##### Table of Contents









SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549




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Form 10-K



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|           |  |                                                                                             
|---------- |  | --------------------------------------------------------------------------------------------
|(Mark One) |  |                                                                                             
|þ          |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR
    15(d) OF THE SECURITIES EXCHANGE ACT OF 1934    
|          
|           |  | For the Fiscal Year Ended December 31,
    2003                                             
|          
|or        
|          
|o          |  | TRANSITION REPORT PURSUANT TO SECTION 13
    OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|           |  | For the Transition Period
    from           to          .                                  

Commission file number: 000-24647



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Terayon Communication
Systems, Inc.

(Exact name of registrant as specified in its
charter)


|                                                                  |  |                                      
|----------------------------------------------------------------- |  | -------------------------------------
|Delaware                                                          |  | 77-0328533                           
|(State or other jurisdiction of
    incorporation or organization |  | (IRS employer
    identification no.)

4988 Great America Parkway

Santa Clara, California 95054


(408) 235-5500


(Address, including zip code, and
telephone number, including area code,


of the registrants principal executive
offices)




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Securities registered pursuant to
Section 12(b) of the Act:

|                     |  |                                           
|-------------------- |  | ------------------------------------------
|Title of Each Class: |  | Name of Each Exchange on Which Registered:
|                     |  |                                           
|None                 |  | None                                      

Securities registered pursuant to
Section 12(g) of the Act:

Common Stock, par value $0.001 per
share


(Title of Class)


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

Indicate by check mark if disclosure of
delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be
contained, to the best of the registrants knowledge, in
definitive proxy or information statements incorporated by
reference in Part III of this Form 10-K or any
amendment to this
Form 10-K.     o

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

The aggregate market value of the voting stock
held by non-affiliates of the registrant, based upon the closing
sale price of the common stock on June 30, 2003 as reported
on the Nasdaq National Market, was approximately $159,297,437.
Shares of common stock held by each officer and director and by
each person known to the registrant who owns 5% or more of the
outstanding common stock have been excluded in that such persons
may be deemed to be affiliates. This determination of affiliate
status is not necessarily a conclusive determination for other
purposes.

As of February 29, 2004, the registrant had
outstanding 75,536,192 shares of common stock.



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TERAYON COMMUNICATION
SYSTEMS, INC.

INDEX

|              |  |                                                                                                 |     |          |     | 
|------------- |  | ----------------------------------------------------------------------------------------------- | --- | -------- | --- | 
|              |  |                                                                                                 |     | Page No.
|              |  |                                                                                                 |     |         
|PART I       
|Item 1.       |  | BUSINESS                                                                                        |     |          | 1   | 
|Item 2.       |  | PROPERTIES                                                                                      |     |          | 8   | 
|Item 3.       |  | LEGAL PROCEEDINGS                                                                               |     |          | 8   | 
|Item 4.       |  | SUBMISSION OF MATTERS TO A
    VOTE OF SECURITY HOLDERS                                         |     |          | 10  | 
|PART II      
|Item 5.       |  | MARKET FOR REGISTRANTS
    COMMON EQUITY AND RELATED STOCKHOLDER MATTERS                       |     |          | 10  | 
|Item 6.       |  | SELECTED FINANCIAL DATA                                                                         |     |          | 13  | 
|Item 7.       |  | MANAGEMENTS DISCUSSION
    AND ANALYSIS OF FINANCIAL CONDITIONAL AND RESULTS OF
    OPERATIONS |     |          | 14  | 
|Item 7A.      |  | QUANTITATIVE AND QUALITATIVE
    DISCLOSURES ABOUT MARKET RISK                                  |     |          | 52  | 
|Item 8.       |  | FINANCIAL STATEMENTS AND
    SUPPLEMENTARY DATA                                                 |     |          | 53  | 
|Item 9.       |  | CHANGES IN AND DISAGREEMENTS
    WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE        |     |          | 90  | 
|Item 9A.      |  | CONTROLS AND PROCEDURES                                                                         |     |          | 90  | 
|PART III     
|Item 10.      |  | DIRECTORS AND EXECUTIVE
    OFFICERS OF THE REGISTRANT                                          |     |          | 90  | 
|Item 11.      |  | EXECUTIVE COMPENSATION                                                                          |     |          | 93  | 
|Item 12.      |  | SECURITY OWNERSHIP OF
    CERTAIN BENEFICIAL OWNERS AND MANAGEMENT                              |     |          | 100 | 
|Item 13.      |  | CERTAIN RELATIONSHIPS AND
    RELATED TRANSACTIONS                                              |     |          | 102 | 
|Item 14.      |  | PRINCIPAL ACCOUNTANT FEES
    AND SERVICES                                                      |     |          | 103 | 
|PART IV      
|Item 15.      |  | EXHIBITS, FINANCIAL
    STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K                            |     |          | 103 | 
|SIGNATURES    |  |                                                                                                 | 108 |         
|EXHIBIT 10.24
|EXHIBIT 10.25
|EXHIBIT 10.26
|EXHIBIT 10.27
|EXHIBIT 10.28
|EXHIBIT 21.1 
|EXHIBIT 23.1 
|EXHIBIT 31.1 
|EXHIBIT 31.2 
|EXHIBIT 32.1 
|EXHIBIT 32.2 





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SPECIAL NOTE ON FORWARD-LOOKING
STATEMENTS

This Report on Form 10-K contains
forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933 and
Section 21E of the Securities Exchange Act of 1934 which
are subject to the safe harbor created by those sections. These
forward-looking statements include, but are not limited to:
statements related to industry trends and future growth in the
markets for broadband delivery systems; our strategies for
reducing the cost of our products; our product development
efforts; the effect of GAAP accounting pronouncements on our
recognition of revenues; our future research and development;
the timing of our introduction of new products; the timing and
extent of deployment of our products by our customers; and
future profitability. We usually use words such as may, will,
should, expect, plan, anticipate, believe, estimate, predict,
future, intend, or certain or the negative of these terms or
similar expressions to identify forward-looking statements.
Discussions containing such forward-looking statements may be
found throughout the document. These forward-looking statements
involve certain risks and uncertainties that could cause actual
results to differ materially from those in such forward-looking
statements. We disclaim any obligation to update these
forward-looking statements as a result of subsequent events. The
business risks discussed in Item 7 of this Report on
Form 10-K, among other things, should be considered in
evaluating our prospects and future financial performance.

This Report on Form 10-K includes trademarks
and registered trademarks of Terayon. Products or service names
of other companies mentioned in this Report on Form 10-K
may be trademarks or registered trademarks of their respective
owners.



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##### Table of Contents






PART I






|        |         
|------- | --------
|Item 1. | Business

Overview

We were founded in 1993 to provide broadband
cable data equipment for cable operators based on our
proprietary Synchronous Code Division Multiple Access (S-CDMA)
technology, which forms the basis of our current technology. By
1999, we were primarily selling proprietary-based modems and
cable modem termination systems (CMTS). Also in 1999 we
initiated an acquisition strategy to expand our product
offerings beyond the cable industry to the telecom and satellite
industries. With the market downturn in 2000, we refocused our
business by concentrating our resources on the cable industry
and began selling products based on industry standard
specifications, particularly the Data Over Cable System
Interface Specification (DOCSIS), thereby transitioning from
proprietary-based products to standards-based products. We also
have terminated all of our acquired businesses, which included
exiting the telecom business, and wrote down the value of those
assets to zero. Today we primarily sell standards-based products
to cable operators.

We were incorporated in California and
reincorporated in Delaware in 1998. Our principal executive
headquarters are located at 4988 Great America Parkway,
Santa Clara, California 95054. Our telephone number is
(408) 235-5500.



| |                  
| | -----------------
| | Industry Dynamics

We participate in the worldwide market for
equipment sold primarily to cable and satellite operators. Our
business is influenced by the following significant changes in
our industry:



| |                                 
| | --------------------------------
| | Increased broadband penetration.

As Internet usage by households continues to
increase, more consumers are electing to switch from dial up
access services to high-speed access services, particularly
those offered by cable operators in the United States. The
DellOro Group, an industry research firm, estimates the
number of worldwide cable modem users in 2003 was approximately
30.6 million, up nearly 30% from 22.9 million in 2002.
DellOro further projects that the number of cable modem
users will continue to grow in 2004, reaching approximately
38.7 million worldwide, an increase of approximately 25%
over 2003. By 2004, cable modem users are expected to represent
59.5% and 28.9% of all high-speed data subscribers in North
America and on a worldwide basis, respectively, based on data
from DellOro.



| |                                                           
| | ----------------------------------------------------------
| | Increased demand for triple play
    broadband services.

Within the last few years, certain cable
operators have begun to offer a triple play bundle
of services that includes voice, video and high-speed data, over
a single network, with the objective of capturing higher average
revenues per subscriber. We believe cable operators are well
positioned to deliver next-generation voice, video and data
services because:



| |   |                                                                                                                                                                                                                                      
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | cable operators have invested significantly over
    the past few years to upgrade their cable plants to digital
    networks; these upgrades allow them to leverage their incumbent
    video and high speed data positions further;
|
| |  | many cable operators have well equipped networks
    to offer video and two-way high speed data services to over 90%
    of their subscribers; and                                                                                   
|
| |  | cable operators existing Hybrid Fiber
    Co-axial (HFC) infrastructure is capable of delivering
    symmetrical high-bandwidth video, voice and data to the
    subscribers.                                                       



| |                                                                                                     
| | ----------------------------------------------------------------------------------------------------
| | Cable operators face increased competition
    from telecom operators for high-speed data solutions.

As competition from telecom operators continues
to increase, many cable operators are looking to their equipment
vendors, such as us, to provide cost-effective solutions to
enable the delivery of differentiated,

1



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robust service offerings to residential and
commercial subscribers. As cable operators add new subscribers
for these services, they must deploy CMTSs and customer premise
equipment (CPE), such as cable modems and embedded multimedia
terminal adapters. Cable operators have sought to compete with
telecom and satellite operators by delivering a differentiated
cost-effective bundled video, data and voice solution to their
subscribers or by providing more value such as guaranteed
downstream and upstream data rate speeds.




| |                                                                                                                      
| | ---------------------------------------------------------------------------------------------------------------------
| | Cable operators face increased competition
    from satellite operators and telecom providers for video
    services.

Cable operators have responded to the increasing
satellite operator digital video offerings by upgrading their
networks to provide comparable digital quality video as well as
other video services such as video-on-demand (VOD) and
pay-per-view (PPV). Recently several telecom operators have
undertaken initiatives such as fiber-to-the-premises
(FTTP) to potentially provide triple play services to their
subscribers. Certain telecom providers have successfully
deployed video over a digital subscriber line (DSL) to a
few markets and are exploring opportunities for additional
roll-outs. In addition, both cable and satellite operators have
recently begun providing high definition television (HDTV)
services to their subscribers. HDTV and VOD are bandwidth
intensive applications often requiring additional hardware and
software that vendors like us provide.



| |                                                           
| | ----------------------------------------------------------
| | Improved financial prospects for many cable
    operators.

Beginning in 2001, the communications industry
overall experienced a severe downturn, which resulted in a
significant reduction in capital spending for communications
equipment. Many cable operators were constrained by high debt
loads and, in a few cases, filed for bankruptcy. In addition,
consolidation in the cable industry, such as the merger of
Comcast Corporation (Comcast) and AT&T Broadband, also
contributed to a temporary reduction in capital spending. We
believe that the recent integration efforts in the industry, as
well as the completion of certain financial restructuring
actions, will allow many cable operators to increase their
investments in access equipment to provide advanced services to
their subscribers in a cost-effective manner. However, the cable
industry continues to face challenges. One of the largest
US cable companies, Adelphia, is still in bankruptcy and
other large cable operators continue to be constrained by
significant amounts of debt. In addition, cable operators may
attempt to expand their business through business combinations,
such as the unsolicited stock offering by Comcast for Disney
Corporation. Consequently, capital equipment expenditures by
cable operators may be limited for the near future, which may
adversely affect our revenues.



| |         
| | --------
| | Business

We develop, market and sell CMTSs, CPE (including
cable modems), imbedded multimedia terminal adapters, and
digital video equipment. Our CMTS and CPE products enable cable
operators to deliver and manage cost-effective broadband
Internet access and voice over Internet Protocol (VoIP)
telephone service. Our digital video equipment allows cable
operators, satellite providers and broadcasters to deliver
advanced digital video services. We focus on the development of
cable broadband access technologies that will improve cable
operators return on investment by leveraging their
existing infrastructure to deliver new broadband services to
residential and commercial subscribers at lower expense. We
believe this strategy will provide the following benefits to
cable operators: a competitive edge in winning new subscribers,
a reduction in subscriber turnover, faster recovery of
subscriber acquisition costs, increased revenues and reduced
operational and capital expenditures.

Over the last year, we completed the transition
from selling proprietary-based products to selling
standards-based products using the DOCSIS 2.0 specification. Due
primarily to the adoption of DOCSIS and our current position as
the only vendor of a DOCSIS 2.0 CMTS, qualified by Cable
Television Laboratories, Inc. (CableLabs), a cable industry
consortium that establishes cable technology standards and
administers compliance testing, we now generate DOCSIS CMTS and
cable modem sales to U.S. cable operators as well as to our
legacy global customers.

The delivery of broadband communication, which
includes voice, video and data, requires expertise in radio
frequency (RF), motion picture experts group (MPEG), and
Internet Protocol (IP). Our products

2



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leverage our expertise in these disciplines and
our experience in designing, developing and manufacturing
complex equipment, such as CMTSs and digital video headend
equipment. We provide our customers with an end-to-end set of
software and hardware products that allow them to deliver and
manage cost-effective, robust broadband offerings for
subscribers. Currently, we are the only vendor to the cable
industry with an end-to-end DOCSIS 2.0 cable data system
qualified and certified by CableLabs. We believe our
standards-based DOCSIS 2.0 cable data products enable cable
operators to deliver high-speed, symmetrical bandwidth to
subscribers cost-effectively. Our cable data equipment is DOCSIS
2.0 qualified and backwards compatible with DOCSIS 1.0 and
DOCSIS 1.1 CMTSs and cable modems. The DOCSIS 2.0 standard
incorporates advanced physical layer technologies, including
S-CDMA. With DOCSIS 2.0, we believe many cable operators can
realize compelling economic and performance advantages over
existing CMTSs through higher data rate channel throughput,
higher spectral efficiency and greater noise resiliency.


DOCSIS 2.0 increases the upstream throughput of
cable networks up to three times the capacity of DOCSIS 1.0 or
1.1. This greater upstream throughput is important for cable
operators as it enables them to more easily handle the greater
amount of upstream traffic on their networks as residential
subscribers increasingly host their own websites, swap music and
video files (this is commonly known as peer-to-peer
computing) and send large email attachments. Further, upstream
capacity is expected to become an increasingly important issue
as cable operators rollout residential VoIP cable telephony,
which is a symmetric two-way service that consumes as much
upstream bandwidth as it does downstream bandwidth.

In addition to enabling cable operators to
deliver as much upstream bandwidth as downstream bandwidth over
their networks, DOCSIS 2.0 is also more resistant to the noise
interference inherent in cable networks, allowing for more
reliable broadband service delivery. This greater reliability is
particularly important as cable operators increasingly seek to
expand their customer base beyond residential subscribers to
include small office/home office (SOHO) and small-to-medium
enterprise (SME) commercial customers. Providing commercial
voice and data services to these customers is potentially quite
lucrative, but requires very reliable service delivery in order
to lure these customers away from the telecom carriers they have
traditionally relied on.

