |       | 475 |   |
| Total stock-based compensation                       |       | $                       | 489        |   | $ | 540 |   |

----

(1)          See Note 2, “Restatementof Consolidated Financial Statements,” in Notes to Consolidated FinancialStatements, beginning on page 5.

 

                Effective as ofthe first quarter of fiscal 2006, we began recording the fair value of ourstock-based compensation in our consolidated financial statements inaccordance with Statement of Financial Accounting Standards No. 123(R), *Share-Based Payment (Revised 2004)*.Stock-based compensation expenses remained stable at $0.5 millionfor the three months ended September 30, 2007 as compared to $0.5 millionfor the three months ended September 24, 2006. We anticipate that stock-basedcompensation expense calculated under SFAS No. 123(R) will continue tohave a material effect on our consolidated statement of operations.

 

*                Interestincome, net*

 

| ** **           | ** ** | **Three Months Ended**  | ** ** |
|----------------------|------------|-------------------------|------------|
| ** **           | ** ** | **September 30,  2007** | ** ** | **September 24,  2006** | ** ** |
| ** **           | ** ** | ** **              | ** ** | **Restated(1)** | ** ** |
| Interest income, net |       | $                       | 584        |   | $ | 61 |   |
|                      |            |                         |            |  |  |  |  |

----

(1)          See Note 2, “Restatementof Consolidated Financial Statements,” in Notes to Consolidated FinancialStatements, beginning on page 5.

 

                Interest income,net increased by $0.5 million or 857% to $0.6 million for the threemonths ended September 30, 2007, as compared to $61,000 for the three monthsended September 24, 2006. This increase in interest income, net was primarilyattributable to higher average cash balances, resulting from the completion ofour secondary public offering in November 2006.

 

*                Incometax expense*

 

                For income taxpurposes, we consider our projected annual income and the utilization of ournet operating loss carryforwards among other factors. For the three monthsended September 30, 2007 and September 24, 2006, we provided $0 and $13,000,respectively, for federal and state income taxes.

 

***                Ninemonths ended September 30, 2007 and September 24, 2006***

 

*                Sales*

 

| ** ** | ** ** | **Nine Months Ended**   | ** ** |
|------------|------------|-------------------------|------------|
| ** ** | ** ** | **September 30,  2007** | ** ** | **September 24,  2006** | ** ** |
| ** ** | ** ** | ** **              | ** ** | **Restated(1)** | ** ** |
| Sales      |       | $                       | 53,884     |   | $ | 46,028 |   |
|            |            |                         |            |  |  |  |  |

----

(1)          See Note 2, “Restatement ofConsolidated Financial Statements,” in Notes to Consolidated FinancialStatements, beginning on page 5.

 

 

16

----

 

                Sales increased by$7.9 million or 17% to $53.9 million for the nine months endedSeptember 30, 2007 as compared to sales of $46.0 million for the ninemonths ended September 24, 2006. This increase was primarily attributable to anexpanded customer base, repeat orders from existing customers and increasedsales of BLC 6000 products, related accessories and cabinets.  The increase was partially offset by asoftening in our business that was attributable to delays associated with ourcustomers’ evaluations of strategic investment decisions concerning theirmovement from copper wire to fiber, a shift in our customer base toward longerterm loan projects funded by RUS, and uncertainty concerning our financialreporting while we were delinquent in our filings with the SEC and subject to adelisting proceeding by the NASDAQ Global Market.  Due to these factors, we do not expect ourrevenues in upcoming periods to grow at the same rates they have grown in pastperiods and expect revenues in upcoming quarters to grow, if at all, onlymodestly relative to prior years.

 

*                Costof sales and gross margin*

 

| ** **    | ** ** | **Nine Months Ended**        | ** ** |
|---------------|------------|------------------------------|------------|
| ** **    | ** ** | **September 30,  2007** | ** ** | **September 24,  2006** | ** ** |
| ** **    | ** ** | ** **                   | ** ** | **Restated(1)** | ** ** |
| Cost of sales |       | $                            | 34,054     |   | $ | 28,676 |   |
| Gross profit  |       | $                            | 19,830     |   | $ | 17,352 |   |
| Gross margin  |       | 37                           | %          | 38 | % |

----

(1)                                  See Note 2, “Restatement ofConsolidated Financial Statements,” in Notes to Consolidated FinancialStatements, beginning on page 5.

 

                Cost of salesincreased by $5.4 million or 19% to $34.1 million for the nine monthsended September 30, 2007 as compared to $28.7 million for the nine monthsended September 24, 2006. The increase in cost of sales during the nine monthsended September 30, 2007 was attributable to increased shipments and sales ofour products and increases of approximately $0.5 million related to additionalwarranty accruals related to design issues associated with a transistor thatresulted in potential equipment disruptions and that required a re-engineeringeffort.

 

                Gross margin wasstable at  37% of sales for the ninemonths ended September 30, 2007 compared to gross margin of 38% of sales forthe nine months ended September 24, 2006. Cost of sales and gross margin inboth periods were adversely affected by additional costs arising from repaircosts on certain new products. As of September 30, 2007 and September 24, 2006,we had accruals of $3.0 million and $1.6 million, respectively, tocover estimated repair costs on field units. These accruals were based upon ourexperience with failures of certain parts and estimated repair costs.

 

                We expect that ourgross margin will vary from quarter-to-quarter due in part to variations inproduct mix. To the extent that cabinets and other lower-margin productsrepresent an increased percentage of our total sales in any period, it willtend to reduce our gross margin.

 

*                Researchand product development expenses*

 

| ** **                                | ** ** | **Nine Months Ended**        | ** ** |
|-------------------------------------------|------------|------------------------------|------------|
| ** **                                | ** ** | **September 30,  2007** | ** ** | **September 24,  2006** | ** ** |
| ** **                                | ** ** | ** **                   | ** ** | **Restated(1)** | ** ** |
| Research and product development expenses |       | $                            | 8,985      |   | $ | 7,147 |   |
| Percentage of sales                       |       | 17                           | %          | 16 | % |
|                                           |            |                              |            |  |  |  |  |

----

(1)                                  See Note 2, “Restatement ofConsolidated Financial Statements,” in Notes to Consolidated FinancialStatements, beginning on page 5.

 

                Research andproduct development expenses increased by $1.8 million or 26% to$9.0 million for the nine months ended September 30, 2007 as compared to$7.1 million for the nine months ended September 24, 2006. The increase inresearch and product development expenses was attributable to increasedpersonnel-related costs and third-party design costs. We expect researchand product development expenses to increase in future periods as a result ofour hiring of certain former Terawave engineers in October 2007 and as wecontinue to make investments in our products and technologies.

 

 

17

----

 

*                Salesand marketing expenses*

 

| ** **                   | ** ** | **Nine Months Ended**        | ** ** |
|------------------------------|------------|------------------------------|------------|
| ** **                   | ** ** | **September 30,  2007** | ** ** | **September 24,  2006** | ** ** |
| ** **                   | ** ** | ** **                   | ** ** | **Restated(1)** | ** ** |
| Sales and marketing expenses |       | $                            | 10,779     |   | $ | 7,669 |   |
| Percentage of sales          |       | 20                           | %          | 17 | % |
|                              |            |                              |            |  |  |  |  |

----

(1)                                  See Note 2, “Restatement of ConsolidatedFinancial Statements,” in Notes to Consolidated Financial Statements, beginningon page 5.

 

                Sales andmarketing expenses increased by $3.1 million or 41% to $10.8 millionfor the nine months ended September 30, 2007 as compared to $7.7 millionfor the nine months ended September 24, 2006. This increase was primarily dueto increased headcount, commissions and marketing events. We expect sales andmarketing costs to increase as a result of our hiring of certain formerTerawave sales and marketing employees in October 2007, increasing our domesticsales coverage and establishing an international sales presence.

 

*Generaland administrative expenses*

 

| ** **                          | ** ** | **Nine Months Ended**        | ** ** |
|-------------------------------------|------------|------------------------------|------------|
| ** **                          | ** ** | **September 30,  2007** | ** ** | **September 24,  2006** | ** ** |
| ** **                          | ** ** | ** **                   | ** ** | **Restated(1)** | ** ** |
| General and administrative expenses |       | $                            | 8,030      |   | $ | 3,031 |   |
| Percentage of sales                 |       | 15                           | %          | 7 | % |
|                                     |            |                              |            |  |  |  |  |

----

(1)                                  See Note 2, “Restatement ofConsolidated Financial Statements,” in Notes to Consolidated FinancialStatements, beginning on page 5.

 

                General andadministrative expenses increased by $5.0 million or 165% to approximately$8.0 million for the nine months ended September 30, 2007 as compared to$3.0 million for the nine months ended September 24, 2006. General andadministrative expenses increased primarily due to increased professional feesand expenses resulting from the audit committee review of our revenuerecognition practices, increased headcount, and the cost of remediatinginternal control deficiencies identified in connection with the audit committeereview. For the nine months ended September 30, 2007, we incurred approximately$4.2 million of professional fees related to the audit committee review.We expect to continue to incur significant general and administrative expensesfor the remainder of 2007 as we concluded the audit committee investigation inOctober 2007 and will incur additional expenses associated withremediation of internal control deficiencies and developing the necessarydocumentation and testing procedures required by Section 404 of the Sarbanes-OxleyAct. We also expect to incur significant business and system integrationexpenses over related to our purchase of certain assets of Terawave.

 

*                Stock-basedcompensation*

 

| ** **                                          | ** ** | **Nine Months Ended**        | ** ** |
|-----------------------------------------------------|------------|------------------------------|------------|
| ** **                                          | ** ** | **September 30,  2007** | ** ** | **September 24,  2006** | ** ** |
| ** **                                          | ** ** | ** **                   | ** ** | **Restated(1)** | ** ** |
| Cost of sales                                       |       | $                            | 194        |   | $ | 183 |   |
| Research and product development                    |       | 542                          |       | 522 |   |
| Sales and marketing                                 |       | 422                          |       | 316 |   |
| General and administrative                          |       | 407                          |       | 243 |   |
| Total stock-based compensation in operating expense |       | $                            | 1,371      |   | $ | 1,081 |   |
| Total stock-based compensation                      |       | $                            | 1,565      |   | $ | 1,264 |   |

----

(1)                                  See Note 2, “Restatement ofConsolidated Financial Statements,” in Notes to Consolidated FinancialStatements, beginning on page 5.

 

 

18

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                Stock-basedcompensation expenses increased by $0.3 million or 24% to$1.6 million for the nine months ended September 30 , 2007 as compared toapproximately $1.3 million for the nine months ended September 24, 2006.This increase is primarily attributable to a change in the estimated forfeiturerate used in our stock-based compensation expense calculations and grantsof additional options. We anticipate that the stock-based compensationexpense calculated under SFAS No. 123(R) will continue to have a materialeffect on our consolidated statement of operations.

 

*                Interestincome, net*

 

| ** **           | ** ** | **Nine Months Ended**        | ** ** |
|----------------------|------------|------------------------------|------------|
| ** **           | ** ** | **September 30,  2007** | ** ** | **September 24,  2006** | ** ** |
| ** **           | ** ** | ** **                   | ** ** | **Restated(1)** | ** ** |
| Interest income, net |       | $                            | 2,141      |   | $ | 66 |   |
|                      |            |                              |            |  |  |  |  |

----

(1)                                  See Note 2, “Restatementof Consolidated Financial Statements,” in Notes to Consolidated FinancialStatements, beginning on page 5.

 

                Interest income,net increased by $2.1 million or 3144% to $2.1 million for the ninemonths ended September 30, 2007, as compared to $66,000 for the nine monthsended September 24, 2006. This increase in interest income, net was primarilyattributable to higher average cash balances, resulting from the completion ofour secondary public offering in November 2006 and, to a lesser extent,higher average interest rates during the first nine months of 2007.

 

*                Incometax expense*

 

                For income taxpurposes, we consider our projected annual income and the utilization of ournet operating loss carryforwards among other factors. For the nine months endedSeptember 30, 2007 and September 24, 2006, we provided $0 and $26,000, respectively,for federal and state income taxes.

 

**Liquidity and Capital Resources**

 

                As of September30, 2007, we had cash and cash equivalents of $43.3 million compared with$59.2 million as of December 31, 2006. The decrease in cash and cashequivalents for the nine months ended September 30, 2007 of $16.0 million wasprimarily due to a $4.6 million increase in restricted cash, a$3.2 million increase in accounts receivable, a $5.0 million increasein prepaid expenses and other current assets, of which $1.6 million increase relatedto the initial investment activity related to Terawave and $8.0 million inequipment purchases, that were partially offset by a $6.7 million increase inaccounts payable and accrued expenses in addition to a $1.3 millionincrease in deferred sales and non-cash charges to net income.

 

                As of September30, 2007, we had restricted cash of $9.0 million related to performancebonds we are required to post in connection with our RUS contracts.

 

                Cash used inoperating activities was $2.1 million for the nine months ended September30, 2007 as compared to cash provided by operating activities of$0.1 million for the nine months ended September24, 2006. This decrease in cashprovided by operating activities was primarily due to a $3.2increase in accounts receivable, a $3.4 million increase in prepaidexpenses and a $1.1 million increase in inventory, partially offset by a$1.3 million increase in deferred sales and a $6.7 million increase in accountspayable and accrued expenses.

 

                Cash used ininvesting activities was $14.2 million for the nine months ended September30, 2007, compared to $1.6 million for the nine months ended September 24,2006. Cash used in investing activities during the first nine months of 2007was primarily related to leasehold improvements and purchases of equipment forour new corporate headquarters in Santa Barbara, California as well asincreases in our restricted cash. Additionally, $1.6 million of cash was usedto fund the purchase of certain assets in Terawave.

 

                Cash provided byfinancing activities was $0.4 million for the nine months ended September30, 2007 compared to $0.6 million for the nine months ended September 24,2006. Cash provided by financing activities during the first nine months of 2007was the result of proceeds from the exercise of stock options and stockpurchases under our employee stock purchase plan. In the first nine months of2006, we received $2.7 million of net proceeds from our rights offering ofSeries A-2 preferred stock and $0.4 million in proceeds from stockoption exercises, partially offset by $2.6 million in debt repayments.

 

 

19

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**Working Capital**

 

                Working capitaldecreased to $55.3 million as of September 30, 2007, compared to $66.1 millionas of December 31, 2006.

 

                We believe thatour cash and cash equivalents will be sufficient to finance our operations overthe next 24 months. Although we believe these funds will be sufficient tomaintain and expand our operations in accordance with our business strategy, wemay need additional funds in the future. If we are unable to raise additionalfinancing when and if needed, we may be required to reduce certaindiscretionary spending, which could have a material adverse effect on our abilityto achieve our intended business objectives.

 

***                ContractualObligations***

 

                A tablesummarizing our minimum purchase commitments to our contract manufacturers andour minimum commitments under non-cancelable operating leases as of September30, 2007 (in thousands) is included in Note 5, “Commitments and Contingencies,”in Notes to Consolidated Financial Statements, beginning on page 7.

 

***                Off-BalanceSheet Arrangements***

 

                As of September30, 2007, we had no material off-balance sheet arrangements, other thanthe purchase commitments and operating leases described in the contractualobligations table referenced above.

 

***                IndemnificationObligations***

 

                We enter intoindemnification provisions under our agreements with other companies in ourordinary course of business, typically with our contractors, customers,landlords and our agreements with investors. Under these provisions, wegenerally indemnify and hold harmless the indemnified party for losses sufferedor incurred by the indemnified party as a result of our activities or, in somecases, as a result of the indemnified party’s activities under the agreement.These indemnification provisions generally survive termination of theunderlying agreement. The maximum potential amount of future payments we couldbe required to make under these indemnification provisions is generallyunlimited. As of September 30, 2007, we have not incurred material costs todefend lawsuits or settle claims related to these indemnifications agreements.We have no liabilities recorded for these agreements as of September 30, 2007.

 

***                RecentAccounting Pronouncements***

 

                In May 2007,the FASB issued FSP No. FIN 48-1 “Definition of Settlement in FASBInterpretation No. 48,” (FSP FIN 48-1 amends FIN 48 to provideguidance on how an entity should determine whether a tax provision iseffectively settled for the purpose of recognizing previously unrecognized taxbenefits. The term “effectively settled” replaces the term “ultimately settled”when used to describe recognition, and the terms “settlement” or “settled”replace the terms “ultimate settlement” or “ultimately settled” when used todescribe measurement of a tax position under FIN 48.FSP FIN 48-1 clarifies that a tax position can be effectively settledupon the completion of an examination by a taxing authority without beinglegally extinguished. For tax positions considered effectively settled, anentity would recognize the full amount of tax benefit, even if the tax positionis not considered more likely than not to be sustained based solely on thebasis of its technical merits and the statue of limitations remains open. We donot anticipate that the adoption of FSP FIN 48-1 will have a materialeffect on our results of operations or financial position, although we arecontinuing to evaluate the full impact of the adoption ofFSP FIN 48-1.

 

                InFebruary 2007, the Financial Accounting Standards Board (FASB) issuedStatement of Financial Accounting Standards (SFAS) No. 159, The Fair ValueOption for Financial Assets and Financial Liabilities—Including an Amendment ofFASB Statement No. 115 (SFAS 159). SFAS 159 expands the use offair value accounting but does not affect existing standards which requireassets or liabilities to be carried at fair value. Under SFAS 159, a companymay elect to use fair value to measure accounts and loans receivable,available-for-sale and held-to-maturity securities, equity method investments,accounts payable, guarantees and issued debt. Other eligible items include firmcommitments for financial instruments that otherwise would not be recognized atinception and non-cash warranty obligations where a warrantor is permitted topay a third party to provide warranty goods or services. If the use of fairvalue is elected, any upfront cost and fees related to the item must berecognized in earnings and cannot be deferred. The fair value election isirrevocable and generally made on an instrument-by-instrument basis even if acompany has similar instruments that it elects not to measure at fair value. Atthe adoption date, unrealized gains and losses on existing items for which thefair value option has been elected are reported as a cumulative adjustment tobeginning retained earnings. Subsequent to the adoption of SFAS 159,changes to fair value are recognized in earnings. SFAS 159 is effectivefor fiscal years beginning after November 15, 2007 and is required to beadopted by Occam in the first quarter of 2008. We are currently determiningwhether fair value 

 

 

20

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accounting is appropriate for any of our eligible items and cannotcurrently estimate the impact, if any, which SFAS 159 may have on ourconsolidated results of operation and financial condition.

 

                InSeptember 2006, the FASB issued SFAS No. 157, Fair Value Measurements(“SFAS No. 157”). SFAS No. 157 defines fair value,establishes a framework and gives guidance regarding the methods used formeasuring fair value, and expands disclosures about fair value measurements.SFAS No. 157 is effective for financial statements issued for fiscalyears beginning after November 15, 2007 and interim periods of thosefiscal years and is required to be adopted by Occam in the first quarter of2008. We are currently assessing the impact that SFAS No. 157 mayhave on our results of operations and financial position.

 

                InSeptember 2006, the Securities and Exchange Commission issuedSAB No. 108, “Considering the Effects of Prior Year Misstatementswhen Quantifying Misstatements in Current Year Financial Statements.”SAB No. 108 provides guidance on the consideration of the effects ofprior year misstatements in quantifying current year misstatements for thepurpose of a materiality assessment. SAB No. 108 establishes anapproach that requires quantification of financial statement errors based onthe effects of each of the Company’s balance sheets and statement of operationsand the related financial statement disclosures. SAB No. 108 permitsexisting public companies to record the cumulative effect of initially applyingthis approach in the first year ending after November 15, 2006 byrecording the necessary correcting adjustments to the carrying values of assetsand liabilities as of the beginning of that year with the offsetting adjustmentrecorded to the opening balance of retained earnings. Additionally, the use ofthe cumulative effect transition method requires detailed disclosure of thenature and amount of each individual error being corrected through thecumulative adjustment and how and when it arose. We implemented SAB No. 108effective January 1, 2006 and considered its effect on our financialposition, results of operations or cash flows for 2006. See Note 2, “Restatementof Consolidated Financial Statements,” of the Notes to Consolidated Statementsfor information regarding the restatement.

 

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

 

                Because ourportfolio of cash equivalents is of a short-term nature, we are not subject tosignificant market price risk related to investments. However, our interest incomeis sensitive to changes in the general level of taxable and short-term U.S.interest rates. Our exposure to market risk due to changes in the general levelof United States interest rates relates primarily to our cash equivalents andshort-term and long-term investment portfolios. We generally invest our surpluscash balances in high credit quality money market funds with original orremaining contractual maturities of less than 90 days. The primaryobjective of our investment activities is the preservation of principal whilemaximizing investment income and minimizing risk. We do not hold financialinstruments for trading or speculative purposes. We do not use any derivativesor similar instruments to manage our interest rate risk.

 

**ITEM 4.  CONTROLS AND PROCEDURES**

 

                ***(a) Evaluation of Disclosure Controls and Procedures***

 

                Under thesupervision and with the participation of our management, including our ChiefExecutive Officer and Chief Financial Officer, we conducted an evaluation ofthe effectiveness of the design and operation of our disclosure controls andprocedures, as defined in Rules 13a-15(e) and 15d-15(e) under theSecurities Exchange Act of 1934, as amended, as of September 30, 2007, which werefer to as the Evaluation Date or the end of the period covered by thisQuarterly Report on Form 10-Q.

 

                The purpose ofthis evaluation was to determine whether as of the Evaluation Date ourdisclosure controls and procedures were effective to provide reasonableassurance that the information we are required to disclose in our filings withthe Securities and Exchange Commission, or SEC, (i) is recorded,processed, summarized and reported within the time periods specified in the SEC’srules and forms and (ii) accumulated and communicated to our management,including our Chief Executive Officer and Chief Financial Officer, asappropriate to allow timely decisions regarding required disclosure.

 

                Based on theirevaluation, our chief executive officer and chief financial officer haveconcluded, as discussed below, that a material weakness existed in ourdisclosure controls and procedures as of the Evaluation Date, and as a result,our disclosure controls and procedures were not effective as of the EvaluationDate.

 

                An internalcontrol deficiency exists when the design or operation of a control does notallow management or employees, in the normal course of performing theirassigned functions, to prevent or detect misstatements on a timely basis.

 

 

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A “material weakness” is a control deficiency, or combination ofcontrol deficiencies, that results in a more than a remote likelihood that amaterial misstatement of the annual or interim consolidated financialstatements will not be prevented or detected. A “significant deficiency” is acontrol deficiency, or combination of control deficiencies, that adverselyaffects a company’s ability to initiate, authorize, record, process or reportexternal financial data reliably in accordance with accounting principlesgenerally accepted in the United States. In the case of a significantdeficiency, a more-than-remote likelihood exists of a misstatement of thecompany’s annual or interim consolidated financial statements that is more thaninconsequential.

 

                As more fullydescribed in Part II, Item 5 of this Quarterly Report on Form 10-Q,in March 2007, our audit committee initiated an internal review of ourrevenue recognition practices. On September 12, 2007, we announced thatour audit committee had identified errors in revenue recognition and that ourboard of directors, based on the recommendation of our audit committee, hadconcluded that we should restate our financial statements for fiscal years 2004and 2005, the corresponding interim quarterly periods of fiscal year 2004 andfiscal year 2005, and the first, second, and third quarters of fiscal 2006. Ourboard of directors also concluded that our previously filed financialstatements for those periods should not be relied on. On October 16, 2007,we announced that our audit committee had concluded its investigation, and weannounced the final restated financial information.

 

                Our auditcommittee concluded that the restatement was required because of errors in ouraccounting for (i) commitments to certain customers in connection withsales for features or deliverable that were not available at the time revenuewas originally recognized, including commitments to prospectively provide freeproduct, software, training, and installation services, for which weprematurely recognized approximately $9.3 million in revenue from fiscalyear 2004 to fiscal year 2006; (ii) sales to value-added resellerswhere the resellers did not have the ability to pay us for these salesindependent of payment to them by the end-user, for which we prematurelyrecognized approximately $20.2 million in revenue from fiscal year 2004 tofiscal year 2006; and (iii) for certain quarters ending on weekends, ouruse of a shipping vendor who picked up product for subsequent delivery toanother shipping company where the terms and conditions of the shipments didnot appropriately transfer title or risk of loss at the time of shipment, forwhich we prematurely recognized approximately $2.3 million in revenue fromfiscal year 2004 to fiscal year 2006. In addition, we prematurely recognizedapproximately $1.1 million of revenue from fiscal year 2004 through fiscalyear 2006 relating principally to errors in accounting for software andsoftware maintenance, customer credits, and undelivered free product.

 

                Our audit committeedetermined that the foregoing errors resulted from deficiencies in our internalcontrols, in particular resulting from internal communication failures betweenour finance and sales departments, a lack of clear understanding by, andcommunication to, sales personnel of technical accounting rules, understaffedfinance functions, and on occasion, failure of finance personnel to applytechnical revenue recognition rules correctly. As part of its letter ofinternal control deficiencies dated October 15, 2007, our currentindependent registered public accounting firm also identified a materialweakness relating to revenue recognition. Our independent registered publicaccounting firm noted that we did not have policies and procedures in place toensure that modifications to, or side agreements associated with, our standardterms of contract were properly documented and approved. Our independentregistered public accounting firm also cited a lack of understanding of theaccounting consequences of modifications to standard terms by certain salesemployees and a lack of communication among our sales, engineering, and financedepartments to ensure that all sales transactions are properly tracked,documented, approved, and recorded.

 

                Our independentregistered public accounting firm identified additional control deficienciesthat it determined to be significant deficiencies but did not deem to bematerial weaknesses. In particular, it identified a significant deficiencyrelating to segregation of duties, noting among other things that in certaininstances journal entries and account reconciliations were approved by thepreparer of the entry or reconciliation. Our independent registered publicaccounting firm also noted a significant deficiency relating to post-closingadjusting journal entries and recommended that we reassess the timeline of ourfinancing statement closing process to ensure that we have reasonable time toconclude a thorough financial statement closing process. Finally, ourindependent registered public accounting firm identified significantdeficiencies relating to recording certain purchase transactions, where partswere ordered and accepted by our engineering department without approval orinvolvement of our finance department and where fixed assets were not properlyclassified for depreciation purposes.