In the digital video management system market,
our expertise in MPEG processing technologies has helped us
secure a leadership position in statistical remultiplexing and
providing the cable and satellite operators with bandwidth
management capabilities for standard (SD) and high
definition digital television (HDTV). Our digital video products
enable cable operators, satellite providers and broadcasters to
maximize their SD and HDTV digital programming through rate
shaping, grooming and advertisement insertion. We believe we are
well positioned to capitalize on the growing demand for cable
and satellite operators to provide advanced video services to
their subscribers, including bandwidth intensive applications
such as HDTV and VOD.



| |                  
| | -----------------
| | Business Strategy

Our goal is to be the leading provider of
intelligent broadband access and delivery solutions that
optimize the delivery of voice, video and data for broadband
service providers, primarily cable operators, on a worldwide
basis. To achieve this goal, we are pursuing the following
strategies:



| |   |                                                                                                                                                                                                                                          
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | increase our CMTS market share by exploiting our
    DOCSIS 2.0 expertise;                                                                                                                                                               
|
| |  | capitalize on the increasing demand for advanced
    video services, including HDTV and VOD, by leveraging our
    leading position in the market for digital video bandwidth
    management products;                                   
|
| |  | use our expertise in DOCSIS, IP, MPEG and RF
    technologies to evolve our solutions into an intelligent access
    platform capable of more effectively delivering and managing
    triple play bundled services for cable operators;

3



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| |   |                                                                                                                                            
| | - | -------------------------------------------------------------------------------------------------------------------------------------------
| |  | selectively enhance our CPE product portfolio to
    increase the value-add for cable operators to offer to their
    subscribers; and     
|
| |  | improve margins through focused product
    cost-reduction efforts and by streamlining operational
    activities across all product lines.



| |         
| | --------
| | Products

DOCSIS 2.0 CMTS
Products
Our DOCSIS 2.0 BlueWave (BW) 3000 CMTS product line
includes a scalable, carrier-class solution for cable operators
with demanding broadband applications and a compact solution
ideal for smaller or segmented cable networks. This product
family was designed from the outset to support integrated voice,
video and data broadband services. CMTSs are used by cable
operators to provide broadband services to cable modems and
other devices installed in their subscribers homes or
businesses.

Cable Modem
Products
Our TeraJet (TJ) 700 series of cable modems includes models
that are certified to meet the DOCSIS 1.1 and 2.0 and
Euro-DOCSIS 1.0 cable modem specifications. Our cable modems are
being deployed by eight of the largest cable operators based in
North America.

Embedded Multimedia Terminal Adapter
Products Our terminal
adapter (TA) series of embedded multimedia terminal adapters
(eMTA) are cable modems that support the delivery of VoIP-based
cable telephony service, in addition to high-speed Internet
access. The TA eMTAs are designed specifically for VoIP cable
telephony and are based on the PacketCable standard, which
CableLabs has developed for cable VoIP. Our eMTAs are also based
on the DOCSIS and Euro-DOCSIS specifications so they can be
deployed by cable operators worldwide.

Video
Products Our CherryPicker
DM 6400 and the BP5100 are both digital video management systems
utilizing advanced statistical remultiplexing technology to give
cable and satellite operators (using the DM 6400) and
broadcasters (using the BP5100) unprecedented flexibility in
managing their digital video content. The DM6400 and BP5100 are
both used for a variety of digital video applications, including
rate shaping to maximize bandwidth for SD and HD programming,
grooming customized channel line-ups, and seamlessly inserting
digital advertisements for local companies.

New
Products We maintain
ongoing research and development activities for our current
product lines and to determine the potential of possible future
products.

For current product lines, our research and
development efforts are focused on developing new features and
functionality that address customer requirements and which keep
our products competitive with products from other vendors.
Another key goal of our ongoing research and development
activities is to improve the gross margins for our existing
products by reducing the component and manufacturing costs of
these products.

We also put a great deal of research and
development effort into investigating potential future products
and technologies. Developing new and innovative solutions is
important for Terayon to remain competitive with larger
companies that devote considerably more resources to product
development.



| |          
| | ---------
| | Customers

We market and sell our data products to cable
operators that provide broadband services to both residential
and business subscribers. We market and sell our video products
to cable operators, satellite providers and broadcasters. Our
target market consists of the largest cable and satellite
operators and broadcasters in each major geographic area,
including North America, Europe and Asia.

4



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Our principal customers include the following:

Adelphia Communications Corporation

Comcast


Cox Communications, Inc.


Hughes Electronics (DirectTV)


EchoStar


J-Com (Cross Beam Networks), a subsidiary of
Sumitomo Corporation(Sumitomo)


i-CABLE Communications Limited


Thomson Electronics (Fox Broadcasting Company)


We believe that a substantial majority of our
revenues will continue to be derived from sales to a relatively
small number of customers for the foreseeable future. For
example, three customers (Adelphia, Cross Beam Networks, a
subsidiary of Sumitomo, and Comcast) accounted for approximately
22%, 16% and 13%, respectively, of our total revenues for the
year ended December 31, 2003. One customer (Cross Beam
Networks) accounted for approximately 28% of our total revenues
for the year ended December 31, 2002. Two customers (Shaw
Communications, Inc. (Shaw) and Cross Beam Networks)
accounted for approximately 33% and 13%, respectively, of the
total revenues for the year ended December 31, 2001. The
loss of any one of our significant customers could have a
material adverse effect on our business and results of
operations.



| |                   
| | ------------------
| | Market Competition

The market for cable equipment vendors is
extremely competitive and is characterized by rapid
technological change, and more recently, market consolidation.
In the past, most cable data systems were based on vendors
proprietary technology. As a result, CPE products, such as
modems, only worked with CMTSs from the same vendor, and
therefore operators generally had to purchase CMTSs and modems
from the same vendor. With the advent of DOCSIS certified and
qualified products, customers can purchase interoperable CMTSs
and CPE products from a variety of equipment manufacturers. The
move to standards-based products may lead to additional pricing
pressures and further declining gross margins.

In the market for cable data products our main
competitors in the sale of CMTSs are ADC, Arris, Cisco Systems
and Motorola. Our main competitors in the sale of CPE products
are Ambit, Motorola, Thomson and Toshiba.



| |                                                                                                                                                                                                                                                                             
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | In the market for video grooming and
    remultiplexing, we believe we are the market leader with our
    CherryPicker digital video management system. However, several
    companies have entered this market, including Motorola and
    privately held BigBand Networks.

The principal competitive factors in our market
include the following:



| |   |                                                           
| | - | ----------------------------------------------------------
| |  | product performance, features and reliability;            
|
| |  | price;                                                    
|
| |  | size and financial stability of operations;               
|
| |  | breadth of product line;                                  
|
| |  | sales and distribution capabilities;                      
|
| |  | technical support and service;                            
|
| |  | relationships with providers of service
    providers; and
|
| |  | compliance with industry standards.                       

Some of the above competitive factors are outside
of our control. Conditions in the market could change rapidly
and significantly as a result of technological advancements. The
development and market acceptance of alternative technologies
could decrease the demand for our products or render them
obsolete. Our competitors may introduce products that are less
costly, provide superior performance or achieve greater

5



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market acceptance than our products. Many of our
current and potential competitors have greater financial,
technical, marketing, distribution, customer support and other
resources, as well as better name recognition and access to
customers than we do. These competitive pressures have and are
likely to continue to adversely impact our business.




| |                    
| | -------------------
| | Sales and Marketing

We market and sell our products directly to
broadband service providers through our direct sales forces in
North America, Europe and Asia. We also market and sell our
products through distributors and resellers throughout the world.

We support our sales activities through marketing
communication vehicles, such as industry press, trade shows,
advertising and the web. Through our marketing efforts, we
strive to educate broadband service providers on the
technological and business benefits of our products, as well as
our ability to provide quality support and service. We
participate in the major trade shows and industry events for the
cable industry in the United States and throughout the world.
Industry referrals and reference accounts are significant
marketing tools we develop and utilize.

We also make our products available for customers
to test, which is very often a prerequisite for making a sale of
our CMTS or other complex products. These tests can be very
comprehensive and lengthy, which can dramatically increase the
sales cycle for these products. Participating in these tests
often requires us to devote considerable time and resources from
our engineering and customer support organizations.



| |                    
| | -------------------
| | International Sales

We have international sales offices in Belgium,
China (Shanghai), Hong Kong and Israel. In fiscal 2003, 2002 and
2001, approximately 44%, 68% and 82%, respectively of our net
revenues were from customers outside of the U.S. Sales to
Japan were 16%, 28% and 13%, in fiscal 2003, 2002 and 2001,
respectively. During 2003, we emphasized sales to U.S., Japanese
and other Asian customers while placing a lower emphasis on
other locations such as Canada, Israel and South America.
See Note 12 in our Notes to Consolidated Financial
Statements.

The majority of our international sales are
currently invoiced in U.S. dollars. However, we do enter
into certain transactions in Euros and other currencies.
Invoicing in other currencies subjects us to risks associated
with foreign exchange rate fluctuations. Although we do not
currently have any foreign currency hedging arrangements in
place, we will consider the need for hedging or other strategies
to minimize these risks if the amount of invoicing in non-dollar
denominated transactions materially increases.

Our international operations are subject to
certain risks common to foreign operations in general, such as
governmental regulations and import restrictions. In addition,
there are social, political, labor and economic conditions in
specific countries or regions as well as difficulties in
staffing and managing foreign operations, and potential adverse
foreign tax consequences, among other factors that could also
have an impact on our business and results of operations outside
of the United States.



| |                                           
| | ------------------------------------------
| | Customer Service and Technical
    Support

We believe that our ability to provide
consistently high quality service and support will be a key
factor in attracting and retaining customers. Our technical
services and support organization, with personnel in North
America, Europe, Israel and Asia, offers support
24 hours a day, seven days per week. Prior to the
deployment of our products, each customers needs are
assessed and proactive solutions are implemented, including
various levels of training, periodic management and coordination
meetings and problem escalation procedures.



| |        
| | -------
| | Backlog

Most of our revenues are generated from orders
booked and shipped within the current quarter. Assuming product
availability, our practice is to ship our products promptly upon
the receipt of purchase orders from our customers. Therefore, we
believe that backlog information is not material to an
understanding of our business.

6



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##### Table of Contents





| |              
| | -------------
| | Manufacturing

Most of our finished goods are produced by
subcontract manufacturers. During 2003, we produced modems
primarily in Thailand. Currently, we dual source our modems from
manufacturers in Thailand and Taiwan. Our data and video headend
equipment are dual sourced from manufacturers in San Jose,
California and Fremont, California.

Our manufacturing operations employ a wide
variety of semiconductors, electromechanical components and
assemblies and raw materials such as plastic resins and sheet
metal. Although we believe the materials and supplies necessary
for our manufacturing operations are currently available in the
quantities required, we sometimes experience a short supply of
certain component parts as a result of strong demand in the
industry for those parts.

Our subcontractors purchase materials, supplies
and product subassemblies from a substantial number of vendors.
For many of our products, there are existing alternate sources
of supply. However, we sole source certain components contained
in our products, such as the semiconductors used in our
products. While this has not resulted in material disruptions in
the past, should any change in these relationships or
disruptions to our vendors operations occur, our business
and results of operations could be adversely affected.

We are engaged in substantial research and
development activities to investigate the potential of possible
future products and to improve our existing products by adding
new functionality and by reducing their cost of manufacture. We
currently anticipate that overall research and development
spending in 2004 will decrease compared to 2003, but will be
more focused on product lines with more strategic importance to
the company. A key area for ongoing research and development
will be to develop new products and features that exploit the
capabilities of the Flexible CMTS architecture of our BW CMTSs.



| |                      
| | ---------------------
| | Intellectual Property

We rely on a combination of patent, trade secret,
copyright and trademark laws and contractual restrictions to
establish and protect proprietary rights in our products. Even
though we seek to establish and protect proprietary rights in
our products, there are risks. Our pending patent applications
may not be granted. Even if they are granted, the claims covered
by the patent may be reduced from those included in our
applications. Any patent might be subject to challenge in court
and, whether or not challenged, might not be broad enough to
prevent third parties from developing equivalent technologies or
products without a license from us.

We have entered into confidentiality and
invention assignment agreements with our employees, and we enter
into non-disclosure agreements with many of our suppliers,
distributors and appropriate customers so as to limit access to
and disclosure of our proprietary information. These contractual
arrangements, as well as statutory protections, may not prove to
be sufficient to prevent misappropriation of our technology or
deter independent third-party development of similar
technologies. In addition, the laws of some foreign countries
may not protect our intellectual property rights to the same
extent as do the laws of the United States. Litigation may be
necessary to enforce our intellectual property rights.

In connection with the development of the DOCSIS
2.0 specification by CableLabs, we entered into an agreement
with CableLabs whereby we licensed to CableLabs on a
royalty-free basis all of our intellectual property rights to
the extent that such rights may be asserted against a party
desiring to design, manufacture or sell DOCSIS based products,
including DOCSIS 2.0 based products. This license agreement
grants to CableLabs the right to sublicense our intellectual
property, including our intellectual property rights in our
S-CDMA patents, to manufacturers that compete with us in the
marketplace for DOCSIS based products.

We have received letters claiming that our
technology infringes the intellectual property rights of others.
We have consulted with our patent counsel and are in the process
of reviewing the allegations made by such third parties. If
these allegations were submitted to a court, the court could
find that our products infringe third party intellectual
property rights. If we are found to have infringed third party
rights, we could be subject to substantial damages and/or an
injunction preventing us from conducting our business. In
addition, other third parties may assert infringement claims
against us in the future. A claim of infringement, whether

7



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##### Table of Contents



meritorious or not, could be time-consuming,
result in costly litigation, divert our managements
resources, cause product shipment delays or require us to enter
into royalty or licensing arrangements. These royalty or
licensing arrangements may not be available on terms acceptable
to us, if at all.


We pursue the registration of our trademarks in
the United States and have applications pending to register
several of our trademarks throughout the world. However, the
laws of certain foreign countries might not protect our products
or intellectual property rights to the same extent as the laws
of the United States. Effective trademark, copyright, trade
secret and patent protection may not be available in every
country in which our products may be manufactured, marketed or
sold.



| |                      
| | ---------------------
| | Access to Our Reports

Our Internet Web site address is www.terayon.com.
Our annual reports on Form 10-K, quarterly reports on
Form 10-Q, current reports on Form 8-K, and amendments
to those reports filed or furnished pursuant to
Section 13(a) or 15 (d) of the Exchange Act are
available free of charge through our Web site as soon as
reasonably practicable after they are electronically filed with,
or furnished to, the Securities and Exchange Commission. We will
also provide those reports in electronic or paper form free of
charge upon a request made to Arthur T. Taylor, Chief
Financial Officer, c/o Terayon Communications Systems,
Inc., 4988 Great America Parkway, Santa Clara, CA 95054.
Furthermore, all reports we file with the Commission are
available free of charge via EDGAR through the Commissions
Web site at www.sec.gov. In addition, the public may read and
copy materials filed by us at the Commissions public
reference room located at 450 Fifth St., N.W.,
Washington, D.C., 20549.

Employees

As of December 31, 2003, we had 423
employees, of which 290 were located in the United States, 95 in
Israel and an aggregate of 38 in Canada, Europe, South America
and Asia. We had 229 employees in research and development, 88
in marketing, sales and customer support, 41 in operations and
65 in general and administrative functions. In connection with
our most recent restructuring that occurred in the first quarter
of 2004, we terminated the employment of approximately 70
employees or 17% of our workforce. None of our employees are
represented by collective bargaining agreements. We believe that
our relations with our employees are good.






|        |           
|------- | ----------
|Item 2. | Properties

Our principal executive offices are located in
Santa Clara, California where we lease approximately
141,000 square feet under a lease that expires in October
2009. In connection with our restructuring plans announced
January 27, 2004, we are seeking to sublease approximately
56,400 square feet of this space. In the United States, we
have additional facilities in Costa Mesa, California and Denver,
Colorado. A nominal amount of the additional facilities space is
subleased.

In addition, we lease properties worldwide. We
have a facility in Tel Aviv, Israel consisting of
approximately 136,000 square feet under a lease that
expires in October 2005. We currently sublease approximately
107,000 square feet of the Israel property. We have offices
in Hong Kong; Brussels; Belgium; Shanghai, China; and Ontario,
Canada. We believe that our existing facilities are adequate to
meet our needs for the foreseeable future. For additional
information regarding obligations under leases, see Note 3
to the Notes to Consolidated Financial Statements.






|        |                  
|------- | -----------------
|Item 3. | Legal Proceedings

Beginning in April 2000, several plaintiffs filed
class action lawsuits in federal court against us and certain of
our officers and directors. Later that year, the cases were
consolidated in the United States District Court, Northern
District of California as In re Terayon Communication
Systems, Inc. Securities Litigation. The Court then
appointed lead plaintiffs who filed an amended complaint. In
2001, the Court granted in part and denied in part
defendants motion to dismiss, and plaintiffs filed a new
complaint. In 2002, the Court denied defendants motion to
dismiss that complaint, which, like the earlier complaints,
alleges that the defendants

8



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##### Table of Contents



violated the federal securities laws by issuing
materially false and misleading statements and failing to
disclose material information regarding our technology. On
February 24, 2003, the Court certified a plaintiff class
consisting of those who purchased or otherwise acquired our
securities between November 15, 1999 and April 11,
2000.


On September 8, 2003, the Court heard
defendants motion to disqualify two of the lead plaintiffs
and to modify the definition of the plaintiff class. On
September 10, 2003, the Court issued an order vacating the
hearing date for the parties summary judgment motions,
and, on September 22, 2003, the Court issued another order
staying all discovery until further notice and vacating the
trial date, which had been November 4, 2003.