 

                ***(b) Changes in Internal Control Over Financial Reporting***

 

                OnSeptember 28, 2007, our audit committee presented the findings andrecommendations of its internal investigation to our board of directors,including a proposed remediation plan regarding internal control over financialreporting. Our board of directors adopted the audit committee’s remediationplan, and we are in the process of implementing it. Remedying the materialweakness and other control deficiencies described above will requiresubstantial management time 

 

 

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and attention and will result in our incurring substantial incrementalexpenses, including increasing the size of our finance organization andretaining outside consultants to assist in the implementation of new internalcontrols. Any failure on our part to remedy our identified control deficienciesor any additional errors or delays in our financial reporting would have amaterial adverse effect on our business and results of operations and couldhave a substantial adverse impact on the trading price of our common stock andour relationships with customers.

 

                Subject tooversight by our board of directors, our chief executive officer and chieffinancial officer will be responsible for implementing the internal controlremediation plan recommended by our audit committee and approved by our boardof directors. We also intend to engage an outside consultant in connection withimplementing the remediation plan.

 

                Our auditcommittee’s remediation plan consists of the following modifications andimprovements in our internal controls relating to the sales and revenue-recognitiontransaction cycle:

 

•                  adjustour reporting structure so that finance has direct oversight of salesadministration and the sales proposal generation management group;

 

•                  reorganizeour variable compensation plan to ensure that sales personnel are notincentivized to attempt to influence the timing of revenue recognition;

 

•                  retaina senior revenue recognition specialist who will report directly to our chieffinancial officer and will possess the appropriate level of experience,authority, and seniority to independently serve as the liaison between alllevels of corporate functions and finance. This individual should have somedegree of managerial oversight of other “liaison” areas (*e.g.*, order entry personnel, salesadministration, and sales proposals generation) and be responsible for thereview and reconciliation of terms given to a customer in the bid/quote processas well as in the final contract.

 

•                  the revenue recognition specialist, or employeesacting under his or her supervision, should review all documentation relatingto a transaction, including purchase orders, special pricing approval forms,customer quotes, letters of intent, emails, etc. to determine whether any ofthe terms will result in the deferral of revenue; and

 

•                  a revenue recognition checklist should accompany thefinancial package for each transaction.

 

•                  engagean outsourced internal audit group to review all significant revenuetransactions each quarter to ensure that transactions have been recordedappropriately, to monitor the status of the remediation of control structure,and report to the audit committee the progress achieved;

 

•                  implementformal training, which would include a signed acknowledgement of all attendeescertifying that they have attended and understood the topics covered, from allfinance, executive, sales, and sales administration personnel, to ensure theyunderstand that certain terms impact revenue recognition, as well as understandhow to document and receive approval for such terms, as well as report them tofinance;

 

•                  institutea formal communication process among marketing, engineering, and finance toensure that all functions understand that any changes have potential accountingimplications and to ensure that finance is appropriately advised as to theimpact on existing and future transactions;

 

•                  implementpolicies and procedures that delineate clear roles, responsibilities, andauthorization levels for all positions defined as “key” to the revenuerecognition transaction cycle;

 

•                  implementa policies and procedure document that will be provided to all sales and salesadministration personnel, including an annual sign off that they have received,read, understood, and complied with the materials, that will ensure that allterms related to any transaction are evidenced in the sales quotes and purchaseorders, and that all transaction documentation has been provided to the financedepartment prior to the recording of revenue. Such policies and procedures mayinclude:

 

•                  standardized language on each customer’s quote andinvoice, as well as on the standard terms and conditions, stating that onlythose terms listed by the customer on its purchase order will be deemed part ofthe final agreement;

 

 

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•                  a central, virtual repository for all documentationrelating to a transaction, including quotes, emails, letters of intent, volumepricing agreements, special pricing approval forms, and all other transactiondocuments, which are uploaded by sales and sales administration personnel; and

 

•                  compliance with the stated order addendum process,to ensure that all terms agreed upon with a customer following the issuance ofthe customer quote or purchase order have been captured and provided tofinance.

 

•                  implementcontrols required to ensure that no items are shipped or provided to thecustomer without being entered as separate line items in our systems;

 

•                  implementcontrols required to ensure that all requests for price responses, contractcloseout, acceptance documentation, and other delivery information is providedto and reviewed by the finance department and is received prior to recording ofrevenue;

 

•                  implementcontrols to ensure that single transactions with a customer are not split intovarious contracts, purchase orders, or shipments, unless these requests areapproved by the finance department; and

 

•                  implementprocedures to ensure that credit checks are performed and the decision-makingprocess as to the credit limit is documented and maintained.

 

                As of November 12,2007, we have implemented the following aspects of the audit committeeremediation plan:

 

•                  adjustedour reporting structure so that the finance department has direct oversight ofsales administration and the sales proposal generation management group;

 

•                  implementedcontrols required to ensure that all contract closeout, acceptancedocumentation, and other delivery information is provided to and reviewed bythe finance department and is received prior to the recording of revenue;

 

•                    implemented procedures to ensurethat credit checks are performed and the decision-making process as tothe credit limit is documented and maintained;

 

•                  createdand filled a new position in our finance department, director of technicalaccounting;

 

•                  retaineda senior revenue recognition specialist who reports directly to our chieffinancial officer and who possesses the experience, authority, and seniority toindependently serve as the liaison between all levels of corporate functionsand finance; and

 

•                  implementedcontrols required to ensure that no items are shipped or provided to thecustomer without being entered as separate line items in our systems. 

 

Many of the remaining remediation items are in various stages of designand implementation. Over the coming quarters, we expect to invest substantialmanagement time and attention as well as financial resources to complete all ofthe modifications and improvements necessary to improve our internal controlsand related systems.

 

**PART II—OTHERINFORMATION**

 

**ITEM 1.  LEGAL PROCEEDINGS**

 

*2007 Class Action Litigation*

 

                On April 26,2007 and May 16, 2007, two putative class action complaints were filed inthe United States District Court for the Central District of California againstus and certain of our officers. The complaints allege that the defendantsviolated sections 10(b) and 20(a) of the Securities Exchange Act of 1934, orthe Exchange Act, and SEC Rule 10b-5 by making false and misleadingstatements and omissions relating to the Company’s financial statements andinternal controls with respect to revenue recognition. The complaints seek, onbehalf of persons who purchased our common stock during the period fromMay 2, 2006 and April 17, 2007, damages of an unspecified amount.

 

                On July 30,2007, Judge Christina A. Snyder consolidated these actions into a singleaction, appointed NECA-IBEW Pension Fund (The Decatur Plan) as lead plaintiff,and approved its selection of lead counsel. The lead plaintiff must file aconsolidated complaint no later than November 16, 2007.

 

 

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                We believe that wehave meritorious defenses in this action, and intend to defend ourselvesvigorously. Failure by the Company to obtain a favorable resolution of theclaims set forth in the current complaints or the consolidated complaint dueNovember 16, 2007 could have a material adverse effect on the Company’sbusiness, results of operations and financial condition. Currently, the amountof such material adverse effect cannot be reasonably estimated.

 

*IPO Allocation Litigation*

 

                In June 2001,three putative stockholder class action lawsuits were filed against AcceleratedNetworks, certain of its then officers and directors and several investmentbanks that were underwriters of Accelerated Networks’ initial public offering.Accelerated Networks was our name prior to the 2002 merger with Occam Networks,Inc. a California Corporation. The cases, which have since been consolidated,were filed in the United States District Court for the Southern District of NewYork. The court appointed a lead plaintiff on April 16, 2002, andplaintiffs filed a consolidated amended class action complaint, or consolidatedcomplaint, on April 19, 2002. The consolidated complaint was filed onbehalf of investors who purchased Accelerated Networks’ stock between June 22,2000 and December 6, 2000 and alleged violations of Sections 11 and 15 ofthe Securities Act of 1933 and Sections 10(b) and 20(a) and Rule 10b-5 ofthe Exchange Act against one or both of Accelerated Networks and the individualdefendants. The claims were based on allegations that the underwriterdefendants agreed to allocate stock in Accelerated Networks’ initial publicoffering to certain investors in exchange for excessive and undisclosedcommissions and agreements by those investors to make additional purchases inthe aftermarket at pre-determined prices. Plaintiffs alleged that theprospectus for Accelerated Networks’ initial public offering was false andmisleading in violation of the securities laws because it did not disclosethese arrangements. These lawsuits are part of the massive “IPO allocation”litigation involving the conduct of underwriters in allocating shares ofsuccessful initial public offerings. We believe that over three hundred othercompanies have been named in more than one thousand similar lawsuits that havebeen filed by some of the same plaintiffs’ law firms. In October 2002, theplaintiffs voluntarily dismissed the individual defendants without prejudice.On February 1, 2003, a motion to dismiss filed by the issuer defendantswas heard, and the court dismissed the 10(b), 20(a) and Rule 10b-5 claimsagainst us.

 

                OnOctober 13, 2004 the court certified a class in six of the approximately300 other nearly identical actions (the “focus” cases) and noted that thedecision was intended to provide guidance to all parties regarding classcertification in the remaining cases. The underwriter defendants appealed thedecision and the Second Circuit Court of Appeals vacated the District Court’sdecision granting class certification in those six cases on December 5,2006. Plaintiffs filed a motion for rehearing. On April 6, 2007, theSecond Circuit denied the petition but noted that plaintiffs could ask theDistrict Court to certify a more narrow class than the one that was rejected.On October 3, 2007, Plaintiff filed a motion to certify a new class. Anopposition brief is due on December 21, 2007, and a reply brief is due onFebruary 15, 2008.

 

                Prior to theSecond Circuit’s December 5, 2006 ruling, we agreed, together with overthree hundred other companies similarly situated, to settle with theplaintiffs. A settlement agreement and related agreements were submitted to thecourt for approval. The settlement would have provided, among other things, fora release of us and the individual defendants for the conduct alleged to bewrongful in the complaint in exchange for a guarantee from the defendants’insurers regarding recovery from the underwriter defendants and otherconsideration from defendants regarding the underwriters. In light of theSecond Circuit opinion, liaison counsel for the issuers informed the DistrictCourt that the settlement cannot be approved because the defined settlementclass, like the litigation class, cannot be certified. We cannot predictwhether we will be able to renegotiate a settlement that complies with theSecond Circuit’s mandate.

 

                Due to theinherent uncertainties of litigation, we cannot accurately predict the ultimateoutcome of the matter. We have not recorded any accrual related to thisproposed settlement because we expect any settlement amounts to be covered byour insurance policies.

 

*Other Matters*

 

                From time to time,we are subject to threats of litigation or actual litigation in the ordinarycourse of business, some of which may be material. We believe that there are nocurrently pending matters that, if determined adversely to us, would have amaterial effect on our business or that would not be covered by our existingliability insurance maintained by us.

 

**ITEM1A.  RISK FACTORS**

 

*                ThisQuarterly Report on Form 10-Q, or Form 10-Q, including anyinformation incorporated by reference herein, contains forward-lookingstatements within the meaning of Section 27A of the Securities Act of1933, as amended, referred to as the Securities Act, and Section 21E ofthe Securities Exchange Act of 1934, as amended, referred to as the ExchangeAct. In some cases, you can identify forward-looking statements by termssuch as “may,” “will,” “should,” “expect,” “plan,”*

 

 

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*“intend,” “forecast,” “anticipate,” “believe,” “estimate,”“predict,” “potential,” “continue” or the negative of these terms or othercomparable terminology. The forward-looking statements contained in thisForm 10-Q involve known and unknown risks, uncertainties and situationsthat may cause our or our industry’s actual results, level of activity,performance or achievements to be materially different from any future results,levels of activity, performance or achievements expressed or implied by thesestatements. These factors include those listed below in this Item 1A andthose discussed elsewhere in this Form 10-Q. We encourage investors toreview these factors carefully. We may from time to time make additionalwritten and oral forward-looking statements, including statementscontained in our filings with the SEC. We do not undertake to update anyforward-looking statement that may be made from time to time by or onbehalf of us.*

 

*                Beforeyou invest in our securities, you should be aware that our business facesnumerous financial and market risks, including those described below, as wellas general economic and business risks. The following discussion providesinformation concerning the material risks and uncertainties that we haveidentified and believe may adversely affect our business, our financialcondition and our results of operations. Before you decide whether to invest inour securities, you should carefully consider these risks and uncertainties,together with all of the other information included in this Quarterly Report onForm 10-Q.*

 

**Risks Related to Our Restatement**

 

***Matters relating to or arising fromour recent restatement, errors in our historic revenue recognition practices,and weaknesses in our internal controls, including adverse publicity and potentialconcerns from our customers and prospective customers, regulatory inquiries,and litigation matters, could have a material adverse effect on our business,revenues, operating results, or financial condition.***

 

                As more fullydescribed in Part II, Item 5 of this Quarterly Report on Form 10-Q,in March 2007, our audit committee initiated a review of our historic revenuerecognition practices that resulted in the restatement of our previously filedfinancial statements for the fiscal years ended December 26, 2004 andDecember 25, 2005, each of the interim quarterly periods of such fiscalyears, and the first, second, and third quarters of the fiscal year endedDecember 31, 2006. The audit committee conducted its investigation andreview with the assistance of independent counsel and an independent forensicaccounting advisor. On October 16, 2007, we announced the completion ofthe investigation and filed our Annual Report on Form 10-K for the year endedDecember 31, 2006, which we refer to as the Form 10-K and which, includesour consolidated financial statements for the year ended December 31, 2006and our restated financial statements for the years ended December 26,2004 and December 25, 2005. The circumstances and findings of the auditcommittee investigation are more fully described in Part II, Item 5of this Quarterly Report on Form 10-Q.