On February 23, 2004, the Court issued an
order disqualifying two of the lead plaintiffs. The order also
states that plaintiffs counsel must provide certain
information to the Court about counsels relationship with
the disqualified lead plaintiffs, and it provides that
defendants may serve certain additional discovery.

On October 16, 2000, a lawsuit was filed
against us and the individual defendants (Zaki Rakib, Selim
Rakib and Raymond Fritz) in the California Superior Court,
San Luis Obispo County. This lawsuit is titled
Bertram v. Terayon Communications Systems, Inc.
The factual allegations in the Bertram complaint were
similar to those in the federal class action, but the
Bertram complaint sought remedies under state law.
Defendants removed the Bertramcase to the United States
District Court, Central District of California, which dismissed
the complaint and transferred the case to the United States
District Court, Northern District of California. That Court
eventually issued an order dismissing the case. Plaintiffs have
appealed this order, and their appeal has been set for oral
argument on April 16, 2004.

We believe that the allegations in both the class
action and the Bertramcase are without merit, and we
intend to contest these matters vigorously. These matters,
however, could prove costly and time consuming to defend, and
there can be no assurances about the eventual outcome.

On January 19, 2003, Omniband Group Limited,
a Russian company, or Omniband, filed a request for arbitration
with the Zurich Chamber of Commerce, claiming damages in an
amount of $2,094,970 allegedly caused by our breach of an
agreement to sell to Omniband certain equipment pursuant to an
agreement between Omniband and Radwiz, Ltd., one of our
wholly-owned subsidiaries. On December 18, 2003, the panel
of arbiters with the Zurich Chamber of Commerce allowed the
arbitration proceeding to continue against Radwiz. We believe
that the allegations are without merit and intend to present a
vigorous defense in the arbitration proceedings.

We, as well as our customers, have received
letters from third parties claiming that our technology and
products infringe on the third parties patents. We have
consulted with our patent counsel and are in the process of
reviewing the allegations made by such third parties. We do not
know whether the third parties will pursue their claims of
patent infringement in court, and if they do, whether we will be
found to infringe the third parties patents. If we are
found to have infringed such third party patents, we could be
subject to substantial damages and/or an injunction preventing
us from selling our products and conducting our business.
Additionally, additional third parties could assert infringement
claims against us in the future. Any such claim of patent
infringement, whether meritorious or not, could be
time-consuming, result in costly litigation, cause product
shipment delays or require us to enter into royalty or licensing
agreements. Such royalty or licensing agreements may not be
available on terms acceptable to us, if at all.

We are currently a party to various other legal
proceedings, in addition to those noted above, and may become
involved from time to time in other legal proceedings in the
future. While we currently believe that the ultimate outcome of
these other proceedings, individually and in the aggregate, will
not have a material adverse effect on our financial position or
overall results of operations, litigation is subject to inherent
uncertainties. Were an unfavorable ruling to occur in any of our
legal proceedings, there exists the possibility of a material
adverse impact on our results of operations for the period in
which the ruling occurs. The estimate of the potential impact on
our financial position and overall results of operations for any
of the above legal proceedings could change in the future.

9



---



##### Table of Contents








|        |                                                        
|------- | -------------------------------------------------------
|Item 4. | Submission of Matters to a Vote of Security
    Holders

There were no matters submitted to a vote of
security holders in the fourth quarter of 2003.




PART II






|        |                                                                              
|------- | -----------------------------------------------------------------------------
|Item 5. | Market for the Registrants Common
    Equity and Related Stockholder Matters

Our common stock is traded on the Nasdaq National
Market under the symbol TERN. Public trading of our
common stock commenced on August 18, 1998. Prior to that
time, there was no public market for our common stock. The
following table sets forth, for the periods indicated, the high
and low per share sale prices of our common stock, as reported
by the Nasdaq National Market.

|      |                |      |   |      |  |  |   |      | 
|----- | -------------- | ---- | - | ---- |  |  | - | ---- | 
|      |                | High |   | Low 
|      |                |      |   |     
|2003: |                |      |   |      |  |  |   |     
|      | First Quarter  |      | $ | 2.84 |  |  | $ | 1.39 | 
|      | Second Quarter |      | $ | 3.20 |  |  | $ | 1.57 | 
|      | Third Quarter  |      | $ | 8.25 |  |  | $ | 2.52 | 
|      | Fourth Quarter |      | $ | 8.04 |  |  | $ | 4.05 | 
|2002: |                |      |   |      |  |  |   |     
|      | First Quarter  |      | $ | 9.35 |  |  | $ | 5.48 | 
|      | Second Quarter |      | $ | 8.48 |  |  | $ | 0.86 | 
|      | Third Quarter  |      | $ | 3.62 |  |  | $ | 1.10 | 
|      | Fourth Quarter |      | $ | 2.97 |  |  | $ | 1.51 | 

As of March 1, 2004, there were
approximately 632 holders of record of our common stock, as
shown on the records of our transfer agent. The number of record
holders does not include shares held in street name
through brokers.

We do not pay any cash dividends on our common
stock. We currently expect to retain future earnings, if any,
for use in the operation and expansion of our business and do
not anticipate paying any cash dividends in the foreseeable
future.

10



---



##### Table of Contents



The following table summarizes our equity
compensation plan information as of December 31, 2003.
Information is included for both equity compensation plans
approved by our stockholders and equity compensation plans not
approved by our stockholders.

|                                                                      |  |                    |            |                    |  |                           |      |  |  |  |            |    
|--------------------------------------------------------------------- |  | ------------------ | ---------- | ------------------ |  | ------------------------- | ---- |  |  |  | ---------- | ---
|                                                                      |  | Common Stock to    |            |                    |  | Common Stock Available   
|                                                                      |  | be Issued upon     |            | Weighted-Average   |  | for Future Issuance Under
|                                                                      |  | Exercise of        |            | Exercise Price of  |  | Equity Compensation Plans
|                                                                      |  | Outstanding        |            | Outstanding        |  | (Excluding Securities    
|                                                                      |  | Options and Rights |            | Options and Rights |  | Reflected in Column (a)) 
|Plan Category                                                         |  |                    |            |                    |  |                          
|                                                                      |  | (a)                |            | (b)                |  | (c)                      
|Equity compensation plans approved by Terayon
    stockholders(1)     |  |                    | 8,364,757  |                    |  | $                         | 5.17 |  |  |  | 16,134,118 |    
|Equity compensation plans not approved by Terayon
    stockholders(2) |  |                    | 9,099,202  |                    |  | $                         | 7.06 |  |  |  | 12,211,593 |    
|                                                                      |  |                    |            |                    |  |                           |      |  |  |  |            |    
|Totals                                                                |  |                    | 17,463,959 |                    |  | $                         | 6.20 |  |  |  | 28,345,711 | (3)
|                                                                      |  |                    |            |                    |  |                           |      |  |  |  |            |    



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Includes options to purchase common stock
    outstanding under the Terayon Communication Systems, Inc.
    1995 Stock Option Plan as amended, Terayon Communication
    Systems, Inc. 1997 Equity Incentive Plan as amended,
    Terayon Communication Systems, Inc. 1998 Employee Stock
    Purchase Plan as amended, Terayon Communication
    Systems, Inc. 1998 Non-Employee Directors Stock Option Plan
    as amended, and the Terayon Communication Systems, Inc.
    1998 Employee Stock Purchase Plan Offering for Foreign Employees.
|   
|(2) | Includes options to purchase the Terayon
    Communication Systems, Inc. 1999 Non-Officer Equity
    Incentive Plan, as amended. See Note 9 in Notes to
    Consolidated Financial Statements.                                                                                                                                                                                                                                                                                                                                                 
|   
|(3) | Includes 2,400,152 shares of common stock
    available for purchase under the Terayon Communication
    Systems, Inc. 1998 Employee Stock Purchase Plan.                                                                                                                                                                                                                                                                                                                                                                                      



| |          
| | ---------
| | 1995 Plan

In March 1995, our Board of Directors approved a
stock option plan (1995 Plan) that authorized shares for future
issuance to be granted as options to purchase shares of our
common stock. As of December 31, 2003 a total of
4,229,494 shares have been authorized for issuance related
to the 1995 Plan.



| |          
| | ---------
| | 1997 Plan

In March 1997, our Board of Directors approved an
equity incentive plan (1997 Plan) that authorized
1,600,000 shares for future issuance to be granted as
options to purchase shares of our common stock. In June 1998,
our Board of Directors authorized the adoption of the amended
1997 Plan, increasing the aggregate number of shares authorized
for issuance under the 1997 Plan to 6,600,000 shares
(5,000,000 additional shares). The amendment also provided for
an increase to the authorized shares each year on
January 1, starting with January 1, 1999, if the
number of shares reserved for future issuance was less than 5%
of our outstanding common stock, then the authorized shares
would be increased to a balance equal to 5% of the common stock
outstanding. There were no increases to the 1997 Plan in 1998 or
1999. On January 1, 2000, 2,384,528 shares were added
to the 1997 Plan for a total of 8,984,528 shares.

The 1997 Plan was amended on June 13, 2000
to increase the shares authorized for issuance by
3,770,000 additional shares and to provide for an increase
in the number of shares of common stock beginning
January 1, 2000 through January 1, 2007, by the lesser
of 5% of the common stock outstanding on such January 1 or
3,000,000 shares. In May 2003, the Companys Board of
Directors authorized the adoption of an amendment to reduce the
number of authorized shares in the 1997 Plan by
6,237,826 shares. As of December 31, 2003, a total of
15,516,702 shares have been authorized for issuance related
to the 1997 Plan.

11



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##### Table of Contents





| |          
| | ---------
| | 1998 Plan

In June 1998, the our Board of Directors
authorized the adoption of the 1998 Non-Employee Directors
Stock Option Plan (1998 Plan), pursuant to which
400,000 shares of our common stock have been reserved for
future issuance to our non-employee directors. In 2002, our
Board of Directors amended the 1998 Plan to increase the shares
authorized for issuance by 400,000 additional shares. As of
December 31, 2003, a total of 800,000 shares have been
authorized for issuance related to the 1998 Plan.



| |          
| | ---------
| | 1999 Plan

In September 1999, our Board of Directors
authorized the adoption of the 1999 Non-Officers Equity
Incentive Plan (1999 Plan), pursuant to which
6,000,000 shares of our common stock have been reserved for
future issuance to our non-officer employees. The plan has been
amended by our Board of Directors to increase the amount of
authorized shares available. Additionally, in May 2003, our
Board of Directors authorized the adoption of an amendment to
reduce the number of authorized shares in the 1999 Plan by
13,762,174 shares. As of December 31, 2003, a total of
14,737,826 shares have been authorized for issuance related
to the 1999 Plan.

The 1995 and 1997 Plans provide for incentive
stock options or nonqualified stock options to be issued to
employees, directors, and our consultants. Prices for incentive
stock options may not be less than the fair market value of the
common stock at the date of grant. Prices for nonqualified stock
options may not be less than 85% of the fair market value of the
common stock at the date of grant. Options are immediately
exercisable and vest over a period not to exceed five years from
the date of grant. Any unvested stock issued is subject to
repurchase by us at the original issuance price upon termination
of the option holders employment. Unexercised options
expire ten years after the date of grant.

The 1998 Plan provides for non-discretionary
nonqualified stock options to be issued to our non-employee
directors automatically as of the effective date of their
election to the Board of Directors and annually following each
annual stockholder meeting. Prices for nonqualified options may
not be less than 100% of the fair market value of the common
stock at the date of grant. Options generally vest and become
exercisable over a period not to exceed three years from the
date of grant. Unexercised options expire ten years after the
date of grant.

The 1999 Plan provides for nonqualified stock
options to be issued to our non-officer employees and
consultants. Prices for nonqualified stock options may not be
less than 85% of the fair market value of the common stock at
the date of the grant. Options generally vest and become
exercisable over a period not to exceed five years from the date
of grant. Unexercised options expire ten years after date of
grant.

12



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##### Table of Contents








|        |                        
|------- | -----------------------
|Item 6. | Selected Financial Data

The following tables contain selected financial
data as of and for each of the five years ended
December 31, 2003, 2002, 2001, 2000, and 1999 and are
derived from our financial statements. The selected financial
data are qualified by reference to, and should be read in
conjunction with, our financial statements and the notes to
those financial statements and Managements Discussion and
Analysis of Financial Condition and Results of Operations.

|                                                                     |                                                  |                                       |         |        |  |      |         |         |  |      |          |         |  |   |          |         |  |   |         |        | 
|-------------------------------------------------------------------- | ------------------------------------------------ | ------------------------------------- | ------- | ------ |  | ---- | ------- | ------- |  | ---- | -------- | ------- |  | - | -------- | ------- |  | - | ------- | ------ | 
|                                                                     |                                                  |                                      
|                                                                     |                                                  | Years Ended December 31,             
|                                                                     |                                                  |                                      
|                                                                     |                                                  | 2003                                  |         | 2002   |  | 2001 |         | 2000    |  | 1999
|                                                                     |                                                  |                                       |         |        |  |      |         |         |  |     
|                                                                     |                                                  |                                      
|                                                                     |                                                  | (In thousands, except per share data)
|Consolidated statement of operations data:                           |                                                  |                                       |         |        |  |      |         |         |  |      |          |         |  |   |          |         |  |   |         |       
|Revenues                                                             |                                                  | $                                     | 133,485 |        |  | $    | 129,403 |         |  | $    | 279,481  |         |  | $ | 339,549  |         |  | $ | 97,009  |       
|Cost of goods sold                                                   |                                                  |                                       | 101,034 |        |  |      | 100,949 |         |  |      | 263,117  |         |  |   | 289,531  |         |  |   | 72,044  |       
|                                                                     |                                                  |                                       |         |        |  |      |         |         |  |      |          |         |  |   |          |         |  |   |         |       
|Gross profit                                                         |                                                  |                                       | 32,451  |        |  |      | 28,454  |         |  |      | 16,364   |         |  |   | 50,018   |         |  |   | 24,965  |       
|                                                                     |                                                  |                                       |         |        |  |      |         |         |  |      |          |         |  |   |          |         |  |   |         |       
|Operating expenses:                                                  |                                                  |                                       |         |        |  |      |         |         |  |      |          |         |  |   |          |         |  |   |         |       
|                                                                     | Research and development                         |                                       |         | 42,839 |  |      |         | 58,696  |  |      |          | 79,927  |  |   |          | 68,270  |  |   |         | 17,579 | 
|                                                                     | Cost of product development assistance agreement |                                       |         |       |  |      |         |        |  |      |          |        |  |   |          | 9,563   |  |   |         | 35,147 | 
|                                                                     | In-process research and development              |                                       |         |       |  |      |         |        |  |      |          |        |  |   |          | 30,535  |  |   |         | 14,600 | 
|                                                                     | Sales and marketing                              |                                       |         | 26,781 |  |      |         | 35,704  |  |      |          | 55,701  |  |   |          | 45,261  |  |   |         | 15,727 | 
|                                                                     | General and administrative                       |                                       |         | 12,127 |  |      |         | 14,715  |  |      |          | 31,309  |  |   |          | 24,809  |  |   |         | 7,476  | 
|                                                                     | Goodwill amortization                            |                                       |         |       |  |      |         |        |  |      |          | 25,410  |  |   |          | 59,057  |  |   |         | 3,524  | 
|                                                                     | Restructuring and asset write-offs(1)            |                                       |         | 2,803  |  |      |         | 8,922   |  |      |          | 587,149 |  |   |          |        |  |   |         |       | 
|                                                                     |                                                  |                                       |         |        |  |      |         |         |  |      |          |         |  |   |          |         |  |   |         |       
|                                                                     | Total operating expenses                         |                                       |         | 84,550 |  |      |         | 118,037 |  |      |          | 779,496 |  |   |          | 237,495 |  |   |         | 94,053 | 
|                                                                     |                                                  |                                       |         |        |  |      |         |         |  |      |          |         |  |   |          |         |  |   |         |       
|Loss from operations                                                 |                                                  |                                       | (52,099 | )      |  |      | (89,583 | )       |  |      | (763,132 | )       |  |   | (187,477 | )       |  |   | (69,088 | )     
|Interest income (expense) and other income
    (expense), net        |                                                  |                                       | 2,062   |        |  |      | (3,481  | )       |  |      | 44       |         |  |   | 6,710    |         |  |   | 5,008   |       
|Gain on early retirement of debt(2)                                  |                                                  |                                       |        |        |  |      | 49,089  |         |  |      | 185,327  |         |  |   |         |         |  |   |        |       
|Income tax (expense) benefit                                         |                                                  |                                       | (316    | )      |  |      | (238    | )       |  |      | 13,915   |         |  |   |         |         |  |   |        |       
|                                                                     |                                                  |                                       |         |        |  |      |         |         |  |      |          |         |  |   |          |         |  |   |         |       
|Net loss                                                             |                                                  | $                                     | (50,353 | )      |  | $    | (44,213 | )       |  | $    | (563,846 | )       |  | $ | (180,767 | )       |  | $ | (64,080 | )     
|                                                                     |                                                  |                                       |         |        |  |      |         |         |  |      |          |         |  |   |          |         |  |   |         |       
|Basic and diluted net loss per share                                 |                                                  | $                                     | (0.68   | )      |  | $    | (0.61   | )       |  | $    | (8.25    | )       |  | $ | (2.95    | )       |  | $ | (1.55   | )     
|                                                                     |                                                  |                                       |         |        |  |      |         |         |  |      |          |         |  |   |          |         |  |   |         |       
|Shares used in computing basic and diluted net
    loss per share(3) |                                                  |                                       | 74,212  |        |  |      | 72,803  |         |  |      | 68,331   |         |  |   | 61,349   |         |  |   | 41,260  |       
|                                                                     |                                                  |                                       |         |        |  |      |         |         |  |      |          |         |  |   |          |         |  |   |         |       

|                                                  |  |                |          |      |  |      |          |      |  |      |          |   |  |   |           |   |  |   |          |  
|------------------------------------------------- |  | -------------- | -------- | ---- |  | ---- | -------- | ---- |  | ---- | -------- | - |  | - | --------- | - |  | - | -------- | -
|                                                  |  |               
|                                                  |  | December 31,  
|                                                  |  |               
|                                                  |  | 2003           |          | 2002 |  | 2001 |          | 2000 |  | 1999
|                                                  |  |                |          |      |  |      |          |      |  |     
|                                                  |  |               
|                                                  |  | (In thousands)
|Consolidated Balance Sheet Data:                  |  |                |          |      |  |      |          |      |  |      |          |   |  |   |           |   |  |   |          |  
|Cash, cash equivalents and short-term investments |  | $              | 138,640  |      |  | $    | 206,503  |      |  | $    | 333,888  |   |  | $ | 562,457   |   |  | $ | 112,992  |  
|Working capital                                   |  |                | 135,943  |      |  |      | 172,829  |      |  |      | 316,175  |   |  |   | 547,938   |   |  |   | 112,374  |  
|Total assets                                      |  |                | 215,240  |      |  |      | 275,710  |      |  |      | 466,646  |   |  |   | 1,426,727 |   |  |   | 301,236  |  
|Long-term obligations (less current portion)(3)   |  |                | 68,447   |      |  |      | 68,580   |      |  |      | 178,641  |   |  |   | 500,477   |   |  |   | 37       |  
|Accumulated deficit                               |  |                | (987,560 | )    |  |      | (937,207 | )    |  |      | (892,994 | ) |  |   | (329,148  | ) |  |   | (148,381 | )
|Total stockholders equity                        |  | $              | 91,388   |      |  | $    | 137,142  |      |  | $    | 180,304  |   |  | $ | 702,681   |   |  | $ | 258,655  |  



---



|    |                                                                                                                                                                                    
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | See Note 5 of Notes to Consolidated
    Financial Statements for an explanation for restructuring and
    asset write-offs.                                                        
|   
|(2) | See Note 7 of Notes to Consolidated
    Financial Statements for an explanation of the repurchase of
    subordinated convertible notes and reclassification of related
    gains. 
|   
|(3) | See Note 1 of Notes to Consolidated
    Financial Statements for an explanation of the method employed
    to determine the number of shares used to compute per share
    amounts.

13



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##### Table of Contents








|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|Item 7. | Managements Discussion and Analysis
    of Financial Condition and Results of Operations

The following discussion and analysis is intended
to provide an investor with a narrative of our financial results
and an evaluation of our financial condition and results of
operations. The discussion should be read in conjunction with
our consolidated financial statements and notes thereto.

Overview

We develop, market and sell cable modem
termination systems (CMTS), customer premise equipment (CPE)
products, including cable modems, and digital video equipment.
Our revenues are generated principally from sales of these three
major product groups either directly to broadband service
providers through direct sales forces primarily in North
America, Europe and Asia and through resellers.

Over the last year, we completed the transition
from selling proprietary-based products to selling
standards-based products using the Data Over Cable System
Interface Specification (DOCSIS) 2.0 specification. We now
generate DOCSIS CMTS and cable modem sales to U.S. cable
operators as well as to our legacy global customers.

Over the last year, we completed the transition
from selling proprietary-based products to selling
standards-based products using the Data Over Cable System
Interface Specification (DOCSIS) 2.0 specification. Due
primarily to the adoption of DOCSIS 2.0 and our current
position as the only vendor with qualified DOCSIS 2.0 CMTS,
we now generate DOCSIS CMTS and cable modem sales to
U.S. cable operators as well as to global customers.

Our gross margins fluctuate from period to period
primarily as a result of the mix of products we sell.
Specifically, we derive substantially higher margins from sales
of our CMTS and digital video equipment products than we do from
sales of our CPE products, which are subject to intense price
competition. To date a majority of our total revenues are
generated by sales of our CPE products. We also believe that the
widespread adoption of industry specifications, such as the
DOCSIS specifications, will further erode ASPs. We anticipate
that the erosion of ASPs of our CPEs will continue, and price
erosion will accelerate in the first half of 2004. We are
working to mitigate pressures on our gross margins by continuing
to focus on product manufacturing cost reductions, especially
for our CPE products, by transitioning to a new Original Design
Manufacturer (ODM) in Asia during the first half of 2004. To the
extent that the containment of our product costs do not keep
pace with ASP declines, our gross margins will be adversely
affected.

We have not been profitable since our inception.
We had a net loss of $50.4 million or $0.68 per share
for the year ended December 31, 2003, and a net loss of
$44.2 million or $0.61 per share for the year ended
December 31, 2002. We are targeting profitability to begin
in the second quarter of 2004, and we believe our ability to
achieve profitability in the long term will depend primarily on
three factors. The first factor is our ability to achieve
improved gross margins through an improved sales mix by
increasing sales of higher margin digital video and CMTS
products relating to expected CPE product growth. To increase
sales of digital video products, we are targeting new markets
such as the broadcast sector and promoting new applications such
as high definition television (HDTV) and digital insertion to
cable satellite operators. To grow the CMTS business, we will
attempt to capitalize on our DOCSIS 2.0 expertise and
provide application solutions for DOCSIS 2.0 advanced
services, including voice over Internet Protocol (VoIP) and
commercial services. To the extent that sales of CPE products
continue to comprise a greater proportion of our total revenues,
our ability to achieve profitability could be adversely
affected. Secondly, we will continue to focus on lowering
product costs for modems through our new ODM relationship in
Asia and the introduction of our new lower cost semiconductor,
which is used in cable modems. In our CMTS business, we will
continue to reduce costs through improved designs, better
leveraging of our contract manufacture supply network, and the
reduction of sole source components. Finally, as discussed
below, we expect to benefit from a lower expense base resulting
in part from a restructuring in the first quarter of 2004
combined with continued focus on cost containment. However,
despite these efforts, we may not succeed in attaining
profitability in the near future, if at all.

When the downturn in the communications industry
became evident in fiscal 2001, we began to implement
restructuring plans to reduce operating expenses and capital
spending and to narrow the focus of

14



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##### Table of Contents



our business. As it became evident in fiscal 2002
that our industry was experiencing an even more pronounced and
prolonged economic downturn, we took additional measures to
align our cost structure. Our most recent restructuring occurred
in the first quarter of 2004 whereby, we initiated a worldwide
reduction in force of approximately 70 employees, or 17% of
the workforce, consolidated certain facilities, and reduced or
eliminated certain discretionary costs and programs. We expect
to record total charges in the range of approximately
$5.0 million to $7.0 million associated with this
realignment in the quarter ending March 31, 2004. Beginning
in the second quarter of 2004, we anticipate annual savings to
be approximately $10.0 million to $12.0 million.
Furthermore, as part of our restructuring efforts to refocus our
business, we sold or discontinued certain lines of products. We
may continue to divest unprofitable product lines in an effort
to focus on growing our business profitably and redirect our
resources. However, despite these restructuring actions, we may
not be able to meet expected revenue levels in any particular
period or attain profitability in any future period.


At December 31, 2003, we had approximately
$138.6 million in cash, cash equivalents and short-term
investments as compared to approximately $206.5 million at
December 31, 2002. The significant decrease in the amount
of cash and cash equivalents in 2003 as compared to 2002
primarily resulted from significant uses of cash for operating
activities in 2003. Although we believe that our current cash
balances will be sufficient to satisfy our cash requirements for
at least the next 12 months, we may need to raise
additional funds in order to support more rapid expansion,
develop new or enhanced services, respond to competitive
pressures, acquire complementary businesses or technologies or
respond to unanticipated requirements. There can be no assurance
that additional financing will be available on acceptable terms,
if at all. If adequate funds are not available or are not
available on acceptable terms, we may be unable to continue
operations, develop our products, take advantage of future
opportunities or respond to competitive pressures or
unanticipated requirements, which could have a material adverse
effect on our business, financial condition and operating
results.

Our ability to grow our business and attain
profitability is dependent on our ability to effectively compete
in the marketplace with our current products and services,
develop and introduce new products and services, contain
operating expenses and improve our gross margins, as well as the
continued recovery of the communications industry. A more
detailed description of the risks to our business can be found
in the section captioned Risk Factors in this annual
report.

Results of Operations



| |                                                             
| | ------------------------------------------------------------
| | Comparison of the Years Ended
    December 31, 2003 and 2002



| |         
| | --------
| | Revenues

|         |  |                    |         |                 |  |           |         |  |  |  |    | 
|-------- |  | ------------------ | ------- | --------------- |  | --------- | ------- |  |  |  | -- | 
|         |  |                    |         |                
|         |  | For the Year Ended |         |                
|         |  | December 31,       |         |                
|         |  |                    |         | Annual % Change
|         |  | 2003               |         | 2002            |  | 2003/2002
|         |  |                    |         |                 |  |          
|         |  |                    |         |                
|         |  | (In thousands)     |         |                
|Revenues |  | $                  | 133,485 |                 |  | $         | 129,403 |  |  |  | 3% | 

We sell our products directly to broadband
service providers, and to a lesser extent resellers. Revenues
related to product sales are recognized when:
(1) persuasive evidence of an arrangement exists,
(2) delivery has occurred or services rendered,
(3) the selling price is fixed or determinable, and
(4) collectibility is reasonably assured. A provision is
made for estimated product returns as product shipments are
made. Our existing agreements typically do not grant return
rights beyond those provided by the warranty. Revenue
arrangements with resellers are generally recognized when
product is shipped to the resellers as we generally do not grant
return rights beyond those provided by the warranty.

Revenues consist primarily of sales of products
to new and existing customers providing broadband services.
Prior to December 31, 2002, we operated primarily in two
principal operating segments: Cable Broadband Access Systems
(Cable) and Telecom Carrier Access Systems (Telecom). Beginning
in 2003, the Telecom segment no longer met the quantitative
threshold for disclosure and we operated as one business segment.

15



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##### Table of Contents



Our revenues increased 3% to $133.5 million
for the year ended December 31, 2003 from
$129.4 million in 2002, primarily due to increased sales of
DOCSIS CMTS and CPE products, particularly in the second half of
2003, partially offset by declining sales of our proprietary
S-CDMA CMTS and CPE products and Telecom products.



| |                                           
| | ------------------------------------------
| | Revenues by Groups of Similar
    Products

|                     |                |                    |   |                 |         |           |   |        |         |  |  |     |    |  
|-------------------- | -------------- | ------------------ | - | --------------- | ------- | --------- | - | ------ | ------- |  |  | --- | -- | -
|                     |                |                    |   |                
|                     |                | For the Year Ended |   |                
|                     |                | December 31,       |   |                
|                     |                |                    |   | Annual % Change
|                     |                | 2003               |   | 2002            |         | 2003/2002
|                     |                |                    |   |                 |         |          
|                     |                |                    |   |                
|                     |                | (In thousands)     |   |                
|Revenues by product: |                |                    |   |                 |         |           |   |        |         |  |  |    
|                     | CMTS products  |                    | $ | 47,486          |         |           | $ | 28,159 |         |  |  | 69  | % 
|                     | CPE products   |                    |   | 64,808          |         |           |   | 69,469 |         |  |  | (7  | )%
|                     | Video products |                    |   | 17,710          |         |           |   | 20,832 |         |  |  | (15 | )%
|                     | Other products |                    |   | 3,481           |         |           |   | 10,943 |         |  |  | (68 | )%
|                     |                |                    |   |                 |         |           |   |        |         |  |  |    
|                     |                | Total              |   | $               | 133,485 |           |   | $      | 129,403 |  |  |     | 3  | %
|                     |                |                    |   |                 |         |           |   |        |         |  |  |    

CMTS product revenues increased 69% in 2003
compared to 2002, due to increased deployment of our DOCSIS
products into new markets, primarily in the U.S. We expect
CMTS revenues to continue to increase in 2004 as we continue to
expand sales into the U.S., Asia and Europe.

CPE product revenues decreased 7% in 2003
compared to 2002, due to a continuing decline in ASPs, partially
offset by increases in the volume of modem sales. The number of
DOCSIS modems sold increased from 0.4 million units in 2002
to 1.2 million units in 2003. The intensely competitive
nature of the market for broadband products resulted in
significant price erosion. We anticipate that modem unit price
erosion will continue in the first half of 2004. However, we
believe that our full transition to an ODM in Asia during the
first half of 2004 and the introduction of our new lower cost
modem semiconductor may allow us to remain competitive in the
marketplace and maintain favorable margins on these products.
CPE revenues also decreased due to the shift in product mix from
our higher-priced proprietary S-CDMA modems to our lower-priced
DOCSIS modems. The number of S-CDMA modems sold decreased from
0.4 million units in 2002 to 0.1 million units in 2003.

Revenues from video products decreased 15% in
2003 compared to 2002, due to decreased sales to
U.S. Multiple System Operators (MSOs). We attribute this
decline to lower capital spending by MSOs, primarily in the
first half of 2003. However, we have seen growth in sales of our
Network Cherrypicker 6400, especially in the second half of
2003, and we believe that we will continue to see increased
sales of video products as demand for high definition television
(HDTV) and other video services grows in 2004.

Other product revenues decreased 68% in 2003
compared to 2002, due to decreased sales of our legacy Telecom
products. We expect sales of Telecom products to be minimal in
2004.