 

                The investigationand resulting restatement could have a material adverse effect on ourrelationships with customers and customer prospects, has already resulted inthe initiation of securities class action litigation, and could result in othercivil litigation or formal or informal regulatory inquiries or litigation, anyof which could have a material adverse effect on our business, revenues,operating results, or financial condition. Under Delaware law, our bylaws, andcertain indemnification agreements, we may have an obligation to indemnifycertain current and former officers and directors in relation to these matters.Such indemnification may have a material adverse effect on our business,results of operations, and financial condition to the extent insurance does notcover our costs. The insurance carriers that provide our directors’ andofficers’ liability policies may seek to rescind or deny coverage with respectto those pending investigations or actions in whole or in part, or we may nothave sufficient coverage under such policies, in which case our business,results of operations, and financial condition may be materially and adverselyaffected.

 

*Impact on our Business*

 

                As a result of theinvestigation, we filed our annual report on Form 10-K approximatelysix and one-half months late, and we also failed until October 2007 tofile our Quarterly Report on Form 10-Q for the quarter ended June 30,2007, and our Quarterly Report on Form 10-Q for the quarter endedMarch 31, 2007, which had been due in August 2007 and May 2007,respectively. Our non-compliance with public reporting obligations alsosubjected us to delisting proceedings from the NASDAQ Global Market. Our priordelinquencies, the restatement, resulting litigation, any regulatory inquiries,and other adverse publicity could continue to affect our relationships withcustomers and customer prospects and could have a material adverse effect onour business, revenues, operating results, and financial condition. Inparticular, in the second quarter of fiscal 2007, following the disclosure ofour audit committee investigation and after we became subject to NASDAQdelisting proceedings, we identified a softening of our business that hascontinued into the third quarter of fiscal 2007. We believe this softening hasbeen attributable in part to delays associated with our customers’ evaluationsof strategic investment decisions concerning their movement from copper wire tofiber, in part to a shift in our customer base toward longer term loan projectsfunded by the U.S. Department of Agriculture’s Rural Utilities Service, or RUS,and in part to delays in our financial

 

 

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reporting. Our customers consist largely of small, conservativelymanaged telecommunications companies, and we expect that these customers andcustomer prospects will continue to evaluate the results of the restatement andconclusions of the internal investigation when determining whether to initiateor continue purchasing from us. Moreover, we anticipate that our competitorswill seek to leverage the restatement and investigation to raise concerns aboutus in the minds of our customers and customer prospects. Any adverse publicityor customer uncertainty resulting from our announcement of the restatement,associated litigation, and any regulatory actions could have a material adverseeffect on our business, revenues, results of operations, and financialcondition.

 

                As a result of theaudit committee investigation, we have implemented personnel changes in oursales department that could adversely affect our revenues and results ofoperations in future periods if we are not successful in managing thetransition of relationships with our existing customers and key prospects. Inparticular, we have terminated two sales personnel, including a senior salesexecutive who managed a geographic region that generated a substantial portionof our revenues in recent years. In order to manage the customer transition aseffectively as possible, we have engaged the former sales executive to consultwith us on certain customer prospects. We believe personal relationshipsbetween our customers and our sales/customer support personnel are criticalfactors in winning new customers and maintaining existing customers, and lossof key sales and customer support personnel could have a material adverseeffect on our future business, revenues, results of operations, and financialcondition.

 

*Litigation and Regulatory Matters*

 

                We and certain ofour executive officers are defendants in a consolidated federal securitiesclass action. Although a consolidated complaint has not yet been filed, thepre-consolidation complaint alleged that defendants violated sections 10(b) and20(a) of the Exchange Act and Rule 10b-5 promulgated under the ExchangeAct by reporting false or misleading revenue from May 2, 2006 throughApril 17, 2007. This consolidated action is in the preliminary stages. Wecannot predict the claims, allegations, class period, or defendants thatultimately will be included in this consolidated complaint. In addition, wecannot provide any assurances that the final outcome of this consolidatedsecurities class action will not have a material adverse effect on ourbusiness, results of operations, or financial condition. We may become subjectto additional litigation, regulatory inquiries, or other proceedings or actionsarising out of the audit committee review and the related restatement of ourhistoric financial statements. Litigation and any potential regulatory actionsor proceedings can be time-consuming and expensive and could divert managementtime and attention from our business, which could have a material adverse effecton our revenues and results of operations. The adverse resolution of anyspecific lawsuit or potential regulatory action or proceeding could have amaterial adverse effect on our business, results of operations, and financialcondition.

 

***If we fail to establish and maintainproper and effective internal controls, our ability to produce accuratefinancial statements on a timely basis could be impaired, which would adverselyaffect our consolidated operating results, our ability to operate our businessand our stock price.***

 

                Ensuring that wehave adequate internal financial and accounting controls and procedures inplace to produce accurate financial statements on a timely basis is a costlyand time-consuming effort that needs to be re-evaluated frequently. Failure onour part to have effective internal financial and accounting controls wouldcause our financial reporting to be unreliable, could have a material adverseeffect on our business, operating results, and financial condition and couldcause the trading price of our common stock to fall dramatically. We and ourcurrent and former independent registered public accounting firms haveidentified control deficiencies in the past, and in connection with itsinvestigation and determination to restate our financial statements, our auditcommittee, management, and current independent registered public accountingfirm have recently identified deficiencies in our internal controls thatcontributed to the need to restate our historic financial statements. As aresult of these identified control deficiencies, our chief executive officerand chief financial officer have determined that, as of September 30, 2007, ourinternal controls over financial reporting were not effective to providereasonable assurance regarding the reliability of our financial reporting andthe preparation of financial statements for external reporting in accordancewith generally accepted accounting principles in the United States.

 

                Our auditcommittee’s investigation of revenue recognition issues identified weaknessesand other control deficiencies relating principally to revenue recognition andthe processes and procedures associated with customer transactions andinteraction with and review by our finance department. As part of its letter ofinternal control deficiencies dated October 15, 2007, our currentindependent registered public accounting firm identified a material weaknessrelating to revenue recognition. Our independent registered public accountingfirm noted that we did not have policies and procedures in place to ensure thatmodifications to, or side agreements associated with, our standard terms ofcontract are properly documented and approved. Our independent registeredpublic accounting firm also cited a lack of understanding of the accountingconsequences of modifications to standard terms by certain sales employees anda lack of communication among our sales, engineering, and finance departmentsto ensure that all sales transactions are properly tracked, documented, approved,and recorded.

 

 

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                Our independentregistered public accounting firm identified additional control deficienciesthat it determined to be significant deficiencies but that it did not deem tobe material weaknesses. In particular, it identified a significant deficiencyrelating to segregation of duties, noting among other things that in certaininstances journal entries and account reconciliations were approved by thepreparer of the entry or reconciliation. Our independent registered publicaccounting firm also noted a significant deficiency relating to post-closingadjusting journal entries and recommended that we reassess the timeline of ourfinancial statement process to ensure that we have reasonable time to concludea thorough financial statement closing process. Finally, our independentregistered public accounting firm identified significant deficiencies relatingto recording certain purchase transactions, where parts were ordered andaccepted by our engineering department, without approval or involvement of ourfinance department, and where fixed assets were not properly classified fordepreciation purposes.

 

                Remedying ourmaterial weakness and other control deficiencies will require substantial managementtime and attention and will result in our incurring substantial incrementalexpenses, including with respect to increasing the size of our financeorganization and retaining outside consultants to assist in the implementationof new internal controls. Any failure to remedy our identified controldeficiencies or any additional errors or delays in our financial reporting,whether or not resulting from a failure to remedy the deficiencies thatresulted in the current restatement, would have a material adverse effect onour business and results of operations and could have a substantial adverseimpact on the trading price of our common stock and our relationships withcustomers.

 

                Our management isresponsible for establishing and maintaining adequate internal control overfinancial reporting to provide reasonable assurance regarding the reliabilityof our financial reporting and the preparation of financial statements forexternal purposes in accordance with generally accepted accounting principlesin the United States. Our management does not expect that our internal controlover financial reporting will prevent or detect all errors and all fraud. Acontrol system, no matter how well designed and operated, can provide onlyreasonable, not absolute, assurance that the control system’s objectives willbe met. Because of the inherent limitations in all control systems, noevaluation of controls can provide absolute assurance that misstatements due toerror or fraud will not occur or that all control issues and instances offraud, if any, within the company will have been detected. As discussed in theForm 10-K and this Form 10-Q, our audit committee and management,together with our current and former independent registered public accountingfirms, have identified numerous control deficiencies in the past and mayidentify additional deficiencies in the future.

 

                We expect that wewill be required to comply with Section 404 of the Sarbanes-OxleyAct of 2002 in connection with our Annual Report on Form 10-K for our yearending December 31, 2007. We are expending significant resources indeveloping the necessary documentation and testing procedures required bySection 404 of the Sarbanes-Oxley Act. We cannot be certain that theactions we are taking to improve our internal controls over financial reportingwill be sufficient or that we will be able to implement our planned processesand procedures in a timely manner. In addition, we may be unable to produceaccurate financial statements on a timely basis. Any of the foregoing couldcause investors to lose confidence in the reliability of our consolidatedfinancial statements, which could cause the market price of our common stock todecline and make it more difficult for us to finance our operations and growth.

 

**Risks Related to Our Business and Industry**

 

***Our focus on independent telephoneoperating companies limits our sales volume with individual customers and makesour future operating results difficult to predict.***

 

                We currently focusour sales efforts on the independent telephone operating companies, or IOCs, inNorth America. These customers generally operate relatively small networks withlimited capital expenditure budgets. Accordingly, we believe the totalpotential sales volume for our products at any individual IOC is limited, andwe must identify and sell products to new IOC customers each quarter tocontinue to increase our sales. In addition, the spending patterns of many IOCsare characterized by small and sporadic purchases. Moreover, because our salesto IOCs are predominantly based on purchase orders rather than long-termcontracts, our customers may stop purchasing equipment from us with littleadvance notice. As a result, we have limited backlog, our future operatingresults are difficult to predict and we will likely continue to have limitedvisibility into future operating results.

 

 

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***Fluctuations in our quarterly andannual operating results may adversely affect our business and prospects.***

 

A number of factors, many of which areoutside our control, may cause or contribute to significant fluctuations in ourquarterly and annual operating results. These fluctuations may make financialplanning and forecasting more difficult. In addition, these fluctuations mayresult in unanticipated decreases in our available cash, which could limit ourgrowth and delay implementation of our expansion plans. Factors that may causeor contribute to fluctuations in our operating results include:

 

•                  fluctuations in demand for our products, includingthe timing of decisions by our target customers to upgrade their networks anddeploy our products;

 

•                  delays in customer orders as IOCs evaluate andconsider their capital expenditures and investments in light of the industrytransition from copper wire to fiber;

 

•                  increases in warranty accruals and other costsassociated with remedying any performance problems relating to our products, aswe experienced in fiscal 2004 and expect to experience in 2007;

 

•                  seasonal reductions in field work during the wintermonths and the impact of annual budgeting cycles;

 

•                  the size and timing of orders we receive andproducts we ship during a given period;

 

•                  delays in recognizing revenue under applicablerevenue recognition rules, particularly from government-funded contracts,as a result of additional commitments we may be required to make to securepurchase orders, or with respect to sales to value-added resellers wherewe cannot establish based on our credit analysis that collectability isreasonably assured;

 

•                  introductions or enhancements of products, servicesand technologies by us or our competitors, and market acceptance of these newor enhanced products, services and technologies;

 

•                  the amount and timing of our operating costs, includingsales, engineering and manufacturing costs and capital expenditures; and

 

•                  quarter-to-quarter variations in our operatingmargins resulting from changes in our product mix.

 

As a consequence, operating results for aparticular future period are difficult to predict and prior results are notnecessarily indicative of results to be expected in the future. Any of theforegoing factors may have a material adverse effect on our consolidatedresults of operations.

 

***We have a history of losses andnegative cash flow, and we may not be able to generate positive operatingincome and cash flows in the future to support the expansion of our operations.***

 

We have incurred significant losses since ourinception. As of September 30, 2007, we had an accumulated deficit of $115.2million. We realized income from operations and were profitable on a net incomebasis for the year ended December 31, 2006. Previously, we had not beenprofitable on a quarterly or annual basis. Beginning with the quarter endedJune 30, 2007, we began to experience a softening in our business. We haveexperienced operating losses for each of the first three quarters of 2007 andnet losses for the second and third quarters of 2007 and currently expect toexperience operating and net losses for the fourth quarter and full year.  For the nine months ended September 30, 2007,we recorded a net loss of $5.8 million, with an operating loss for this periodof $8.0 million. We believe the softening that we have experienced in ourmarkets since the first quarter of 2007 is attributable in part to adversetrends affecting our target customer markets, in part to delays associated withour customers’ evaluations of strategic investment decisions concerning theirmovement from copper wire to fiber, and in part to uncertainty surrounding ourfinancial reporting. Our inability to generate positive operating income andcash flow would materially and adversely affect our liquidity, consolidatedresults of operations and consolidated financial condition.