16



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##### Table of Contents





| |                              
| | -----------------------------
| | Revenues by Geographic Region

|                              |                       |                    |   |                 |         |           |   |        |         |  |  |     |    |  
|----------------------------- | --------------------- | ------------------ | - | --------------- | ------- | --------- | - | ------ | ------- |  |  | --- | -- | -
|                              |                       |                    |   |                
|                              |                       | For the Year Ended |   |                
|                              |                       | December 31,       |   |                
|                              |                       |                    |   | Annual % Change
|                              |                       | 2003               |   | 2002            |         | 2003/2002
|                              |                       |                    |   |                 |         |          
|                              |                       |                    |   |                
|                              |                       | (In thousands)     |   |                
|Revenues by geographic areas: |                       |                    |   |                 |         |           |   |        |         |  |  |    
|                              | United States         |                    | $ | 74,341          |         |           | $ | 41,150 |         |  |  | 81  | % 
|                              | Canada                |                    |   | 3,145           |         |           |   | 17,247 |         |  |  | (82 | )%
|                              | Europe                |                    |   | 17,635          |         |           |   | 11,381 |         |  |  | 55  | % 
|                              | Israel                |                    |   | 7,038           |         |           |   | 8,283  |         |  |  | (15 | )%
|                              | Japan                 |                    |   | 21,183          |         |           |   | 36,214 |         |  |  | (42 | )%
|                              | Asia, excluding Japan |                    |   | 9,575           |         |           |   | 11,845 |         |  |  | (19 | )%
|                              | South America         |                    |   | 568             |         |           |   | 3,283  |         |  |  | (83 | )%
|                              |                       |                    |   |                 |         |           |   |        |         |  |  |    
|                              |                       | Total              |   | $               | 133,485 |           |   | $      | 129,403 |  |  |     | 3  | %
|                              |                       |                    |   |                 |         |           |   |        |         |  |  |    

Revenues in the United States increased 81% to
$74.3 million in 2003, up from $41.2 million in 2002,
due to increased sales of DOCSIS 2.0 CMTSs, modems and
video products to U.S. MSOs. During 2003, we emphasized
sales to our U.S., European, Japanese and other Asian customers
while placing a lower emphasis on other locations such as
Canada, Israel and South America. In 2004, we expect revenues to
increase in the United States, Asian and European markets. Three
customers, Adelphia Communications Corporation (Adelphia), J-Com
(Cross Beam Networks), a subsidiary of Sumitomo, and Comcast
each accounted for more than 10% of our total revenues for the
year ended December 31, 2003 (22%, 16%, 13%). One customer,
Cross Beam Networks accounted for more than 10% of our total
revenues for the year ended December 31, 2002 (28%).



| |                       
| | ----------------------
| | Related Party Revenues

|                        |                   |                              |   |                 |       |           |   |       |       |  |  |     |     |   
|----------------------- | ----------------- | ---------------------------- | - | --------------- | ----- | --------- | - | ----- | ----- |  |  | --- | --- | --
|                        |                   |                              |   |                
|                        |                   | For the Year Ended           |   |                
|                        |                   | December 31,                 |   |                
|                        |                   |                              |   | Annual % Change
|                        |                   | 2003                         |   | 2002            |       | 2003/2002
|                        |                   |                              |   |                 |       |          
|                        |                   |                              |   |                
|                        |                   | (In thousands)               |   |                
|Related party revenues: |                   |                              |   |                 |       |           |   |       |       |  |  |    
|                        | Rogers revenues   |                              | $ | 1,453           |       |           | $ | 8,040 |       |  |  | (82 | )% 
|                        | Harmonic revenues |                              |   | 3,241           |       |           |   | 1,057 |       |  |  | 207 | %  
|                        |                   |                              |   |                 |       |           |   |       |       |  |  |    
|                        |                   | Total related party revenues |   | $               | 4,694 |           |   | $     | 9,097 |  |  |     | (48 | )%
|                        |                   |                              |   |                 |       |           |   |       |       |  |  |    

Related party revenues decreased 48% in 2003
compared to 2002. Related party revenues in 2002 included
revenues from Rogers Communications, Inc. (Rogers) and
Harmonic, Inc. (Harmonic). Alek Krstajic, a member of our
board of directors, was the Senior Vice President of Interactive
Services, Sales and Product Development for Rogers until January
2003. Effective in April 2003, Rogers was no longer a related
party to us. Consequently, revenues attributable to Rogers are
only classified as related party revenues in the first quarter
of 2003. Lewis Solomon, another member of our board of
directors, is a member of the board of directors of Harmonic.
All revenues attributable to Harmonic were included in related
party revenues in 2003 and 2002. The decline in related party
revenues was primarily due to the classification of revenues
attributable to Rogers as general revenues instead of related
party revenues after the first quarter of 2003, as well as lower
overall sales to Rogers, offset by an increase of sales to
Harmonic in 2003. None of our related parties is a supplier to
us.

In December 2001, we entered into co-marketing
arrangements with Shaw Communications, Inc. (Shaw) and
Rogers. We paid $7.5 million to Shaw and $0.9 million
to Rogers, and recorded these amounts as other current assets.
In July 2002, we began amortizing these prepaid assets and
charging them against related party revenues in accordance with
Emerging Issues Task Force (EITF) 01-09, Accounting for
Consideration

17



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##### Table of Contents



given by a Vendor to a Customer or Reseller in
Connection with the Purchase or Promotion of the Vendors
Products. We charged $1.4 million per quarter of the
amortization of these assets against total revenues through
December 31, 2003. Amounts charged against total revenues
in the year ended December 31, 2002 and December 31,
2003, totaled approximately $2.8 million and
$5.6 million, respectively. Of the co-marketing
amortization charged to total revenues, $0.15 million and
$0.3 million were charged to related party revenue in the
year ended 2003 and 2002, respectively. No further amounts of
these co-marketing arrangements are included in other current
assets at December 31, 2003 and no further amortization
will occur in 2004.




| |                                    
| | -----------------------------------
| | Cost of Goods Sold and Gross Profit

|                               |  |                    |         |                 |  |      |         |  |  |  |     |   
|------------------------------ |  | ------------------ | ------- | --------------- |  | ---- | ------- |  |  |  | --- | --
|                               |  |                    |         |                
|                               |  | For the Year Ended |         |                
|                               |  | December 31,       |         |                
|                               |  |                    |         | Annual % Change
|                               |  | 2003               |         | 2002            |  | 2003
|                               |  |                    |         |                 |  |     
|                               |  |                    |         |                
|                               |  | (In thousands)     |         |                
|Cost of product revenues       |  | $                  | 99,261  |                 |  | $    | 92,497  |  |  |  | 7   | % 
|Cost of related party revenues |  |                    | 1,773   |                 |  |      | 8,452   |  |  |  | (79 | )%
|                               |  |                    |         |                 |  |      |         |  |  |  |     |   
|Total cost of goods sold       |  | $                  | 101,034 |                 |  | $    | 100,949 |  |  |  |    |   
|                               |  |                    |         |                 |  |      |         |  |  |  |     |   
|Gross profit                   |  | $                  | 32,451  |                 |  | $    | 28,454  |  |  |  | 14  | % 
|                               |  |                    |         |                 |  |      |         |  |  |  |     |   

Cost of goods sold consists of direct product
costs as well as the cost of our manufacturing operations. The
cost of manufacturing includes contract manufacturing, test and
quality assurance for products, warranty costs and associated
costs of personnel and equipment. In 2003, cost of goods sold
was approximately 76% of revenues compared to 78% of revenues in
2002. Cost of goods sold in 2003 and 2002 included the benefit
of reversals of approximately $10.0 million and
$15.3 million, respectively, in special charges taken in
2001 and 2000 for vendor cancellation charges and inventory
previously reserved for as excess and obsolete. We reversed
these provisions as we were able to sell inventory originally
considered to be in excess and obsolete. In addition, we were
able to negotiate downward certain vendor cancellation claims to
terms more favorable to us. Additionally, during 2003 and 2002,
we recorded inventory charges of $4.1 million and
$6.1 million, respectively, to reduce some of our inventory
due to excess and obsolescence and to reduce the inventory to
the lower of cost or market value in 2002 as ASPs fell below the
cost of these products and to record charges for excess and
obsolete inventory.

In 2003, related party cost of revenues decreased
compared to 2002 due to increased sales of our higher margin
video products to Harmonic in 2003 as well as fewer sales of our
lower margin CPE products to Rogers classified as related party
revenue in 2003 compared to 2002. Additionally, in the first
quarter of 2003, we sold $0.8 million of software to
Rogers, which was classified as related party revenues, with no
cost of related party revenues associated with this sale.

Our gross profit increased 14% to
$32.5 million or 24% of sales in the year ended
December 31, 2003 compared to $28.5 million, or 22% of
sales, in 2002. The increase in our gross profit was primarily
related to an improved sales mix, with higher margin video and
CMTS products constituting a higher proportion of sales
particularly in the second half of 2003, and improved product
manufacturing costs for modems.

During 2004, we anticipate further decreases in
our ASPs and continued pressure on our CPE margins.
Consequently, we continue to focus on improving sales of higher
margin products and reducing product manufacturing costs. We are
now partnering with contract manufacturers in Asia and the
U.S. for our CMTS, CPE, and video products, which may
provide us with more competitive component pricing, economies of
scale, and improved manufacturing capabilities. In addition, we
are currently evaluating possible outsourcing partnerships for
certain of our supply chain functions, with the objective of
increasing our focus on our core competencies, reducing our
costs, and leveraging our target partners capabilities. As
we endeavor to shift our product mix from CPE revenues to higher
margin CMTS and digital video product revenues, we expect our
margins to increase.

18



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##### Table of Contents





| |                   
| | ------------------
| | Operating Expenses

|                           |  |                    |        |                 |  |           |        |  |  |  |     |   
|-------------------------- |  | ------------------ | ------ | --------------- |  | --------- | ------ |  |  |  | --- | --
|                           |  |                    |        |                
|                           |  | For the Year Ended |        |                
|                           |  | December 31,       |        |                
|                           |  |                    |        | Annual % Change
|                           |  | 2003               |        | 2002            |  | 2003/2002
|                           |  |                    |        |                 |  |          
|                           |  |                    |        |                
|                           |  | (In thousands)     |        |                
|Research and development   |  | $                  | 42,839 |                 |  | $         | 58,696 |  |  |  | (27 | )%
|Sales and marketing        |  | $                  | 26,781 |                 |  | $         | 35,704 |  |  |  | (25 | )%
|General and administrative |  | $                  | 12,127 |                 |  | $         | 14,715 |  |  |  | (18 | )%

Research and
Development.Research and development
expenses consist primarily of personnel costs, internally
designed prototype material expenditures, and expenditures for
outside engineering consultants, equipment and supplies required
to develop and enhance our products. Research and development
expenses decreased 27% to $42.8 million or 32% of sales in
the year ended December 31, 2003 from $58.7 million or
45% of sales in 2002. The $15.9 million decrease in
research and development expenses was attributable to
$4.2 million of reductions in employee related expenses,
partially offset by an increase of $0.1 million
attributable to an executive incentive plan implemented in 2003.
The decrease in research and development expense also included
reductions of $0.6 million of outside engineering
consultants and $7.1 million of reductions in purchases of
materials, costs incurred to develop prototypes, and other
research and development expenses. Additionally, we have reduced
research and development efforts by $4.1 million due to the
elimination of our Telecom-related products. We believe it is
critical to continue to make significant investments in research
and development to create innovative technologies and products
that meet the current and future requirements of our customers.
Accordingly, we intend to continue our investment in research
and development although at slightly lower levels. In connection
with our worldwide restructuring plan announced in January 2004,
we currently expect research and development expenses to
continue to decrease in 2004.

Sales and Marketing.Sales and marketing expenses consist primarily of salaries and
commissions for sales personnel, and marketing and support
personnel, and costs related to trade shows, consulting and
travel. Sales and marketing expenses decreased by
$8.9 million to $26.8 million or 20% of sales in the
year ended December 31, 2003 from $35.7 million or 28%
of sales in 2002. The decrease in sales and marketing expenses
was primarily due to $5.2 million in reduced employee
expenses due to lower headcount, partially offset by an increase
of $0.3 million attributable to an executive incentive
plan. The decrease in sales and marketing expenses also included
$0.8 million of decreased spending for outside consultants,
$0.9 million of decreased travel costs, and
$2.3 million of overall sales and marketing cost
reductions. In connection with our worldwide restructuring plan
announced in January 2004, we currently expect sales and
marketing expenses to continue to decrease in 2004.

General and
Administrative.General and
administrative expenses consist primarily of salary and benefits
for administrative officers and support personnel, travel
expenses and legal, accounting and consulting fees. General and
administrative expenses decreased by $2.6 million or 18% of
sales to $12.1 million or 9% of sales in the year ended
December 31, 2003 from $14.7 million or 11% of sales
in 2002. The decrease was primarily due to $1.4 million in
reduced employee expenses due to lower headcount, partially
offset by an increase of $0.4 million attributable to an
executive incentive plan, $2.8 million of decreased
spending for outside consultants, partially offset by
$0.3 million of severance expense related to the
termination of an executive officer and $0.9 million of
overall general and administrative cost increases. In connection
with our worldwide restructuring plan announced in January 2004,
we currently expect general and administrative expenses to
continue to decrease in 2004.

19



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| |                                             
| | --------------------------------------------
| | Restructuring Costs and Asset
    Write-offs

|                                         |  |                    |       |      |  |   |       | 
|---------------------------------------- |  | ------------------ | ----- | ---- |  | - | ----- | 
|                                         |  |                   
|                                         |  | For the Year Ended
|                                         |  | December 31,      
|                                         |  |                   
|                                         |  | 2003               |       | 2002
|                                         |  |                    |       |     
|                                         |  |                   
|                                         |  | (In thousands)    
|Restructuring charges                    |  | $                  | 2,745 |      |  | $ | 3,641 | 
|Restructuring (recovery)                 |  |                    | (359  | )    |  |   |      | 
|Long-lived assets written-off            |  |                    | 417   |      |  |   | 1,309 | 
|Intangible assets written off            |  |                    |      |      |  |   | 3,972 | 
|                                         |  |                    |       |      |  |   |       | 
|Restructuring costs and asset write-offs |  | $                  | 2,803 |      |  | $ | 8,922 | 
|                                         |  |                    |       |      |  |   |       | 

Restructuring Costs.During the first quarter of 2003, we initiated a restructuring
program to conform our expenses to our revenue levels and to
better position us for future growth and eventual profitability.
We incurred restructuring charges in the amount of
$2.7 million related to employee termination costs. At
December 31, 2003, no restructuring charges remain accrued,
81 of our employees have been terminated under the 2003
restructuring plan, and we paid $2.7 million in termination
costs. In the second and third quarter of 2003, we reversed
$0.4 million of previously accrued termination costs
related to this restructuring.

In the third quarter of 2002, we initiated a
restructuring program to conform our expense to our revenue
levels and to better position us for future growth and eventual
profitability. As part of this program, we restructured our
worldwide operations including a worldwide reduction in
workforce and the consolidation of excess facilities. We
incurred additional restructuring charges of $3.6 million
in 2002. Of the total restructuring charge, $2.3 million
was related to employee termination costs. The remaining
$1.3 million related primarily to costs for excess leased
facilities. During 2002, 153 employees have been terminated
under the 2002 restructuring plan, and we made cash payments of
$2.2 million against the restructuring accrual.
Additionally, in 2002, we reclassified $0.1 million from
employee termination costs to excess leased facilities costs. We
anticipate the remaining restructuring accrual, primarily
relating to excess leased facilities, will be utilized for
servicing operating lease payments or negotiated buyout of
operating lease commitments, through 2005.

In 2001 we incurred restructuring charges of
$12.7 million. Of the total restructuring charges recorded,
$3.2 million related to employee termination costs covering
293 technical, production, and administrative employees. The
remaining $9.5 million of restructuring charges related
primarily to costs for excess leased facilities. During 2003, we
made cash payments and recoveries of $1.9 million against
the restructuring accrual. As of December 31, 2003,
restructuring charges of $3.3 million remain accrued,
primarily related to excess facility costs. During 2003, we
reversed $0.3 million of previously accrued termination
costs due to a change in estimate. We anticipate utilizing the
remaining restructuring accrual of $3.3 million, which
relates to servicing operating lease payments or negotiated
buyout of operating lease commitments, through 2005.

Asset Write-offs.In
connection with our restructuring in 2003, we wrote-off
$0.4 million of fixed assets which were determined to have
no remaining useful life. In connection with our restructuring
in 2002, we wrote-off $1.3 million of fixed assets which
were determined to have no remaining useful life.

We adopted Statement of Financial Accounting
Standards Goodwill and Other Intangible Assets,
(SFAS No. 142) on January 1, 2002. We tested
goodwill for impairment using the two-step process prescribed in
SFAS No. 142. The first step is a screen for potential
impairment, while the second step measures the amount of the
impairment, if any. We completed the initial goodwill impairment
review as of the beginning of 2002, and found no impairment. Due
to a difficult economic environment and heightened price
competition in the modem and telecom businesses during the three
months ended June 30, 2002, we experienced a significant
drop in our market capitalization, and therefore proceeded to
perform an interim test to measure goodwill and intangible
assets for impairment at June 30, 2002. Based on our
forecast, the estimated undiscounted future cash flows from the
use of the goodwill would be less than its carrying amount. We
determined that the outcome of this test reflected that the fair
value of the goodwill was zero. This

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resulted in a non-cash charge of
$4.0 million to write off the remaining goodwill in 2002,
of which $3.0 million was related to the Cable segment and
$1.0 million was related to the Telecom segment.




| |                       
| | ----------------------
| | Non-Operating Expenses

|                                 |  |                    |        |                 |  |           |        |   |  |  |     |   
|-------------------------------- |  | ------------------ | ------ | --------------- |  | --------- | ------ | - |  |  | --- | --
|                                 |  |                    |        |                
|                                 |  | For the Year Ended |        |                
|                                 |  | December 31,       |        |                
|                                 |  |                    |        | Annual % Change
|                                 |  | 2003               |        | 2002            |  | 2003/2002
|                                 |  |                    |        |                 |  |          
|                                 |  |                    |        |                
|                                 |  | (In thousands)     |        |                
|Interest income                  |  | $                  | 2,917  |                 |  | $         | 6,838  |   |  |  | (57 | )%
|Interest expense                 |  | $                  | (3,279 | )               |  | $         | (6,174 | ) |  |  | (47 | )%
|Other expense                    |  | $                  | (2,424 | )               |  | $         | (4,145 | ) |  |  | (42 | )%
|Gain on early retirement of debt |  | $                  |       |                 |  | $         | 49,089 |   |  |  |    |   

Interest Income.Interest income decreased 57% to $2.9 million in 2003
compared to $6.8 million in 2002. The decrease in interest
income was primarily due to lower invested average cash balances
due to the use of cash to repurchase Convertible Subordinated
Notes (Notes) in 2002 and usage of cash for operations, as well
as lower interest rates.