 

A significant portion of our expenses isfixed, and we expect to continue to incur significant expenses for research anddevelopment, sales and marketing, customer support, and general andadministrative functions. Given the rate of growth in our customer base, ourlimited operating history and the intense competitive pressures we face, we maybe unable to adequately control our operating costs. In order to achieve andmaintain profitability, we must increase our sales while maintaining controlover our expense levels.

 

 

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***Because our markets are highlycompetitive and dominated by large, well-financed participants, we may beunable to compete effectively.***

 

Competition in our market is intense, and weexpect competition to increase. The market for broadband access equipment isdominated primarily by large, established suppliers such as ADTRAN, Inc.,Alcatel, and Tellabs, Inc. While these suppliers focus primarily on largeservice providers, they have competed, and may increasingly compete, in the IOCmarket segment. In addition, a number of emerging companies, including CalixNetworks, Inc., have developed, or are developing, products that competewith ours, including within our core IOC segment.

 

Our ability to compete successfully dependson a number of factors, including:

 

•                  the successful identification and development of newproducts for our core market;

 

•                  our ability to timely anticipate customer and marketrequirements and changes in technology and industry standards;

 

•                  our ability to gain access to and use technologiesin a cost-effective manner;

 

•                  our ability to timely introduce cost-effective newproducts;

 

•                  our ability to differentiate our products from ourcompetitors’ offerings;

 

•                  our ability to gain customer acceptance of ourproducts;

 

•                  the performance of our products relative to ourcompetitors’ products;

 

•                  our ability to market and sell our products througheffective sales channels;

 

•                  the protection of our intellectual property,including our processes, trade secrets and know-how; and

 

•                  our ability to attract and retain qualifiedtechnical, executive and sales personnel.

 

Many of our existing and potentialcompetitors are larger than we are and have greater financial resources andbetter-established brands and customer relationships. In addition, manyof our competitors have broader product lines than we do, so they can offerbundled products, which may appeal to certain customers.

 

As the market for our products is new andevolving, winning customers early in the growth of this market is critical toour ability to expand our business and increase sales. Because the productsthat we and our competitors sell require a substantial investment of time andfunds to install, customers are typically reluctant to switch equipmentsuppliers once a particular supplier’s product has been installed. As a result,competition among equipment suppliers to secure contracts with potentialcustomers is particularly intense and will continue to place pressure on productpricing. Some of our competitors have in the past and may in the future resortto offering substantial discounts to win new customers and generate cash flows.If we are forced to reduce prices in order to secure customers, we may beunable to sustain gross margins at desired levels or maintain profitability.

 

***We have relied, and expect tocontinue to rely, on our BLC 6000 product line for the substantial majority ofour sales, and a decline in sales of our BLC 6000 line would cause our overallsales to decline proportionally.***

 

We have derived a substantial majority of oursales in recent years from our BLC 6000 product line. We expect that sales ofthis product line will continue to account for a substantial majority of oursales for the foreseeable future. Any factors adversely affecting the pricingof, or demand for, our BLC 6000 line, including competition or technologicalchange, could cause our sales to decline materially and our business tosuffer.  With our acquisition ofcertain assets of Terawave Communications, Inc. we are seeking to broaden andexpand our product line to include Passive Optical Networking, or PON.  However, we are early in the integrationprocess and the addition of former Terawave products and technology to ourbusiness is not expected to significantly reduce our reliance on our BLC 6000product line.

 

 

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***If we fail to enhance our existingproducts and develop new products and features that meet changing customerrequirements and support new technological advances, our sales would bematerially and adversely affected.***

 

                Our market ischaracterized by rapid technological advances, frequent new productintroductions, evolving industry standards and recurring changes in end-userrequirements. Our future success will depend significantly on our ability toanticipate and adapt to such changes and to offer, on a timely andcost-effective basis, products and features that meet changing customer demandsand industry standards. The timely development of new or enhanced products is acomplex and uncertain process, and we may not be able to accurately anticipatemarket trends or have sufficient resources to successfully manage longdevelopment cycles. We may also experience design, manufacturing, marketing andother difficulties that could delay or prevent the development, introduction ormarketing of new products and enhancements. The introduction of new or enhancedproducts also requires that we manage the transition from older products to thesenew or enhanced products in order to minimize disruption in customer orderingpatterns and ensure that adequate supplies of new products are available fordelivery to meet anticipated customer demand. If we are unable to develop newproducts or enhancements to our existing products on a timely andcost-effective basis, or if our new products or enhancements fail to achievemarket acceptance, our business, consolidated financial condition andconsolidated results of operations would be materially and adversely affected.

 

                Weenhanced our BLC 6000 platform to support Gigabit Passive Optical Network(GPON)  fiber-to-the-premises, or FTTP, services. Although we haveinvested significant time and resources to develop this enhancement, theseFTTP-enabled products are relatively new, with limited sales to date, andmarket acceptance of these products may fall below our expectations. We recentlyannounced our acquisition of certain assets of Terawave Communications, Inc.,including its portfolio of broadband access solutions incorporating gigabitpassive optical network, or GPON, and other technologies.  We have since added Terawave’s PON productsto our product offering and we intend to continue to integrate former Terawaveproducts and technologies into our product offerings.  The introduction of newproducts is expected to place pressure on our gross margins as most newproducts require time and increased sales volumes to achieve cost-savingefficiencies in production. To the extent our new products and enhancements donot achieve broad market acceptance, we may not realize expected returns on ourinvestments, and we may lose current and potential customers.

 

***Our efforts to increase our salesand marketing efforts to larger telecom operators, which may require us tobroaden our reseller relationships, may be unsuccessful.***

 

                To date, our salesand marketing efforts have been focused on small and mid-sized IOCs. A keyelement of our long-term strategy is to increase sales to large IOCs,competitive local exchange carriers, regional Bell operating companies andinternational telecom service providers. We may be required to devotesubstantial technical, marketing and sales resources to the pursuit of thesecustomers, who have lengthy equipment qualification and sales cycles. Inparticular, sales to these customers may require us to upgrade our products tomeet more stringent performance criteria, develop new customer-specificfeatures or adapt our product to meet international standards. We may incursubstantial technical, sales and marketing expenses and expend significantmanagement effort without any assurance of generating sales. Because we havelimited resources and large telecom operators may be reluctant to purchaseproducts from a relatively small supplier like us, we plan to target thesecustomers in cooperation with strategic resellers. These reseller relationshipsmay not be available to us, and if formed, may include terms, such asexclusivity and non-competition provisions, that restrict our activities or imposeonerous requirements on us. Moreover, in connection with these relationships,we may forego direct sales opportunities in favor of forming relationships withstrategic resellers. If we are unable to successfully increase our sales tolarger telecom operators or expand our reseller relationships, we may be unableto implement our long-term growth strategy.

 

***We may be unable to successfullyexpand our international operations. In addition, our international expansionplans, if implemented, will subject us to a variety of risks that may adverselyaffect our business.***

 

                We currentlygenerate almost all of our sales from customers in North America and have verylimited experience marketing, selling and supporting our products and servicesoutside North America or managing the administrative aspects of a worldwideoperation. While we intend to expand our international operations, we may notbe able to create or maintain international market demand for our products. Inaddition, regulations or standards adopted by other countries may require us toredesign our existing products or develop new products suitable for sale inthose countries. If we invest substantial time and resources to expand ourinternational operations and are unable to do so successfully and in a timelymanner, our business, financial condition and results of operations willsuffer.

 

 

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In the course of expanding our internationaloperations and operating overseas, we will be subject to a variety of risks,including:

 

•                  differing regulatory requirements, including taxlaws, trade laws, labor regulations, tariffs, export quotas, custom duties orother trade restrictions and changes thereto;

 

•                  greater difficulty supporting and localizing ourproducts;

 

•                  different or unique competitive pressures as aresult of, among other things, the presence of local equipment suppliers;

 

•                  challenges inherent in efficiently managing anincreased number of employees over large geographic distances, including the needto implement appropriate systems, policies, benefits and compliance programs;

 

•                  limited or unfavorable intellectual propertyprotection;

 

•                  changes in a specific country’s or region’spolitical or economic conditions; and

 

•                  restrictions on the repatriation of earnings.

 

***If we lose any of our key personnel,or are unable to attract, train and retain qualified personnel, our ability tomanage our business and continue our growth would be negatively impacted.***

 

Our success depends, in large part, on the continuedcontributions of our key management, engineering, sales and marketingpersonnel, many of whom are highly-skilled and would be difficult toreplace. None of our senior management or key technical or sales personnel isbound by a written employment contract to remain with us for a specifiedperiod. In addition, we do not currently maintain key-man life insurancecovering our key personnel. If we lose the services of any key personnel, ourbusiness, financial condition and results of operations may suffer.

 

Competition for skilled personnel,particularly those specializing in engineering and sales is intense. We cannotbe certain that we will be successful in attracting and retaining qualifiedpersonnel, or that newly-hired personnel will function effectively,either individually or as a group. In particular, we must continue to expandour direct sales force, including hiring additional sales managers, to grow ourcustomer base and increase sales. Even if we are successful in hiringadditional sales personnel, new sales representatives require up to a year tobecome effective, and the recent loss of a senior sales executive could have anadverse impact on our ability to recruit and train additional sales personnel.In addition, our industry is characterized by frequent claims relating tounfair hiring practices. We may become subject to such claims and may incursubstantial costs in defending ourselves against these claims, regardless oftheir merits. If we are unable to effectively hire, integrate and utilize newpersonnel, the execution of our business strategy and our ability to react tochanging market conditions may be impeded, and our business, financialcondition and results of operations could suffer.

 

***We may have difficulty managing ourgrowth, which could limit our ability to increase sales and cash flow.***

 

We have experienced significant growth in oursales and operations in recent years. We expect to expand our research anddevelopment, sales, marketing and support activities, including our activitiesoutside the U.S. Our historical growth has placed, and any future growth wouldplace, significant demands on our management, as well as our financial andoperational resources, as required to:

 

•                  implement and maintain effective financialdisclosure controls and procedures, including the remediation of internalcontrol deficiencies identified in our audit committee investigation;

 

•                  implement appropriate operational and financialsystems;

 

•                  manage a larger organization;

 

•                  expand our manufacturing and distribution capacity;

 

•                  increase our sales and marketing efforts; and

 

•                  broaden our customer support capabilities.

 

 

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                In addition, asdiscussed in this Form 10-Q under Part I, Item 3, our internal controlsover financial reporting are currently ineffective, and we will need to expandour finance organization and retain outside advisors to implement adequate andeffective financial controls. If we cannot grow or manage our business growtheffectively, we may not be able to execute our business strategies and ourbusiness, consolidated financial condition and consolidated results ofoperations would suffer.

 

***Because we depend upon a smallnumber of outside contractors to manufacture our products, our operations couldbe disrupted if we encounter problems with any of these contractors.***

 

                We do not haveinternal manufacturing capabilities and rely upon a small number of contractmanufacturers to build our products. In particular, we rely on FlashElectronics, Inc. for the manufacture of our BLC 6000 blade products. Ourreliance on a small number of contract manufacturers makes us vulnerable topossible capacity constraints and reduced control over component availability,delivery schedules, manufacturing yields and costs. We do not have long-termsupply contracts with our primary contract manufacturers. Consequently, thesemanufacturers are not obligated to supply products to us for any specificperiod, in any specific quantity or at any certain price, except as may beprovided by a particular purchase order. If any of our manufacturers wereunable or unwilling to continue manufacturing our products in required volumesand at high quality levels, we would have to identify, qualify and selectacceptable alternative manufacturers. It is possible that an alternate sourcemay not be available to us when needed or may not be in a position to satisfyour production requirements at commercially reasonable prices and quality. Anysignificant interruption in manufacturing would require us to reduce our supplyof products to our customers, which in turn could have a material adverseeffect on our customer relations, business, consolidated financial conditionand consolidated results of operations.

 

                We recently moveda portion of our manufacturing to the overseas facilities of our primarycontract manufacturer. This transition presents a number of risks, includingthe potential for a supply interruption or a reduction in manufacturing qualityor controls, any of which would negatively impact our business, customerrelationships and results of operations.

 

***We depend on sole source and limitedsource suppliers for key components and license technology from third parties.If we are unable to source these components and technologies on a timely basis,we will not be able to deliver our products to our customers.***

 

                We depend on solesource and limited source suppliers for key components of our products. Any ofthe sole source and limited source suppliers upon which we rely could stopproducing our components, cease operations entirely, or be acquired by, orenter into exclusive arrangements with, our competitors. We do not havelong-term supply agreements with our suppliers, and our purchase volumes arecurrently too low for us to be considered a priority customer by most of oursuppliers. As a result, these suppliers could stop selling components to us atcommercially reasonable prices, or at all. Any such interruption or delay mayforce us to seek similar components from alternate sources, if available atall. Switching suppliers may require that we redesign our products toaccommodate the new component and may potentially require us to re-qualify ourproducts with our customers, which would be costly and time-consuming. Any interruptionin the supply of sole source or limited source components would adverselyaffect our ability to meet scheduled product deliveries to our customers andwould materially and adversely affect our business, consolidated financialcondition and consolidated results of operations.

 

                Periodically, wemay be required to license technology from third parties to develop newproducts or product enhancements. These third-party licenses may beunavailable to us on commercially reasonable terms, if at all. Our inability toobtain necessary third-party licenses may force us to obtain substitutetechnology of lower quality or performance standards or at greater cost, any ofwhich could seriously harm the competitiveness of our products and which wouldresult in a material and adverse effect on our business, consolidated financialcondition and consolidated results of operations.

 

***If we fail to accurately predict ourmanufacturing requirements and manage our inventory, we could incur additionalcosts, experience manufacturing delays, or lose revenue.***

 

                Lead times for thematerials and components that we order through our contract manufacturers mayvary significantly and depend on numerous factors, including the specificsupplier, contract terms and market demand for a component at a given time. Ifwe overestimate our production requirements, our contract manufacturers maypurchase excess components and build excess inventory. If our contractmanufacturers purchase excess components that are unique to our products or buildexcess products, we could be required to pay for these excess parts or productsand recognize related inventory write-down costs. If we underestimate ourproduct requirements, our contract manufacturers may have inadequate componentinventory, which could interrupt manufacturing of our products and result indelays or cancellation of sales. In prior periods we have experienced excessinventory write-downs and standard cost revaluations associated withexcess or obsolete inventory. This may continue in the future, which would havean adverse effect on our gross margins, consolidated financial condition andconsolidated results of operations.

 

 

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***If our products contain undetecteddefects, including errors and interoperability issues, we could incursignificant unexpected expenses to remedy the defects, which could have amaterial adverse effect on our sales, results of operations or financialcondition.***

 

Although our products are tested prior toshipment, they may contain software or hardware errors, defects orinteroperability issues (collectively described as “defects”) that can only bedetected when deployed in live networks that generate high amounts ofcommunications traffic. We also continue to introduce new products that mayhave undetected software or hardware defects. Our customers may discoverdefects in our products after broad deployment and as their networks areexpanded and modified. Any defects in our products discovered in the future, orfailures of our customers’ networks, whether caused by our products or those ofanother vendor, could result in lost sales and market share and negativepublicity regarding our products. For example, during fiscal 2004, weexperienced unusually high repair costs related to the effect of lightningstrikes on selected BLC 6000 installations. As a result, we experienced higherthan anticipated costs of sales, which management believes were necessary tomaintain customer satisfaction. In late 2006 and early 2007, we identifieddesign issues associated with a transistor that resulted in potential equipmentdisruptions and that required a re-engineering effort. As a result, weexpect to increase our warranty accruals in fiscal 2007. Any similaroccurrences in the future could have a material adverse effect on our business,consolidated financial condition and consolidated results of operations.

 

***Our business is dependent on thecapital spending patterns of telecom operators, and any decrease or delay incapital spending by our customers, such as recently appears to have occurredamong IOCs evaluating their capital expenditures and investment decisions inlight of the industry transition from copper wire to fiber, would adverselyaffect our consolidated operating results and consolidated financial condition.***

 

Demand for our products depends on themagnitude and timing of capital spending by telecom service providers as theyconstruct, expand and upgrade their networks. The capital spending patterns oftelecom service providers are dependent on a variety of factors, including:

 

•                  competitive pressures, including pricing pressures;

 

•                  consumer demand for new services;

 

•                  an emphasis on generating sales from servicesdelivered over existing networks instead of new network construction orupgrades;

 

•                  the timing of annual budget approvals;

 

•                  evolving industry standards and networkarchitectures;

 

•                  free cash flow and access to external sources ofcapital; and

 

•                  completion of major network upgrades.

 

Beginning in late 2000 and continuing into2004, the telecom industry experienced a severe downturn, and many telecomservice providers filed for bankruptcy. Those companies that survived thedownturn substantially reduced their investments in new equipment. In addition,uncertain and volatile capital markets depressed the market values of telecomservice providers and restricted their access to capital, resulting in delaysor cancellations of certain projects. More recently, we believe capitalexpenditures among IOCs have been adversely affected as our customers considertheir investment and capital expenditure decisions in light of the industrytransition from copper wire to fiber. Because many of our customers are IOCs,their revenues are particularly dependent upon intercarrier payments (primarilyinterstate and intrastate access charges) and federal and state universalservice subsidies. The FCC and some states are considering changes to bothintercarrier payments and universal service subsidies, and such changes couldreduce IOC revenues. Furthermore, many IOCs use government-supported loanprograms or grants to finance capital spending. Changes to those programs, suchas the United States Department of Agriculture’s Rural Utility Service, couldreduce the ability of IOCs to access capital. Any decision by telecom serviceproviders to reduce capital expenditures, whether caused by economic cycles,changes in government regulations and subsidies, or other reasons, would have amaterial adverse effect on our business, consolidated financial condition andresults of operations.

 

 

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***Demand for our products is dependenton the willingness of our customers to deploy new services, the success of ourcustomers in selling new services to their subscribers, and the willingness ofour customers to utilize IP and Ethernet technologies in local access networks.***

 

                Demand for ourproducts is dependent on the success of our customers in deploying and sellingservices to their subscribers. Our BLC 6000 platform simultaneously supportsIP-based services, such as broadband Internet, VoIP, IPTV and FTTP, andtraditional voice services. If end-user demand for IP-based services does notgrow as expected or declines and our customers are unable or unwilling todeploy and market these newer services, demand for our products may decrease orfail to grow at rates we anticipate.

 

                Our strategyincludes developing products for the local access network that incorporate IPand Ethernet technologies. If these technologies are not widely adopted bytelecom service providers for use in local access networks, demand for ourproducts may decrease or not grow. As a result, we may be unable to sell ourproducts to recoup our expenses related to the development of these productsand our consolidated results of operations would be harmed.

 

***Changes in existing accounting ortaxation rules or practices may adversely affect our consolidated results ofoperations.***

 

                Changes inexisting accounting or taxation rules or practices, or varying interpretationsof current rules or practices, could have a significant adverse effect on ourfinancial results or the manner in which we conduct our business. For example,prior to fiscal 2006, we accounted for options granted to employees using theintrinsic value method, which, given that we generally granted employee optionswith exercise prices equal to the fair market value of the underlying stock atthe time of grant, resulted in no compensation expense. Beginning in fiscal2006, we began recording expenses for our stock-based compensation plans,including option grants to employees, using the fair value method, under whichwe expect our ongoing accounting charges related to equity awards to employeesto be significantly greater than those we would have recorded under theintrinsic value method. We expect to continue to use stock-based compensationas a significant component of our compensation package for existing and futureemployees. Accordingly, changes in accounting for stock-basedcompensation expense under the newer accounting method are expected to have amaterial adverse affect on our reported results. Any similar changes inaccounting or taxation rules or practices could have a material impact on ourconsolidated financial results.

 

***We may pursue acquisitions, whichmay involve a number of risks. If we are unable to address and resolve theserisks successfully, such acquisitions could have a material adverse impact toour business, consolidated results of operations and consolidated financialcondition.***

 

                We may makeacquisitions of businesses, products or technologies to expand our productofferings and capabilities, customer base and business. We recently completedthe acquisition of certain assets and the assumption of certain liabilities ofTerawave Communications and have evaluated, and expect to continue to evaluate,a wide array of other potential strategic transactions. We have limitedexperience making such acquisitions. Any of these transactions could bematerial to our consolidated financial condition and results of operations. Theanticipated benefit of acquisitions may never materialize. In addition, theprocess of integrating an acquired business, products or technologies maycreate unforeseen operating difficulties and expenditures. Some of the areaswhere we may face acquisition-related risks include:

 

•                  diversionof management time and potential business disruptions;

 

•                  expenses,distractions and potential claims resulting from acquisitions, whether or notthey are completed;

 

•                  retainingand integrating employees from any businesses we may acquire;

 

•                  issuanceof dilutive equity securities or incurrence of debt;

 

•                  integratingvarious accounting, management, information, human resource and other systemsto permit effective management;

 

•                  incurringpossible write-offs, impairment charges, contingent liabilities, amortizationexpense or write-offs of goodwill;

 

•                  difficultiesintegrating and supporting acquired products or technologies;

 

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•                  unexpectedcapital equipment outlays and related costs;

 

•                  insufficientrevenues to offset increased expenses associated with the acquisition;

 

•                  under-performanceproblems associated with acquisitions;

 

•                  opportunitycosts associated with committing capital to such acquisitions;, and

 

•                  becominginvolved in acquisition-related litigation.

 

                Foreignacquisitions involve unique risks in addition to those mentioned above,including those related to integration of operations across different culturesand languages, currency risks and the particular economic, political andregulatory risks associated with specific countries. We cannot assure that wewill be able to address these risks successfully, or at all, without incurringsignificant costs, delay or other operating problems. Our inability to resolveany of such risks could have a material adverse impact on our business,consolidated financial condition and consolidated results of operations.

 

***If we are not able to effectively integrate anddevelop the operations of Terawave Communications, Inc., our business maysuffer.***

 

InOctober 2007, we acquired substantially all assets of Terawave Communications,Inc., or Terawave, and hired 29 former employees of Terawave. We are continuingto integrate the products, technology and employees of Terawave into ourorganizational structure and working towards the effective utilization of theadditional technology and workforce. We face various risks as a result of thisacquisition including, but not limited to:

 

•                  ourability to retain and motivate Terawave’s employees; 

 

•                  ourability to retain and develop Terawave’s customers; 

 

•                  thefailure or a delay in integrating the technology, operations and workforce ofTerawave with our company; 

 

•                  thefailure to realize the potential financial or strategic benefits of theacquisition; 

 

•                  theincurrence of substantial unanticipated integration costs; 

 

•                  thediversion of significant management attention and financial resources inassimilating Terawave’s business; or 

 

•                  thedisruption of our ongoing business. 

 

Ifwe are not able to successfully integrate and develop Terawave’s assets andpersonnel, our business may be negatively affected in future periods, which maycause our stock price to decline. In addition, if the value of intangibleassets acquired becomes impaired, we will be required to write down the valueof the assets, which would negatively affect our financial results. We mayincur liabilities from Terawave including liabilities for intellectual propertyinfringement or indemnification of Terawave’s customers for similar claims thatcould materially and adversely affect our business. If our efforts to integrateTerawave’s business with our existing business are unsuccessful, our futurerevenue and operating results could be negatively affected, which could causeour stock price to decline.

 

***Our acquisition of Terawave will make******planning******and predicting our futuregrowth rates and operating results more difficult.***

 

Ouracquisition of Terawave may reduce our revenue growth rate and make predictionof our future revenue, costs and expenses and operating results more difficult.We have begun to offer Terawave’s PON products to our existing customer base.However, we cannot predict the level of demand for Terawave’s products fromthese customers. If we are unable to expand the existing customer base forthese products beyond Terawave’s historical customer base, revenues from theseproducts may not grow. We may also incur additional costs in order to customizethe existing Terawave products to meet our customer requirements. We expect ourresults of operations in future periods will reflect an expanded workforce andproduct development effort and changed customer base. Due to the acquisition,we may not be able to accurately predict:

 

•                  howthe combined business will evolve; 

 

•                  thepossible impairment of relationships with employees and customers as a resultof the integration of the combined businesses; or 

 

 

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•                  theimpairment of goodwill and other intangible assets resulting from theacquisition. 

 

Ifwe are unable to efficiently manage this integration, we may incur additionalexpenses and experience delays in our engineering and marketing efforts.

 

***Business combinations and otherfinancial restructurings by telecom service providers or our competitors couldadversely affect our business.***

 

                In recent years,the telecom service provider market has undergone substantial consolidation,illustrated by the merger of SBC Communications Inc. withAT&T Inc., the merger of SBC Communications (now renamed AT&T) withBellSouth Corporation (now also renamed AT&T), and the merger of VerizonCommunications Inc. with MCI, Inc. Transactions such as thesegenerally have negative implications for equipment suppliers like us, includinga reduction in the number of potential customers for telecom equipmentproducts, a decrease in aggregate capital spending and greater pricing power byservice providers over equipment suppliers. Continued consolidation of thetelecom service provider industry, including among IOC customers which we focuson, could make it more difficult for us to grow our customer base, increasesales of our products and maintain adequate gross margins.

 

                Thetelecommunications equipment industry is also characterized by frequent mergersand acquisitions, as illustrated by the merger of Alcatel with LucentTechnologies and the acquisition of Advanced Fibre Communications, Inc. byTellabs. An acquisition of one of our competitors, or merger between ourcompetitors, could harm our competitive position or cause our target customersto delay purchases of our products while they assess the impact of thecombination. If a larger company with more resources were to acquire acompetitor of ours, they may invest additional resources in developing,marketing and supporting competitive products, which would negatively impactour business, consolidated financial condition and consolidated results ofoperations.