Interest Expense.Interest expense, which related primarily to interest on our
Notes due in 2007, decreased 47% to $3.3 million during
2003 compared to $6.2 million in 2002, primarily due to the
repurchase of $109.1 million of our Notes in 2002.

Other Expense.Other
expense is generally comprised of realization of foreign
currency translations and realized gains or losses on
investments. Other expense of $2.4 million in 2003, was
primarily comprised of a $0.9 million gain on the sale of
the Miniplex product line and related inventory to Verilink, a
$0.6 million reversal of a liability associated with an
overseas government grant which is now satisfied, and
$0.7 million from a favorable legal settlement. Other
expense in 2002 included a write-down of a $4.5 million
long-term investment.

Gain on Early Retirement of
Debt.In 2002, we repurchased
approximately $109.1 million of our Notes for
$57.6 million in cash, resulting in a gain included in
operations of approximately $49.1 million net of related
unamortized issuance costs of $2.4 million. We did not
repurchase any Notes during 2003.



| |             
| | ------------
| | Income Taxes

|                   |  |                    |      |      |  |   |      |  
|------------------ |  | ------------------ | ---- | ---- |  | - | ---- | -
|                   |  |                   
|                   |  | For the Year Ended
|                   |  | December 31,      
|                   |  |                   
|                   |  | 2003               |      | 2002
|                   |  |                    |      |     
|                   |  |                   
|                   |  | (In thousands)    
|Income tax expense |  | $                  | (316 | )    |  | $ | (238 | )

We have generated losses since our inception. In
2003 and 2002, we recorded an income tax expense of
$0.3 million and $0.2 million, respectively, which was
related primarily to foreign taxes.



| |                                                             
| | ------------------------------------------------------------
| | Comparison of the Years Ended
    December 31, 2002 and 2001



| |         
| | --------
| | Revenues

|                  |                  |                    |   |                 |         |           |   |         |         |  |  |     |     |   
|----------------- | ---------------- | ------------------ | - | --------------- | ------- | --------- | - | ------- | ------- |  |  | --- | --- | --
|                  |                  |                    |   |                
|                  |                  | For the Year Ended |   |                
|                  |                  | December 31,       |   |                
|                  |                  |                    |   | Annual % Change
|                  |                  | 2002               |   | 2001            |         | 2002/2001
|                  |                  |                    |   |                 |         |          
|                  |                  |                    |   |                
|                  |                  | (In thousands)     |   |                
|Product revenues: |                  |                    |   |                 |         |           |   |         |         |  |  |    
|                  | Cable revenues   |                    | $ | 118,929         |         |           | $ | 245,828 |         |  |  | (52 | )% 
|                  | Telecom revenues |                    |   | 10,474          |         |           |   | 33,653  |         |  |  | (69 | )% 
|                  |                  |                    |   |                 |         |           |   |         |         |  |  |    
|                  |                  | Total revenues     |   | $               | 129,403 |           |   | $       | 279,481 |  |  |     | (54 | )%
|                  |                  |                    |   |                 |         |           |   |         |         |  |  |    

21



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Prior to December 31, 2002, we operated
primarily in two principal operating segments: Cable and
Telecom. We determined these reportable operating segments based
upon how the businesses were managed and operated.

Cable Broadband Access Systems (Cable)
Revenue.Revenues from Cable were
$118.9 million for the year ended December 31, 2002,
down 52% from $245.8 million in 2001 due to lower shipments
of modems and head-ends in 2002 than in 2001, as well as a
continued decline in ASPs of products year over year as ongoing
competitive pricing pressures affected revenue performance in
several of our Cable products.

Telecom Carrier Access Systems (Telecom)
Revenue.Revenues from Telecom were
$10.5 million, down 69% from $33.7 million in 2001. We
had a small customer base, and revenues were impacted by
significant declines in telecom industry spending. Additionally,
we continued to decrease focus on our Telecom segment and apply
our resources to our Cable segment.

During 2002, the cable industry moved to purchase
more standards-based DOCSIS products as opposed to our
proprietary modems and head-ends, and we faced increased
competition from multiple vendors, which unfavorably impacted
revenues. Further, during 2001 and 2002, we were unfavorably
impacted by declines in ASPs of our modems. In addition,
revenues from our Telecom segment were impacted by declines in
telecom industry spending. The intensely competitive nature of
the market for broadband products resulted in significant price
erosion in 2002.



| |                                           
| | ------------------------------------------
| | Revenues by Groups of Similar
    Products

|                     |                          |                    |   |                 |         |           |   |         |         |  |  |     |     |   
|-------------------- | ------------------------ | ------------------ | - | --------------- | ------- | --------- | - | ------- | ------- |  |  | --- | --- | --
|                     |                          |                    |   |                
|                     |                          | For the Year Ended |   |                
|                     |                          | December 31,       |   |                
|                     |                          |                    |   | Annual % Change
|                     |                          | 2002               |   | 2001            |         | 2002/2001
|                     |                          |                    |   |                 |         |          
|                     |                          |                    |   |                
|                     |                          | (In thousands)     |   |                
|Revenues by product: |                          |                    |   |                 |         |           |   |         |         |  |  |    
|                     | CMTS products            |                    | $ | 28,159          |         |           | $ | 43,355  |         |  |  | (35 | )% 
|                     | CPE products             |                    |   | 69,469          |         |           |   | 186,111 |         |  |  | (63 | )% 
|                     | Video products           |                    |   | 20,832          |         |           |   | 16,363  |         |  |  | 27  | %  
|                     | Other (Telecom) products |                    |   | 10,943          |         |           |   | 33,652  |         |  |  | (67 | )% 
|                     |                          |                    |   |                 |         |           |   |         |         |  |  |    
|                     |                          | Total              |   | $               | 129,403 |           |   | $       | 279,481 |  |  |     | (54 | )%
|                     |                          |                    |   |                 |         |           |   |         |         |  |  |    

CMTS, CPE and other product revenues decreased in
2002 compared to 2001, due to the slowdown in the general
economy, constraints on technology-related capital spending by
cable service providers, increased competition, and the decline
of ASPs in 2001 and 2002. Additionally, our CMTS and CPE
revenues decreased in 2002 as we transitioned from our
proprietary S-CDMA products to DOCSIS products. Sales of our
Video products increased primarily due to sales of our Network
Cherrypicker products. Other product revenue decreased due to
the de-emphasis of our legacy Telecom products.

22



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##### Table of Contents





| |                              
| | -----------------------------
| | Revenues by Geographic Region

|                              |                       |                    |   |                 |         |           |   |         |         |  |  |     |     |   
|----------------------------- | --------------------- | ------------------ | - | --------------- | ------- | --------- | - | ------- | ------- |  |  | --- | --- | --
|                              |                       |                    |   |                
|                              |                       | For the Year Ended |   |                
|                              |                       | December 31,       |   |                
|                              |                       |                    |   | Annual % Change
|                              |                       | 2002               |   | 2001            |         | 2002/2001
|                              |                       |                    |   |                 |         |          
|                              |                       |                    |   |                
|                              |                       | (In thousands)     |   |                
|Revenues by geographic areas: |                       |                    |   |                 |         |           |   |         |         |  |  |    
|                              | United States         |                    | $ | 41,150          |         |           | $ | 50,291  |         |  |  | (18 | )% 
|                              | Canada                |                    |   | 17,247          |         |           |   | 113,300 |         |  |  | (85 | )% 
|                              | Europe                |                    |   | 11,381          |         |           |   | 34,952  |         |  |  | (67 | )% 
|                              | Israel                |                    |   | 8,283           |         |           |   | 16,528  |         |  |  | (50 | )% 
|                              | Japan                 |                    |   | 36,214          |         |           |   | 37,721  |         |  |  | (4  | )% 
|                              | Asia, excluding Japan |                    |   | 11,845          |         |           |   | 24,094  |         |  |  | (51 | )% 
|                              | South America         |                    |   | 3,283           |         |           |   | 2,595   |         |  |  | 27  | %  
|                              |                       |                    |   |                 |         |           |   |         |         |  |  |    
|                              |                       | Total              |   | $               | 129,403 |           |   | $       | 279,481 |  |  |     | (54 | )%
|                              |                       |                    |   |                 |         |           |   |         |         |  |  |    

Revenues in North America, which included the
United States and Canada decreased 64% to $58.4 million in
2002, down from $163.6 million in 2001. Revenues from
international locations decreased 39% to $71.0 million in
2002 down from $115.9 million in 2001. One customer, Cross
Beam Networks, a subsidiary of Sumitomo, accounted for more than
10% of our total revenues for the year ended December 31,
2002 (28%). Two customers, Cross Beam Networks and Shaw, each
accounted for more than 10% of our total revenues for the year
ended December 31, 2001 (33% and 13%). Decrease in
revenues, year over year and decrease in North American revenues
were primarily due to the slowdown in the general economy,
over-capacity of broadband products especially in North America,
and constraints on technology-related capital spending, in
particular by the cable service providers.



| |                       
| | ----------------------
| | Related Party Revenues

|                        |                   |                    |   |                 |       |           |   |        |        |  |  |     |     |   
|----------------------- | ----------------- | ------------------ | - | --------------- | ----- | --------- | - | ------ | ------ |  |  | --- | --- | --
|                        |                   |                    |   |                
|                        |                   | For the Year Ended |   |                
|                        |                   | December 31,       |   |                
|                        |                   |                    |   | Annual % Change
|                        |                   | 2002               |   | 2001            |       | 2002/2001
|                        |                   |                    |   |                 |       |          
|                        |                   |                    |   |                
|                        |                   | (In thousands)     |   |                
|Related party revenues: |                   |                    |   |                 |       |           |   |        |        |  |  |    
|                        | Rogers revenues   |                    | $ | 8,040           |       |           | $ | 21,045 |        |  |  | (62 | )% 
|                        | Harmonic revenues |                    |   | 1,057           |       |           |   |       |        |  |  |    |    
|                        | Shaw revenue      |                    |   |                |       |           |   | 31,400 |        |  |  |    |    
|                        |                   |                    |   |                 |       |           |   |        |        |  |  |    
|                        |                   | Total revenues     |   | $               | 9,097 |           |   | $      | 52,445 |  |  |     | (83 | )%
|                        |                   |                    |   |                 |       |           |   |        |        |  |  |    

Related party revenues decreased 83% to
$9.1 million for the year ended December 31, 2002 from
$52.4 million in 2001. Related party revenues in 2002
included revenues from Rogers and Harmonic. Alek Krstajic, a
member of our board of directors, was the Senior Vice President
of Interactive Services, Sales and Product Development for
Rogers until January 2003. Lewis Solomon, another member of our
board of directors, is a member of the board of directors of
Harmonic. The decline in related party revenues was primarily
due to the same economic and competitive pressures discussed
above. In addition, Shaw was a related party during the first
three quarters of 2001. In the fourth quarter of 2001, Shaw was
no longer determined to be a related party as they no longer
exercised voting rights over their shares of our stock, and a
board member that was an employee of Shaw resigned from our
board of directors. Accordingly, revenues from Shaw were no
longer included in related party revenues beginning in the
fourth quarter of 2001. None of our related parties is a
supplier to us.

23



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##### Table of Contents





| |                                    
| | -----------------------------------
| | Cost of Goods Sold and Gross Profit

|                               |  |                    |         |                 |  |      |         |  |  |  |     |   
|------------------------------ |  | ------------------ | ------- | --------------- |  | ---- | ------- |  |  |  | --- | --
|                               |  |                    |         |                
|                               |  | For the Year Ended |         |                
|                               |  | December 31,       |         |                
|                               |  |                    |         | Annual % Change
|                               |  | 2002               |         | 2001            |  | 2002
|                               |  |                    |         |                 |  |     
|                               |  |                    |         |                
|                               |  | (In thousands)     |         |                
|Cost of product revenues       |  | $                  | 92,497  |                 |  | $    | 229,936 |  |  |  | (60 | )%
|Cost of related party revenues |  |                    | 8,452   |                 |  |      | 33,181  |  |  |  | (75 | )%
|                               |  |                    |         |                 |  |      |         |  |  |  |     |   
|Total cost of goods sold       |  | $                  | 100,949 |                 |  | $    | 263,117 |  |  |  | (62 | )%
|                               |  |                    |         |                 |  |      |         |  |  |  |     |   
|Gross profit                   |  | $                  | 28,454  |                 |  | $    | 16,364  |  |  |  | 74  | % 
|                               |  |                    |         |                 |  |      |         |  |  |  |     |   

Cost of goods sold consists of direct product
costs as well as the cost of our manufacturing operations. The
cost of manufacturing includes contract manufacturing, test and
quality assurance for products, warranty costs and associated
costs of personnel and equipment. In 2002, cost of goods sold
decreased 62% to $100.9 million or 78% of revenues from
$263.1 million or 94% of revenues in 2001. Cost of goods
sold in 2002 included the benefit of a reversal of approximately
$15.3 million in special charges taken in 2001 and 2000 for
vendor cancellation charges and inventory previously reserved
for obsolescence. We reversed this provision as we were able to
sell inventory originally considered to be in excess. In
addition, we were able to negotiate downward certain vendor
cancellation claims to terms more favorable to us. Cost of goods
sold for the year ended December 31, 2001 included special
charges of $33.5 million and approximately
$13.9 million of amortization of acquired intangible
assets. Additionally, during 2002, we recorded an inventory
charge of $6.1 million to reduce some of our inventory due
to excess and obsolescence and to reduce the inventory to the
lower of cost or market value as ASPs fell below the cost of
these products. No charge to record a lower of cost or market
value was recorded by us in 2001. In accordance with
SFAS No. 142, there was no amortization of acquired
intangible assets in 2002.

We achieved a gross profit of $28.5 million
or 22% of sales in the year ended December 31, 2002
compared to $16.4 million or 6% of sales in 2001. The
increase in our gross profit was primarily related to a reversal
of special charges in 2002. This decrease in gross profit
excluding special charges and amortization was primarily due to
decreases in ASPs. We were not able to decrease our cost of
goods sold as quickly as the decrease in ASPs.

In 2002, related party cost of revenues decreased
compared to 2001 primarily due to Shaw no longer being a related
party to us beginning in the fourth quarter of 2001.



| |                   
| | ------------------
| | Operating Expenses

|                           |  |                    |        |                 |  |           |        |  |  |  |     |   
|-------------------------- |  | ------------------ | ------ | --------------- |  | --------- | ------ |  |  |  | --- | --
|                           |  |                    |        |                
|                           |  | For the Year Ended |        |                
|                           |  | December 31,       |        |                
|                           |  |                    |        | Annual % Change
|                           |  | 2002               |        | 2001            |  | 2002/2001
|                           |  |                    |        |                 |  |          
|                           |  |                    |        |                
|                           |  | (In thousands)     |        |                
|Research and development   |  | $                  | 58,696 |                 |  | $         | 79,927 |  |  |  | (27 | )%
|Sales and marketing        |  | $                  | 35,704 |                 |  | $         | 55,701 |  |  |  | (36 | )%
|General and administrative |  | $                  | 14,715 |                 |  | $         | 31,309 |  |  |  | (53 | )%
|Goodwill amortization      |  |                    |       |                 |  | $         | 25,410 |  |  |  |    |   

Research and
Development.Research and development
expenses consist primarily of personnel costs, internally
designed prototype material expenditures, expenditures for
outside engineering consultants, and equipment and supplies
required to develop and enhance our products. Research and
development expenses decreased to $58.7 million or 45% of
sales in the year ended December 31, 2002 from
$79.9 million or 29% of sales in 2001. The decrease of
$21.2 million was attributable to a $7.5 million
decline in spending in our Cable segment, an $8.0 million
decline in spending in our Telecom segment, and a
$5.7 million reduction in amortization of intangible
assets. Research and development expenses in the Cable segment
decreased primarily due to reductions in employee related
expenses and expenditures for outside engineering consultants.
Discontinuing the development of our Digitrans product line
contributed to $1.6 million of the Cable segment

24



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##### Table of Contents



expense reduction. Additionally, we reduced
research and development efforts in our Telecom segment by
$8.0 million due to market conditions in the Telecom
sector. In 2001, we recorded amortization of acquired intangible
assets of $5.7 million. In accordance with
SFAS No. 142, there was no amortization in 2002.


Sales and Marketing.Sales and marketing expenses consist primarily of salaries and
commissions for sales personnel, marketing and support
personnel, and costs related to trade shows, consulting and
travel. Sales and marketing expenses decreased by
$20.0 million to $35.7 million or 28% of sales in the
year ended December 31, 2002 from $55.7 million or 20%
of sales in 2001. The decrease in sales and marketing expenses
was primarily due to $8.5 million in decreased headcount
from the restructuring and other expenses in our Telecom
segment, and $7.2 million in decreased spending for
promotional activities in our Cable segment. The decreased
spending for promotional activities in the Cable segment,
included a $2.2 million decrease in employee salaries and
related costs, a $2.0 million decrease in co-marketing
activities, a $1.8 million decrease for advertising, a
$1.8 million decrease for field trials, a $1.1 million
decrease for tradeshows, a $1.1 million decrease for public
relations and other consulting services, and a $0.8 million
decrease in promotional literature. These spending decreases
were partially offset by $3.6 million of additional
expenses in 2002 related to an aircraft lease obtained in early
2002. Additionally, in 2001, we recorded amortization of
acquired intangible assets of $4.3 million. In accordance
with SFAS No. 142, there was no amortization in 2002.

General and
Administrative.General and
administrative expenses consist primarily of salary and benefits
for administrative officers and support personnel, travel
expenses and legal, accounting and consulting fees. General and
administrative expenses decreased 53% to $14.7 million or
11% of sales in the year ended December 31, 2002 from
$31.3 million or 11% of sales in 2001. The decrease was
primarily due to lower headcount from the restructuring and
reduced legal and information technology expenditures in 2002.
Additionally, in 2001, general and administrative expenses
included $4.6 million of amortization of acquired
intangible assets. In accordance with SFAS No. 142,
there was no amortization in 2002.

Goodwill
Amortization.The amortization of
goodwill arising from acquisitions completed during 1999 and
2000 was $25.4 million for the year ended December 31,
2001.

Upon adoption of SFAS No. 142,
effective January 1, 2002, we were no longer required to
amortize the goodwill of assets associated with our acquisitions
in 1999 and 2000. Consequently, we recorded no amortization in
2002.



| |                                             
| | --------------------------------------------
| | Restructuring Costs and Asset
    Write-offs

|                                         |  |                    |       |      |  |   |         | 
|---------------------------------------- |  | ------------------ | ----- | ---- |  | - | ------- | 
|                                         |  |                   
|                                         |  | For the Year Ended
|                                         |  | December 31,      
|                                         |  |                   
|                                         |  | 2002               |       | 2001
|                                         |  |                    |       |     
|                                         |  |                   
|                                         |  | (In thousands)    
|Restructuring charges                    |  | $                  | 3,641 |      |  | $ | 12,669  | 
|Long-lived assets written-off            |  |                    | 1,309 |      |  |   | 1,688   | 
|Intangible assets written off            |  |                    | 3,972 |      |  |   | 572,792 | 
|                                         |  |                    |       |      |  |   |         | 
|Restructuring costs and asset write-offs |  | $                  | 8,922 |      |  | $ | 587,149 | 
|                                         |  |                    |       |      |  |   |         | 

Restructuring Costs.In the third quarter of 2002, we initiated a restructuring
program to conform our expense and revenue levels and to better
position us for future growth and eventual profitability. As
part of this program, we restructured our worldwide operations
including a worldwide reduction in workforce and the
consolidation of excess facilities. We incurred additional
restructuring charges of $3.6 million in 2002. Of the total
restructuring charge, $2.3 million was related to employee
termination costs. The remaining $1.3 million related
primarily to costs for excess leased facilities. During 2002,
the employment of 147 employees was terminated and we made cash
payments of $2.1 million against the restructuring accrual.
Additionally, in 2002, we reclassified $0.1 million from
employee termination costs to excess leased facilities costs.

We incurred restructuring charges of
$12.7 million in 2001. Of the total restructuring charges
recorded, $3.2 million related to employee termination
costs covering 293 technical, production, and administrative
employees. The remaining $9.5 million of restructuring
charges related primarily to costs for excess leased

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facilities. During 2002, we made cash payments of
$2.9 million against the restructuring accrual. In 2002, we
reclassified $1.1 million, which had originally been
accrued for as employee termination costs to accrued excess
lease facility costs due to a revision in estimate.


Asset Write-offs.In
connection with our restructuring in 2002, we wrote-off
$1.3 million of fixed assets which were determined to have
no remaining useful life. In 2001, we wrote-off
$1.6 million of impaired fixed assets, which were
determined to have no remaining useful life.

Downturns in the broadband services and
telecommunications markets created unique circumstances with
regard to the assessment of goodwill and other intangible assets
for recoverability during 2001. As a result of our decision to
suspend certain product lines and product development efforts
during the first quarter of 2001, intangible assets totaling
$163.1 million related to certain acquisitions were deemed
to be impaired with no future value and were written off.
Further, the aforementioned downturns in the principal markets
in which we continue to operate, negatively impacted the
forecasted revenues and cash flows from certain other companies
acquired during fiscal 1999 and 2000. In accordance with our
policy and accounting standards applicable at that date, the
comparison of the discounted expected future cash flows to the
carrying amount of the related intangible assets resulted in a
write-down of these assets related to both our Cable and Telecom
segments of $409.7 million during the first quarter 2001.

As described above, we recorded a non-cash charge
of $4.0 million to write off the remaining goodwill of
which $3.0 million was related to the Cable segment and
$1.0 million was related to the Telecom segment.



| |                       
| | ----------------------
| | Non-Operating Expenses

|                                 |  |                    |        |                 |  |           |         |  |  |  |     |   
|-------------------------------- |  | ------------------ | ------ | --------------- |  | --------- | ------- |  |  |  | --- | --
|                                 |  |                    |        |                
|                                 |  | For the Year Ended |        |                
|                                 |  | December 31,       |        |                
|                                 |  |                    |        | Annual % Change
|                                 |  | 2002               |        | 2001            |  | 2002/2001
|                                 |  |                    |        |                 |  |          
|                                 |  |                    |        |                
|                                 |  | (In thousands)     |        |                
|Interest income                  |  | $                  | 6,838  |                 |  | $         | 18,132  |  |  |  | (62 | )%
|Interest expense                 |  | $                  | 6,174  |                 |  | $         | 15,224  |  |  |  | (59 | )%
|Other expense                    |  | $                  | 4,145  |                 |  | $         | 2,864   |  |  |  | 45  | % 
|Gain on early retirement of debt |  | $                  | 49,089 |                 |  | $         | 185,327 |  |  |  | (74 | )%

Interest Income.Interest income decreased 62% to $6.8 million in 2002
compared to $18.1 million in 2001. The decrease in interest
income was primarily due to lower invested average cash balances
due to the use of cash to repurchase our Notes in 2001 and 2002
and usage of cash for operations, as well as lower interest
rates.

Interest Expense.Interest expense, which relates primarily to interest on our
Notes due in 2007, decreased 59% to $6.2 million during
2002 compared to $15.2 million in 2001, primarily due to
the repurchase of $325.9 million of our Notes in 2001 and
$109.1 million of our Notes in 2002.

Other Expense.We
accounted for our equity investments in accordance with
SFAS No. 115, Accounting for Certain Investments
in Debt and Equity Securities (SFAS No. 115),
and Securities and Exchange Commission (SEC) Staff
Accounting Bulletin (SAB) 59, Accounting for
Noncurrent Marketable Equity Securities (SAB 59),
which provides guidance in determining when an investment is
other-than-temporarily impaired. In applying this guidance we
evaluated, among other factors, the duration and extent to which
the fair value of the investment was less than its cost, the
financial health of and business outlook for the investee,
including factors such as industry and sector performance,
changes in technology, and operational and financing cash flow,
available financial information, and our intent and ability to
hold the investment. During 2001, based upon this analysis, we
wrote off $2.5 million of our long-term equity investment,
which was included in our Cable segment and was charged to other
expense. During 2002, based upon additional analysis, we wrote
off an additional $4.5 million of our long-term equity
investment, which was charged to other expense in the
Consolidated Statements of Operations.

Gain on early retirement of
debt.In 2001, we repurchased
approximately $325.9 million of our Notes for
$113.4 million in cash and $17.9 million in stock,
resulting in a gain of approximately $185.3 million net of

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related unamortized issuance costs of
$9.3 million. In 2002, we repurchased approximately
$109.1 million of our Notes for $57.6 million in cash,
resulting in a gain included in operations of approximately
$49.1 million net of related unamortized issuance costs of
$2.4 million.




| |             
| | ------------
| | Income Taxes

|                             |  |                    |      |      |  |   |        | 
|---------------------------- |  | ------------------ | ---- | ---- |  | - | ------ | 
|                             |  |                   
|                             |  | For the Year Ended
|                             |  | December 31,      
|                             |  |                   
|                             |  | 2002               |      | 2001
|                             |  |                    |      |     
|                             |  |                   
|                             |  | (In thousands)    
|Income tax (expense) benefit |  | $                  | (238 | )    |  | $ | 13,915 | 

During 2001 we recorded a benefit of
$14.7 million, which consisted of a reduction of deferred
tax liabilities related to the Telegate, Radwiz, Ultracom, and
ComBox acquisitions and a $0.8 million provision for
foreign taxes. In 2002, we recorded an income tax expense of
$0.2 million, which was related primarily to foreign taxes.

Litigation

Beginning in April 2000, several plaintiffs filed
class action lawsuits in federal court against us and certain of
our officers and directors. Later that year, the cases were
consolidated in the United States District Court, Northern
District of California as In re Terayon Communication
Systems, Inc. Securities Litigation. The Court then
appointed lead plaintiffs who filed an amended complaint. In
2001, the Court granted in part and denied in part
defendants motion to dismiss, and plaintiffs filed a new
complaint. In 2002, the Court denied defendants motion to
dismiss that complaint, which, like the earlier complaints,
alleges that the defendants violated the federal securities laws
by issuing materially false and misleading statements and
failing to disclose material information regarding our
technology. On February 24, 2003, the Court certified a
plaintiff class consisting of those who purchased or otherwise
acquired our securities between November 15, 1999 and
April 11, 2000.

On September 8, 2003, the Court heard
defendants motion to disqualify two of the lead plaintiffs
and to modify the definition of the plaintiff class. On
September 10, 2003, the Court issued an order vacating the
hearing date for the parties summary judgment motions,
and, on September 22, 2003, the Court issued another order
staying all discovery until further notice and vacating the
trial date, which had been November 4, 2003.

On February 23, 2004, the Court issued an
order disqualifying two of the lead plaintiffs. The order also
states that plaintiffs counsel must provide certain
information to the Court about counsels relationship with
the disqualified lead plaintiffs, and it provides that
defendants may serve certain additional discovery.

On October 16, 2000, a lawsuit was filed
against us and the individual defendants (Zaki Rakib, Selim
Rakib and Raymond Fritz) in the California Superior Court,
San Luis Obispo County. This lawsuit is titled
Bertram v. Terayon Communications Systems, Inc.
The factual allegations in the Bertram complaint were
similar to those in the federal class action, but the
Bertram complaint sought remedies under state law.
Defendants removed the Bertram case to the United States
District Court, Central District of California, which dismissed
the complaint and transferred the case to the United States
District Court, Northern District of California. That Court
eventually issued an order dismissing the case. Plaintiffs have
appealed this order, and their appeal has been set for oral
argument on April 16, 2004.

We believe that the allegations in both the class
action and the Bertramcase are without merit, and we
intend to contest these matters vigorously. These matters,
however, could prove costly and time consuming to defend, and
there can be no assurances about the eventual outcome.

On January 19, 2003, Omniband Group Limited,
a Russian company, or Omniband, filed a request for arbitration
with the Zurich Chamber of Commerce, claiming damages in an
amount of $2,094,970 allegedly caused by our breach of an
agreement to sell to Omniband certain equipment pursuant to an
agreement between Omniband and Radwiz, Ltd., one of our
wholly-owned subsidiaries. On December 18, 2003, the

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panel of arbiters with the Zurich Chamber of
Commerce allowed the arbitration proceeding to continue against
Radwiz. We believe that the allegations are without merit and
intend to present a vigorous defense in the arbitration
proceedings.


We, as well as our customers, have received
letters from third parties claiming that our technology and
products infringe on the third parties patents. We have
consulted with our patent counsel and are in the process of
reviewing the allegations made by such third parties. We do not
know whether the third parties will pursue their claims of
patent infringement in court, and if they do, whether we will be
found to infringe the third parties patents. If we are
found to have infringed such third party patents, we could be
subject to substantial damages and/or an injunction preventing
us from selling our products and conducting our business.
Additionally, additional third parties could assert infringement
claims against us in the future. Any such claim of patent
infringement, whether meritorious or not, could be
time-consuming, result in costly litigation, cause product
shipment delays or require us to enter into royalty or licensing
agreements. Such royalty or licensing agreements may not be
available on terms acceptable to us, if at all.

We are currently a party to various other legal
proceedings, in addition to those noted above, and may become
involved from time to time in other legal proceedings in the
future. While we currently believe that the ultimate outcome of
these other proceedings, individually and in the aggregate, will
not have a material adverse effect on our financial position or
overall results of operations, litigation is subject to inherent
uncertainties. Were an unfavorable ruling to occur in any of our
legal proceedings, there exists the possibility of a material
adverse impact on our results of operations for the period in
which the ruling occurs. The estimate of the potential impact on
our financial position and overall results of operations for any
of the above legal proceedings could change in the future.

Off-Balance Sheet Financings and
Liabilities

Other than lease commitments and unconditional
purchase obligations incurred in the normal course of business,
we do not have any off-balance sheet financing arrangements or
liabilities, guarantee contracts, retained or contingent
interests in transferred assets or any obligation arising out of
a material variable interest in an unconsolidated entity. We do
not have any majority-owned subsidiaries that are not included
in the consolidated financial statements.

Liquidity and Capital Resources

At December 31, 2003, we had approximately
$30.2 million in cash and cash equivalents and
$108.5 million in short-term investments.

Cash used in operating activities for the year
ended December 31, 2003 was $68.4 million compared to
$67.7 million used in 2002. In 2003, significant uses of
cash from operating activities included $50.4 million loss
from operations, $12.6 million increase in accounts
receivable, $12.3 million of settlement and payment of
vendor cancellation liabilities, and $12.2 million of
increase in gross inventory. Accounts receivable increased as
our sales in the fourth quarter of 2003 increased when compared
to the same period in 2002. Inventory levels increased at
December 31, 2003 when compared to December 31, 2002
due to increased modem inventories in the fourth quarter of 2003
in order to meet service levels established with our key
customers. In 2002, significant uses of cash from operating
activities included $44.2 million loss from operations,
$49.1 million of gain on the repurchase of a portion of the
Notes, and $18.9 million decrease in accounts payable. Net
cash used in operating activities were partially offset by
decreases in accounts receivable of $29.4 million in 2002.
We did not repurchase any Notes in 2003.

Cash used in investing activities in 2003 was
$23.3 million compared to cash provided by investing
activities of $139.0 million in 2002. Investing activities
consisted primarily of net purchases of short-term investments
and purchases of property and equipment in 2003 and 2002. Cash
used in investing activities increased in 2003 due to our usage
of investments to fund operations and movement from cash and
cash equivalents to short-term investments in 2003.

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Cash provided by financing activities was
$3.7 million in 2003 compared to $53.9 million of cash
used in financing activities in 2002. In 2003 we received
proceeds from the exercise of stock options and the sale of
shares of common stock through our Employee Stock Purchase Plan
of $3.7 million. In 2002, we paid approximately
$57.6 million to repurchase a portion of the Notes. In
2002, we received a total of $1.7 million from the exercise
of stock options and the sale of shares of common stock through
our Employee Stock Purchase Plan.

In July 2000, we issued $500 million of
Notes, resulting in net proceeds to us of approximately
$484.4 million. The Notes are our general unsecured
obligation and are subordinated in right of payment to all of
our existing and future senior indebtedness and to all of the
liabilities of our subsidiaries. The Notes are convertible into
shares of our common stock at a conversion price of
$84.01 per share at any time on or after October 24,
2000 through maturity, unless previously redeemed or
repurchased. Interest is payable semi-annually. Debt issuance
costs related to the Notes were approximately $15.6 million.