 

***Our customers are subject togovernment regulation, and changes in current or future laws or regulationsthat negatively impact our customers could harm our business.***

 

                The jurisdictionof the Federal Communications Commission, or FCC, extends to the entiretelecommunications industry, including our customers. Future FCC regulationsaffecting the broadband access industry, our customers, or the serviceofferings of our customers, may harm our business. For example, FCC regulatorypolicies affecting the availability of data and Internet services may impedethe penetration of our customers into certain markets or affect the prices theymay charge in such markets. Furthermore, many of our customers are subject toFCC rate regulation of interstate telecommunications services, and arerecipients of federal universal service subsidies implemented and administeredby the FCC. In addition, many of our customers are subject to state regulationof intrastate telecommunications services, including rates for such services,and may also receive state universal service subsidies. Changes in FCC or staterate regulations or federal or state universal service subsidies couldadversely affect our customers’ revenues and capital spending plans. Inaddition, international regulatory bodies are beginning to adopt standards andregulations for the telecom industry. These domestic and foreign standards,laws and regulations address various aspects of VoIP and broadband use,including issues relating to liability for information retrieved from, ortransmitted over, the Internet. Changes in standards, laws and regulations, orjudgments in favor of plaintiffs in lawsuits against service providers couldadversely affect the development of Internet and other IP-based services. This,in turn, could directly or indirectly materially adversely impact the telecomindustry in which our customers operate. To the extent our customers areadversely affected by laws or regulations regarding their business, products orservice offerings, our business, financial condition and results of operationswould suffer.

 

***If we fail to comply withregulations and evolving industry standards, sales of our existing and futureproducts could be adversely affected.***

 

                The markets forour products are characterized by a significant number of laws, regulations andstandards, both domestic and international, some of which are evolving as newtechnologies are deployed. Our products are required to comply with these laws,regulations and standards, including those promulgated by the FCC. For example,the FCC recently required that all facilities-based providers ofbroadband Internet access and interconnect VoIP services meet the capabilityrequirements of the Communications Assistance for Law Enforcement Act byMay 14, 2007. Subject to certain statutory parameters, we are required tomake available to our customers, on a reasonably timely basis and at areasonable charge, such features or modifications as are necessary to permitour customers to meet those capability requirements. In some cases, we arerequired to obtain certifications or authorizations before our products can beintroduced, marketed or sold. There can be no assurance that we will be able tocontinue to design our products to comply with all necessary requirements inthe future. Accordingly, any of these laws, regulations and standards maydirectly affect our ability to market or sell our products.

 

 

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                Some of ouroperations are regulated under various federal, state and local environmentallaws. Our planned international expansion will likely subject us to additionalenvironmental and other laws. For example, the European Union Directive2002/96/EC on waste electrical and electronic equipment, known as the WEEEDirective, requires producers of certain electrical and electronic equipment,including telecom equipment, to be financially responsible for the specifiedcollection, recycling, treatment and disposal of past and present coveredproducts placed on the market in the European Union. The European UnionDirective 2002/95/EC on the restriction of the use of hazardous substances inelectrical and electronic equipment, known as the RoHS Directive, restricts theuse of certain hazardous substances, including lead, in covered products.Failure to comply with these and other environmental laws could result in finesand penalties and decreased sales, which could adversely affect our plannedinternational expansion and our consolidated operating results.

 

***We may not be able to protect ourintellectual property, which could adversely affect our ability to competeeffectively.***

 

                We depend on ourproprietary technology for our success and ability to compete. We currentlyhold 16 issued patents and have several patent applications pending. We rely ona combination of patent, copyright, trademark and trade secret laws, as well asconfidentiality agreements and licensing arrangements, to establish and protectour proprietary rights. Existing patent, copyright, trademark and trade secretlaws will afford us only limited protection. In addition, the laws of someforeign countries do not protect proprietary rights to the same extent, as dothe laws of the U.S. We cannot assure you that any pending patent applicationswill result in issued patents, and issued patents could prove unenforceable.Any infringement of our proprietary rights could result in significantlitigation costs. Further, any failure by us to adequately protect ourproprietary rights could result in our competitors offering similar products,resulting in the loss of our competitive advantage and decreased sales.

 

                Despite ourefforts to protect our proprietary rights, attempts may be made to copy orreverse engineer aspects of our products, or to obtain and use information thatwe regard as proprietary. Accordingly, we may be unable to protect ourproprietary rights against unauthorized third-party copying or use.Furthermore, policing the unauthorized use of our intellectual property wouldbe difficult for us. Litigation may be necessary in the future to enforce ourintellectual property rights, to protect our trade secrets or to determine thevalidity and scope of the proprietary rights of others. Litigation could resultin substantial costs and diversion of resources and could have a materialadverse effect on our business, consolidated financial condition andconsolidated results of operations.

 

***We could become subject tolitigation regarding intellectual property rights that could materially harmour business.***

 

                We may be subjectto intellectual property infringement claims that are costly to defend andcould limit our ability to use some technologies in the future. Our industry ischaracterized by frequent intellectual property litigation based on allegationsof infringement of intellectual property rights. From time to time, thirdparties have asserted and may assert in the future patent, copyright, trademarkor other intellectual property rights to technologies or rights that areimportant to our business. In addition, we have agreed, and may in the futureagree, to indemnify our customers for any expenses or liabilities resultingfrom claimed infringements of patents, trademarks or copyrights of thirdparties. Any claims asserting that our products infringe, or may infringe on,the proprietary rights of third parties, with or without merit, could betime-consuming, resulting in costly litigation and diverting the efforts of ourmanagement. These claims could also result in product shipment delays orrequire us to modify our products or enter into royalty or licensingagreements. Such royalty or licensing agreements, if required, may not beavailable to us on acceptable terms, if at all.

 

***Our business could be shut down orseverely impacted if a natural disaster or other unforeseen catastrophe occurs,particularly in California.***

 

                Our business andoperations depend on the extent to which our facilities and products areprotected against damage from fire, earthquakes, power loss and similar events.Some of our key business activities currently take place in regions consideredas high risk for certain types of natural disasters. Despite precautions wehave taken, a natural disaster or other unanticipated problem could, amongother things, hinder our research and development efforts, delay the shipmentof our products and affect our ability to receive and fulfill orders. For example,because the final assembly and testing of our product line is currentlyperformed in one location in California, any earthquake, fire, other disasteror power outage at this location would have a material adverse effect on ourbusiness, consolidated financial condition and consolidated results ofoperations. While we believe that our insurance coverage is comparable to thoseof similar companies in our industry, it does not cover all natural disasters,in particular, earthquakes and floods.

 

 

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**Risks Related to Our Common Stock**

 

***Our executive officers, directorsand their affiliates hold a large percentage of our stock and their interestsmay differ from other stockholders.***

 

                As ofSeptember 30, 2007, our executive officers, directors and their affiliatesbeneficially owned, in the aggregate, approximately 31.6% of our outstandingcommon stock. Investment funds affiliated with U.S. Venture Partners andNorwest Venture Partners, collectively control approximately 27.7% of ouroutstanding common stock. Representatives of U.S. Venture Partners and NorwestVenture Partners are directors of Occam. These stockholders have significantinfluence over most matters requiring approval by stockholders, including the electionof directors, any amendments to our certificate of incorporation andsignificant corporate transactions.

 

***Our stock price may be volatile, andyou may not be able to resell shares of our common stock at or above the priceyou paid.***

 

                Our shares ofcommon stock recently began trading on The NASDAQ Global Market. An activepublic market for our shares on The NASDAQ Global Market may not be sustained.In particular, limited trading volumes and liquidity may limit the ability ofstockholders to purchase or sell our common stock in the amounts and at thetimes they wish. Trading volume in our common stock tends to be modest relativeto our total outstanding shares, and the price of our common stock mayfluctuate substantially (particularly in percentage terms) without regard tonews about us or general trends in the stock market.

 

                In addition, thetrading price of our common stock could become highly volatile and could besubject to wide fluctuations in response to various factors, some of which arebeyond our control. These factors include those discussed in this “Risk Factors”section of this Quarterly Report on Form 10-Q and others such as:

 

•                  quarterlyvariations in our consolidated results of operations or those of ourcompetitors;

 

•                  changesin earnings estimates or recommendations by securities analysts;

 

•                  announcementsby us or our competitors of new products, significant contracts, commercialrelationships, acquisitions or capital commitments;

 

•                  developmentswith respect to intellectual property rights;

 

•                  ourability to develop and market new and enhanced products on a timely basis;

 

•                  commencementof, or involvement in, litigation;

 

•                  changesin governmental regulations or in the status of our regulatory approvals; and

 

•                  aslowdown in the telecom industry or general economy.

 

                In recent years,the stock market in general, and the market for technology companies inparticular, has experienced extreme price and volume fluctuations that haveoften been unrelated or disproportionate to the operating performance of thosecompanies. Broad market and industry factors may seriously affect the marketprice of our common stock, regardless of our actual operating performance. Inaddition, in the past, following periods of volatility in the overall market andthe market price of a particular company’s securities, securities class actionlitigation has often been instituted against these companies. We are currentlya defendant in securities class action litigation arising from our restatement.This litigation or any additional litigation that may be instituted against uscould result in substantial costs and a diversion of our management’s attentionand resources.

 

***Provisions in our charter documentsand under Delaware law could discourage a takeover that stockholders mayconsider favorable.***

 

                Provisions in ourcertificate of incorporation and bylaws, as amended and restated upon theclosing of this offering, may have the effect of delaying or preventing achange of control or changes in our management. These provisions include thefollowing:

 

•                  ourboard of directors has the right to elect directors to fill a vacancy createdby the expansion of the board of directors or the resignation, death or removalof a director, which prevents stockholders from being able to fill vacancies onour board of directors;

 

•                  ourstockholders may not act by written consent or call special stockholders’meetings; as a result, a holder, or holders, controlling a majority of ourcapital stock would not be able to take certain actions other than at annualstockholders’ meetings or special stockholders’ meetings called by the board ofdirectors, the chairman of the board, the chief executive officer or thepresident;

 

 

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•                  ourcertificate of incorporation prohibits cumulative voting in the election ofdirectors, which limits the ability of minority stockholders to elect directorcandidates;

 

•                  stockholdersmust provide advance notice to nominate individuals for election to the boardof directors or to propose matters that can be acted upon at a stockholders’meeting, which may discourage or deter a potential acquiror from conducting asolicitation of proxies to elect the acquiror’s own slate of directors orotherwise attempting to obtain control of our company; and

 

•                  ourboard of directors may issue, without stockholder approval, shares ofundesignated preferred stock; the ability to authorize undesignated preferredstock makes it possible for our board of directors to issue preferred stockwith voting or other rights or preferences that could impede the success of anyattempt to acquire us.

 

                As a Delawarecorporation, we are also subject to certain Delaware anti-takeover provisions.Under Delaware law, a corporation may not engage in a business combination withany holder of 15% or more of its capital stock unless the holder has held thestock for three years or, among other things, the board of directors hasapproved the transaction. Our board of directors could rely on Delaware law to preventor delay an acquisition of us.

 

***We may be unable to raise additionalcapital to fund our future operations, and any future financings oracquisitions could result in substantial dilution to existing stockholders.***

 

                While weanticipate our cash balances and any cash from operations, will be sufficientto fund our operations for at least the next 24 months, we may need toraise additional capital to fund operations in the future. There is noguarantee that we will be able to raise additional equity or debt funding whenor if it is required. The terms of any financing, if available, could beunfavorable to us and our stockholders and could result in substantial dilutionto the equity and voting interests of our stockholders. Any failure to obtainfinancing when and as required would have an adverse and material effect on ourbusiness, consolidated financial condition and consolidated results ofoperations.

 

**ITEM 2.  UNREGISTERED SALES OF EQUITY SECURITIES ANDUSE OF PROCEEDS**

 

                None.

 

**ITEM 3.  DEFAULTS UPON SENIOR SECURITIES**

 

                None.

 

**ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS**

 

                None.

 

**ITEM 5.  OTHER INFORMATION**

 

                We have notamended any of our Annual Reports on Form 10-K or Quarterly Reports onForm 10-Q that were filed prior to October 16, 2007. You should notrely on any of these annual or quarterly reports. In addition, you should notrely on any information contained in our registration statements onForm S-1, which were declared effective by the SEC on December 29,2005, January 31, 2006, and November 1, 2006, respectively.

 

**Restatement of Consolidated Financial Statements**

 

                OnOctober 16, 2007, we announced that the audit committee of our board ofdirectors had completed its previously announced internal review of our revenuerecognition practices. Among other matters, our audit committee, assisted byindependent forensic accountants and legal advisors, reviewed our practicesrelating to the following:

 

•                  commitmentsto provide customers with software, hardware and software maintenance, hardwareand software upgrades, training and other services in connection with customers’purchases of our network equipment;

 

•                  salesto value added resellers; and

 

•                  useof intermediate shipping vendors in connection with shipments of product at theend of quarters falling on weekends.

 

 

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                As a result of ouraudit committee’s review, we identified errors in our previous recognition ofrevenue and determined that we recognized approximately $33.0 million ofrevenue prematurely during fiscal years 2004 through 2006. The errorsidentified by our audit committee’s review pertained to the timing of revenuerecognition rather than our ability to collect or ultimately realize revenuefrom the underlying transactions. Our audit committee did not identify anyinstances where we recognized revenue that was not ultimately collected orrealizable. As a result of the restatement, $4.9 million of previouslyrecorded revenue was deferred as of December 31, 2006. On a restatedbasis, our net losses were $16.7 million and $7.6 million for theyears ended December 26, 2004 and December 25, 2005, respectively,and we had net income of $1.2 million for the year ended December 31,2006. The restatement adjustments did not affect our previously reported cash,cash equivalent and short-term investment balances in any of the years beingrestated.

 

                Unless otherwiseindicated, all financial information in this Form 10-Q gives effect to therestatement. Information regarding the effect of the restatement on ourfinancial position and results of operations is provided in Note 2 of theNotes to Consolidated Financial Statements.

 

**Background of the Restatement**

 

                InMarch 2007, as part of our standard closing procedures, a cost accountantin our finance department discovered a customer invoice indicating that a third-partyproduct had been provided to the customer for free. Finance departmentpersonnel subsequently discovered a letter in which we committed to provide thecustomer with the third-party product as well as with extended softwaremaintenance and free training. Upon learning of the letter, our chief financialofficer notified our audit committee and our independent registered publicaccounting firm.

 

                Our auditcommittee promptly initiated a review of this transaction. Our audit committeeinitially retained Wilson Sonsini Goodrich & Rosati, PC, our outsidelegal counsel, to assist in the internal accounting review and StoneTurn GroupLLP to provide forensic accounting and technology services. Subsequently, ouraudit committee retained independent legal counsel, Irell & ManellaLLP, to review the conduct of persons involved.

 

                The scope of theinitial investigation was to determine the facts surrounding the transactiondiscovered by finance department personnel in March 2007 and to determinewhether other transactions might exist with similar issues that could affectour accounting and reported financial results. Upon determining that othertransactions did exist and required further review, our audit committeeexpanded its investigation accordingly. The investigation covered numeroustransactions from 2003 through the first quarter of fiscal 2007. During thecourse of the investigation, the audit committee’s legal counsel and forensicaccountants collectively examined approximately 285,000 hard copy andelectronic documents and conducted 58 interviews of current and formeremployees, outside counsel, and customers. The information obtained throughthis review was analyzed in conjunction with transactional documents, whichincluded customer quotes, proposal responses, purchase orders, contracts,volume purchase arrangements, letters of intent, sales orders, customercorrespondence, emails, and other electronic documents. The audit committee’saccounting and conduct reviews ultimately focused in particular on a detailedreview of our transactions with all value-added resellers, or VARs,shipments of product at or near quarter end, and a comprehensive review of alltransactions with 22 significant customers.

 

                OnSeptember 9, 2007, our board of directors, based on a recommendation ofour audit committee, concluded that we should restate our financial statementsfor fiscal years 2004 and 2005, the corresponding interim quarterly fiscal periods,and the first, second, and third quarters of fiscal 2006 and that ourpreviously filed financial statements for these periods should not be reliedon. On September 12, 2007, we issued a press release announcing therestatement and non-reliance on our previously published financial informationfor those periods, and we filed a Current Report on Form 8-K with the SECdisclosing equivalent information.

 

                OnSeptember 28, 2007, our audit committee presented its findings andrecommendations relating to the investigation to our board of directors, andthese findings are summarized below. At the meeting, our board of directorsadopted the findings and recommendations of the audit committee, including aproposed remediation plan regarding internal controls and certain personnelactions.

 

                OnOctober 16, 2007, we filed the Form 10-K and our Quarterly Reports onForm 10-Q for the quarters ended March 31 and June 30, 2007. We alsoissued a press release and filed a Current Report on Form 8-K to announcethe final restated financial information and conclusions of our audit committee’sinvestigation. Among other information, we announced that our management hadassessed our internal control over financial reporting as of June 30, 2007 andconcluded that we had a material weakness and other control deficienciesrelating to revenue recognition. As a result, our chief executive officer andchief financial officer have concluded that our internal controls overfinancial reporting were not effective as of June 30, 2007.

 

 

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**Audit Committee Findings and Recommendations**

 

                Our auditcommittee determined that the revenue adjustments arising from theinvestigation resulted from a failure in internal controls around the sales andrevenue transactional cycles and did not result from fraud. Specifically, alladjustments reflect changes in the timing of revenue recognition; the auditcommittee determined that the underlying transactions reflected legitimatesales of product or services. The investigation determined that thetransactions reflected accurately the sale of goods and services, for which thecustomers paid, but that a portion of the revenue from these transactionsshould have been deferred and recognized in a later reporting period whenapplicable accounting rules governing the recognition of revenue would havepermitted the revenue to be recognized. For a number of transactions, theinvestigation determined that not all terms affecting revenue recognition wereproperly communicated to, or considered by, our finance department although theaudit committee did not conclude that the failure to communicate thisinformation involved fraudulent intent by any person.

 

                Our auditcommittee concluded that the errors and omissions requiring an adjustment ofour prior-period financial statements resulted from (i) weaknessesin internal controls; (ii) a lack of clear understanding by, andcommunication to, sales personnel of technical accounting rules;(iii) understaffed finance functions, resulting in over-reliance on salesand sales administration personnel to record completely and accurately theterms of sales transactions; and (iv) on occasion, failure of financepersonnel to apply technical revenue recognition rules correctly.

 

                The principalaccounting issues resulting in the need to restate our financial statementsderived from (i) commitments to certain customers in connection with salesfor features or deliverables that were not available at the time revenue wasoriginally recognized, including commitments to prospectively provide freeproduct, software, training, and installation services, for which weprematurely recognized approximately $9.3 million in revenue from fiscal2004 to fiscal 2006; (ii) sales to value-added resellers where theresellers did not have the ability to pay us for these sales independent ofpayment to them by the end-user, for which we prematurely recognizedapproximately $20.2 million in revenue from fiscal 2004 to fiscal 2006;and (iii) for certain quarters ending on weekends, our use of a shippingvendor who picked up product for subsequent delivery to another shippingcompany where the terms and conditions of the shipments did not appropriatelytransfer title or risk of loss at the time of shipment, for which weprematurely recognized approximately $2.3 million in revenue from fiscal2004 to fiscal 2006. In addition, we prematurely recognized approximately$1.1 million of revenue from fiscal 2004 through fiscal 2006 relatingprincipally to errors in accounting for software and software maintenance,customer credits, and undelivered free product.

 

                Our auditcommittee found that individuals involved in sales of our products did notfully appreciate the implications of certain terms and arrangements on revenuerecognition and did not receive consistent and clear guidance as to thoseissues or instructions on communicating with our finance department to ensure acomplete communication of all terms that might affect revenue recognition. Theaudit committee also found that our finance department did not receivesufficient information on all transactions necessary to make appropriatejudgments, that it relied too heavily on others to determine the informationnecessary to make those decisions, and that it relied too heavily on objectivetests and measurements, such as days-sales-outstanding and returns data,to determine the risk of revenue recognition issues. The audit committee alsoconcluded that individuals in our finance department failed to appreciate thesignificance, or were not sufficiently aware, of the impact of certain termsand arrangements on revenue recognition.

 

                Our auditcommittee determined that one non-officer sales executive had a critical rolein negotiating and/or documenting a significant number of the transactions thatresulted in adjustments. Our audit committee concluded that the sales executiveknew or should have known the importance of fully reflecting and reporting allmaterial terms and commitments made to customers and that he knew or shouldhave known that processes were not in place to ensure timely and completecommunication of this information. Our audit committee ultimately recommended,and our board of directors approved, the termination of this individual salesexecutive, with a transition period during which the former sales executivewill consult with us with respect to pending transactions and customerprospects but will not have authority to enter into any binding commitments onour behalf.

 

                Our auditcommittee also recommended, and our board of directors approved, that a salesdirector be terminated based on the committee’s conclusion that the salesdirector had not cooperated during the investigation.

 

                Our auditcommittee also concluded that our former and current chief financial officersbear responsibility for failing to fully and correctly account for all knowninformation, but the committee determined that these oversights and failuresresulted from an inadequate control environment and a failure to fullyappreciate or understand the proper application of technical rules forrecognizing revenue in the context of our contracts and sales. Among otherrecommendations, our audit committee determined that a new position of revenuerecognition director should be created to assume responsibility for assuringthat all available information material to revenue recognition determinationsis gathered in a centralized location and 

 

 

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properly considered by the finance department. The committee alsorecommended that the position of chief financial officer be strengthened,including by bringing in senior outside finance and accounting advisors toassist in implementing the control improvements.

 

**Internal Control Weaknesses and Remediation**

 

                As furtherdiscussed in Part I, Item 4 of this Form 10-Q under the caption “Controlsand Procedures,” during the course of its investigation, our audit committeeidentified internal control weaknesses relating primarily to the approval,documentation, communication and accounting for transactions with non-standardterms or for commitments of future functionality or features of the productssold. Our audit committee determined that we lacked sufficient guidelines orprocesses concerning approval of non-standard terms and that we had noconsistent practice to ensure that non-standard terms and shipping methods wereconsistently documented. Although our audit committee identified some recentimprovements in our internal controls, it found that control deficienciesexisted relating to the documentation of the terms of transactions and theinternal controls in place to ensure that such terms were accurately andcompletely communicated for revenue recognition purposes to our financedepartment. The audit committee also found weaknesses relating to the failureto apply, or misapplication of, technical accounting rules relating to thetiming of revenue recognition. Finally, certain of the control weaknessesrelated to accounting for VAR transactions and the manner in which we assessedand documented our evaluation of the creditworthiness of these resellers.

 

                In addition, ouraudit committee received a letter dated October 15, 2007 from our currentindependent registered public accounting firm identifying a material weaknessrelating to revenue recognition and significant deficiencies relating tosegregation of duties, post-closing adjusting journal entries, and accountingfor parts and fixed asset purchases. Our chief executive officer and our chieffinancial officer have further determined that, as of September 30, 2007,our internal controls over financial reporting were not effective to providereasonable assurance regarding the reliability of our financial reporting andthe preparation of our consolidated financial statements for external purposesin accordance with generally accepted accounting principles in the UnitedStates.

 

                Our auditcommittee, with the assistance of special counsel to the audit committee andreflecting input from our current independent registered public accountingfirm, has developed a list of identified goals and directives to enhance ourinternal control over financial reporting, including development of meaningfuland comprehensive training programs and protocols for the communication andenforcement of our recently amended and restated code of ethics and conduct.These recommendations are described in greater detail in the discussion underPart I, Item 4, section (b) relating to changes in internal controls.Our full board of directors has adopted these recommendations, and we are inthe process of implementing them, in consultation with our independentregistered public accounting firm and an independent outside consultant we haveretained in connection with the development of our implementation plan forSection 404 of the Sarbanes-Oxley Act of 2002.

 

**SEC Matter**

** **

                In advance of the Company’sannouncement of the audit committee investigation and pending restatementdescribed under Note 2, the Company advised the staff of the Enforcement Divisionof the United States Securities and Exchange Commission (“SEC”) of thesedevelopments.  After the conclusion ofthe investigation, the Company met with the SEC staff.  On November 13, 2007, the Companyreceived a letter from the SEC staff stating that the investigation as to OccamNetworks, Inc. has been completed and that the SEC staff does not intend torecommend any enforcement action by the SEC.

 

**ITEM 6.  EXHIBITS**

 
| **Exhibit  Number** | ** ** | **Exhibit Title**                                                                                                                                                                          |
|---------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.80               |       | Asset Purchase Agreement by and among Occam Networks, Inc. and  Terawave Communications, Inc. dated September 27, 2007.                                                                         |
|                |       |                                                                                                                                                                                            |
| 31.01               |       | Certification of Chief Executive Officer pursuant to Section 302  of the Sarbanes-Oxley Act of 2002.                                                                                       |
|                |       |                                                                                                                                                                                            |
| 31.02               |       | Certification of Chief Financial Officer pursuant to Section 302  of the Sarbanes-Oxley Act of 2002.                                                                                       |
|                |       |                                                                                                                                                                                            |
| 32.01               |       | Certification of Chief Executive Officer and Chief Financial Officer  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002. |

 

 

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**SIGNATURES**

 

                Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
|                     | OCCAM NETWORKS, INC.   (Registrant) |
|--------------------------|------------------------------------------|
|                     |                                     |   |
|                     | By:                                      | /s/ CHRISTOPHER B. FARRELL |
|                     |                                     | Christopher B. Farrell |
|                     |                                     | Chief Financial Officer  (Principal Financial and Accounting Officer) |
| Dated: November 14, 2007 |                                     |   |

 

 

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**EXHIBITINDEX**

 
| **Exhibit  Number** | ** ** | **Exhibit Title**                                                                                                                                                                          |
|---------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.80               |       | Asset Purchase Agreement by and among Occam Networks, Inc. and  Terawave Communications, Inc. dated September 27, 2007.                                                                    |
|                |       |                                                                                                                                                                                            |
| 31.01               |       | Certification of Chief Executive Officer pursuant to Section 302  of the Sarbanes-Oxley Act of 2002.                                                                                       |
|                |       |                                                                                                                                                                                            |
| 31.02               |       | Certification of Chief Financial Officer pursuant to Section 302  of the Sarbanes-Oxley Act of 2002.                                                                                       |
|                |       |                                                                                                                                                                                            |
| 32.01               |       | Certification of Chief Executive Officer and Chief Financial Officer  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906  of the Sarbanes-Oxley Act of 2002. |

 

 

 

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