Through December 31, 2003, we had
repurchased approximately $434.9 million of the Notes for
$171.0 million in cash and $17.9 million in stock,
resulting in a gain on early retirement of debt of approximately
$234.4 million net of related unamortized issuance costs of
$11.6 million. No Notes were repurchased in 2003.

We believe that our current cash balances will be
sufficient to satisfy our cash requirements for at least the
next 12 months. As noted above, we are working to achieve
profitability by the second quarter of 2004. To do so, we will
need to increase revenues, primarily through sales of more
profitable products, and decrease costs. In the first quarter of
2004, we initiated a worldwide reduction in force of
approximately 70 employees, or 17% of the workforce,
consolidation of certain facilities, and reduction or
elimination of discretionary costs and programs. We expect to
record total charges in the range of approximately
$5.0 million to $7.0 million associated with this
realignment in the quarter ending March 31, 2004. Beginning
in the second quarter of 2004, we anticipate annual savings to
be approximately $10.0 to $12.0 million. These statements
are forward-looking in nature and involve risks and
uncertainties. Actual results may vary as a result of a number
of factors, including those discussed under the risk factor
Our Operating Results May Fluctuate below and
elsewhere. We may need to raise additional funds in order to
support more rapid expansion, develop new or enhanced services,
respond to competitive pressures, acquire complementary
businesses or technologies or respond to unanticipated
requirements. We may seek to raise additional funds through
private or public sales of securities, strategic relationships,
bank debt, and financing under leasing arrangements or
otherwise. If additional funds are raised through the issuance
of equity securities, the percentage ownership of our current
stockholders will be reduced, stockholders may experience
additional dilution or such equity securities may have rights,
preferences or privileges senior to those of the holders of our
common stock. We cannot assure that additional financing will be
available on acceptable terms, if at all. If adequate funds are
not available or are not available on acceptable terms, we may
be unable to continue operations, develop our products, take
advantage of future opportunities or respond to competitive
pressures or unanticipated requirements, which could have a
material adverse effect on our business, financial condition and
operating results.

On October 7, 2003, we filed a registration
statement on Form S-3 with the Securities and Exchange
Commission. This shelf registration statement, which was
declared effective by the SEC on November 4, 2003, will
allow us to issue various types of securities, including common
stock, preferred stock, debt securities and warrants to purchase
common stock from time to time up to an aggregate of
$125.0 million, subject to market conditions and our
capital needs. On November 7, 2003, we filed a prospectus
supplement with reference to our intention to offer
10,800,000 shares of common stock, which would result in
gross proceeds of $75.0 million. On November 14, 2003,
we withdrew our previously announced public offering of
10,800,000 shares of common stock under the shelf
registration statement.

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Contractual Obligations

The following summarizes our contractual
obligations at December 31, 2003, and the effect such
obligations are expected to have on our liquidity and cash flows
in future periods (in millions):

|                                   |  |                        |       |           |  |       |      |       |  |         |      |  |  |   |      |  |  |   |     | 
|---------------------------------- |  | ---------------------- | ----- | --------- |  | ----- | ---- | ----- |  | ------- | ---- |  |  | - | ---- |  |  | - | --- | 
|                                   |  |                       
|                                   |  | Payments Due by Period
|                                   |  |                       
|                                   |  |                        |       | Less Than |  | 1-3   |      | 4-5   |  | After 5
|                                   |  | Total                  |       | 1 Year    |  | Years |      | Years |  | Years  
|                                   |  |                        |       |           |  |       |      |       |  |        
|Capital Lease Obligations          |  | $                      | 0.1   |           |  | $     | 0.1  |       |  | $       |     |  |  | $ |     |  |  | $ |    | 
|Unconditional Purchase Obligations |  |                        | 54.4  |           |  |       | 54.4 |       |  |         |     |  |  |   |     |  |  |   |    | 
|Long Term Debt                     |  |                        | 68.4  |           |  |       |     |       |  |         | 1.6  |  |  |   | 65.1 |  |  |   | 1.7 | 
|Operating Lease Obligations        |  |                        | 24.4  |           |  |       | 6.8  |       |  |         | 9.0  |  |  |   | 6.1  |  |  |   | 2.5 | 
|Aircraft Lease                     |  |                        | 4.4   |           |  |       | 1.4  |       |  |         | 2.9  |  |  |   | 0.1  |  |  |   |    | 
|                                   |  |                        |       |           |  |       |      |       |  |         |      |  |  |   |      |  |  |   |     | 
|Total Contractual Commitments      |  | $                      | 151.7 |           |  | $     | 62.7 |       |  | $       | 13.5 |  |  | $ | 71.3 |  |  | $ | 4.2 | 
|                                   |  |                        |       |           |  |       |      |       |  |         |      |  |  |   |      |  |  |   |     | 

We have unconditional purchase obligations to
certain of our suppliers that support our ability to manufacture
our products. The obligations require us to purchase minimum
quantities of the suppliers products at a specified price.
As of December 31, 2003, we had approximately
$54.4 million of purchase obligations, of which
$2.9 million is included in the Consolidated Balance Sheets
as accrued vendor cancellation charges, and the remaining $51.5
is attributable to open purchase orders. The remaining
obligations are expected to become payable at various times
through 2004.

Other commercial commitments, primarily required
to support operating leases, are as follows (in millions):

|                             |  |                                            |     |           |  |       |     |       |  |         |     |  |  |   |     |  |  |   |     | 
|---------------------------- |  | ------------------------------------------ | --- | --------- |  | ----- | --- | ----- |  | ------- | --- |  |  | - | --- |  |  | - | --- | 
|                             |  |                                           
|                             |  | Amount of Commitment Expiration Per Period
|                             |  |                                           
|                             |  | Total                                      |     |          
|                             |  | Amounts                                    |     | Less Than |  | 1-3   |     | 4-5   |  | Over   
|                             |  | Committed                                  |     | 1 Year    |  | Years |     | Years |  | 5 Years
|                             |  |                                            |     |           |  |       |     |       |  |        
|Deposits                     |  | $                                          | 1.0 |           |  | $     | 0.3 |       |  | $       | 0.7 |  |  | $ |    |  |  | $ |    | 
|Standby Letters of Credit    |  |                                            | 8.2 |           |  |       | 0.5 |       |  |         |    |  |  |   | 7.5 |  |  |   | 0.2 | 
|                             |  |                                            |     |           |  |       |     |       |  |         |     |  |  |   |     |  |  |   |     | 
|Total Commercial Commitments |  | $                                          | 9.2 |           |  | $     | 0.8 |       |  | $       | 0.7 |  |  | $ | 7.5 |  |  | $ | 0.2 | 
|                             |  |                                            |     |           |  |       |     |       |  |         |     |  |  |   |     |  |  |   |     | 

In 2002, we entered into an operating lease
arrangement to lease a corporate aircraft. This lease
arrangement was secured by a $9.0 million letter of credit.
The letter of credit was reduced to $7.5 million in
February 2003. This lease commitment is included in the table
above. In March 2004, in connection with our worldwide
restructuring, we notified the lessor of our intentions to
locate a purchaser for our remaining obligations under this
lease. From time to time, our Chief Executive Officer,
Dr. Rakib, uses the aircraft for personal use and the
charge is reported by him as compensation. Dr. Rakib was
charged approximately $62,000 for personal aircraft usage during
fiscal 2003.

Critical Accounting Policies

We consider certain accounting policies related
to our use of estimates, revenue recognition, bad debt reserves,
inventory valuation, impairment of long-lived assets, warranty
returns, restructuring, income taxes and contingencies to be
critical policies due to the estimation processes involved in
each. We discuss each of our critical accounting policies, in
addition to certain less significant accounting policies, with
senior members of management and the audit committee, as
appropriate.

Use of Estimates.The preparation of the consolidated financial statements and
related disclosures in conformity with accounting principles
generally accepted in the United States requires us to establish
accounting policies that contain estimates and assumptions that
affect the amounts reported in the consolidated financial
statements and accompanying notes. We base our estimates on
historical experience and on various other assumptions that are
believed to be reasonable under the circumstances, the results
of which

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form the basis for making judgments about the
carrying values of assets and liabilities that are not readily
apparent from other sources. These policies include:




| |   |                                                                                                                                                                                     
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | revenue recognition;                                                                                                                                                                
|
| |  | the allowance for doubtful accounts, which
    impacts revenue;                                                                                                                     
|
| |  | the valuation of exposures associated with the
    contract manufacturing operations and estimating future warranty
    costs, which impact cost of good sold and gross margins; and
|
| |  | the valuation of certain long-lived assets,
    especially goodwill and other purchased intangible assets, which
    has resulted in impairment, which impacts operating expenses.  

We have other equally important accounting
policies and practices, which may not require us to make
significant estimates or assumptions. Despite our intention to
establish accurate estimates and assumptions, actual results
could differ from those estimates under different assumptions or
conditions.

Revenue Recognition.We recognize revenue in accordance with SEC Staff Accounting
Bulletin No. 101, Revenue Recognition in Financial
Statements (SAB 101), as amended by SAB 101A and
101B and updated by SAB 104. SAB 101 requires that
four basic criteria must be met before revenue can be
recognized: (1) persuasive evidence of an arrangement
exists; (2) delivery has occurred or services rendered;
(3) the selling price is fixed and determinable; and
(4) collectibility is reasonably assured. Determination of
criteria (4) is based on managements judgments
regarding the collectibility of the selling price. Should there
be changes to managements judgments, revenue recognized
for any reporting period could be adversely affected.

Contracts and customer purchase orders are
generally used to determine the existence of an arrangement.
Shipping documents and customer acceptance, when applicable, are
used to verify delivery. We assess whether the fee is fixed or
determinable based on the payment terms associated with the
transaction and whether the sales price is subject to
adjustment. We assess collectibility based primarily on the
creditworthiness of the customer as determined by credit checks
and analysis, as well as the customers payment history.

Revenue arrangements with resellers are generally
recognized when product is shipped to the resellers as we
generally do not grant return rights beyond those provided by
the warranty.

Allowance for Doubtful
Accounts.We perform ongoing credit
evaluations of our customers and generally require no
collateral. We evaluate our trade receivables based upon a
combination of factors. Credit losses have historically been
within managements expectations. When we become aware of a
customers inability to pay, such as in the case of
bankruptcy or a decline in the customers operating results
or financial position, we record a specific reserve for bad debt
to reduce the related receivable to an amount we reasonably
believe is collectible. We maintain a reserve for potentially
uncollectible accounts receivable based on an assessment of
collectibility. We assesses collectibility based on a number of
factors, including past history, the number of days an amount is
past due (based on invoice due date), changes in credit ratings
of customers, current events and circumstances regarding the
business of our clients customers and other factors that
we believe are relevant. If circumstances related to a specific
customer change, our estimates of the recoverability of
receivables could be further reduced. Charges for uncollectible
accounts are included as a component of net revenue in the
consolidated statement of operations. At December 31, 2003
and 2002, the reserve for potentially uncollectible accounts was
$3.6 million and $3.5 million, respectively. A
relatively small number of customers account for a significant
percentage of our revenues and accounts receivable. We expect
the sale of our products to a limited number of customers and
resellers to continue to account for a high percentage of
revenues.

Inventory Valuation.We record losses on commitments to purchase inventory in
accordance with Statement 10 of Chapter 4 of Accounting
Release Bulletin No. 43. Our policy for valuation of
inventory and commitments to purchase inventory, including the
determination of obsolete or excess inventory, requires us to
perform a detailed assessment of inventory at each balance sheet
date which includes a review of, among other factors, an
estimate of future demand for products within specific time
horizons, generally six months or less as well as product
lifecycle and product development plans. Given the rapid
technological change in the

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technology and communications equipment
industries as well as significant, unpredictable changes in
capital spending by our customers, we believe that assessing the
value of inventory using generally a six month time horizon is
appropriate.


The estimates of future demand that we use in the
valuation of inventory are the basis for the revenue forecast,
which is also consistent with our short-term manufacturing plan.
Based on this analysis, we reduce the cost of inventory that we
specifically identify and consider obsolete or excessive to
fulfill future sales estimates. We define excess inventory as
inventory that will no longer be used in the manufacturing
process. Excess inventory is generally defined as inventory in
excess of projected usage, and is determined using our best
estimate of future demand at the time, based upon information
then available.

Impairment of Long-Lived
Assets.Our long-lived assets have
principally included long-term investments, goodwill and other
intangible assets. Our estimate of the fair value of the
long-term investments was dependent on the performance of the
companies in which we have invested, as well as the volatility
inherent in the external markets for these investments. If the
companies business forecasts were not met, we had to
record additional impairment charges. At December 31, 2003,
all of our intangible assets had been written-off and we had no
intangible assets recorded on the Consolidated Balance Sheets.

We adopted Statement of Financial Accounting
Standards (SFAS) No. 142, Goodwill and Other
Intangible Assets, (SFAS No. 142) on
January 1, 2002. We reclassified $1.3 million of
assembled workforce, net of accumulated amortization, with an
indefinite life, to goodwill at the date of adoption of this
standard. We test goodwill for impairment using the two-step
process prescribed in SFAS No. 142. The first step is
a screen for potential impairment, while the second step
measures the amount of the impairment, if any. We completed the
initial goodwill impairment review as of the beginning of 2002,
and found no impairment. During the first and second quarters of
2002, we completed a restructuring and impairment review as
further discussed in Note 5 of the Notes to the
Consolidated Financial Statements. Due to a difficult economic
environment and heightened price competition in the modem and
telecom businesses during the second quarter of 2002, we
experienced a significant drop in our market capitalization and
therefore proceeded to perform an interim test to measure
goodwill and intangible assets for impairment. The outcome of
this test resulted in a non-cash charge of $4.0 million to
write-off goodwill in both the Cable and Telecom segments during
the second quarter of 2002. At December 31, 2002 and 2003,
we had no goodwill or intangible assets recorded on the
Consolidated Balance Sheets.

Warranty Reserves.We provide a standard warranty for most of our products,
generally lasting one to five years from the date of purchase.
We provide for the estimated cost of product warranties at the
time revenue is recognized. Our warranty obligations are
affected by product failure rates, material usage and service
delivery costs incurred in correcting a product failure. Our
estimate of costs to service our warranty obligations is based
on historical experience and our expectation of future
conditions. Should actual product failure rates, material usage
or service delivery costs differ from our estimates, revision to
the warranty liability would be required, resulting in decreased
gross profits.

Restructuring and Other Related
Charges.During 2001, 2002, and 2003,
we implemented restructuring programs to focus and streamline
our business and reduce operating expenses. In connection with
these programs, we reduced headcount and abandoned facilities.
As a result of these actions, we recorded restructuring and
other related charges primarily consisting of cash severance
payments made to severed employees and lease payments related to
property abandoned as a result of our facilities consolidation.
Each reporting period, we review these estimates based on the
execution of our restructuring plans and changing market
conditions, such as the real estate market. To the extent that
these assumptions change, the ultimate restructuring expenses
could vary.

Contingencies.We
are subject to proceedings, lawsuits and other claims related to
labor, acquisitions and other matters. We are required to assess
the likelihood of any adverse judgments or outcomes to these
matters as well as potential ranges of probable losses. A
determination of the amount of reserves required, if any, for
these contingencies are made after careful analysis of each
individual issue. The required reserves may change in the future
due to new developments in each matter or changes in approach
such as a change in settlement strategy in dealing with these
matters, any of which may result in higher net loss.

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Taxes.We determine
our provision for income taxes using the asset and liability
method. Under this method, deferred tax assets and liabilities
are recognized for the future tax effects of temporary
differences between the financial statement carrying amounts of
existing assets and liabilities and their respective tax bases.
Future tax benefits of tax loss and credit carryforwards are
also recognized as deferred tax assets. We evaluate the
realizability of our deferred tax assets by assessing the
likelihood of future profitability and available tax planning
strategies that could be implemented to realize our net deferred
tax assets. The ultimate realization of our net deferred tax
assets will require profitability. We have assessed the future
profit plans and tax planning strategies together with the years
of expiration of carryforward benefits, and have concluded that
the deferred tax assets will be not be currently realized and
have recorded a valuation allowance against the entire amount of
the deferred tax assets. Should our operating performance
improve, future assessments could conclude that a reduction to
the valuation allowance will be needed to reflect deferred tax
assets. In addition, we operate within multiple taxing
jurisdictions and are subject to tax audits in these
jurisdictions. These audits can involve complex issues, which
may require an extended period of time to resolve. However, we
believe we have made adequate provision for income taxes for all
years that are subject to audit.

Impact of Recently Issued Accounting
Standards

In May 2003, the Financial Accounting Standards
Board (FASB) issued Statement of Financial Accounting
Standards (SFAS) No. 150, Accounting For Certain
Financial Instruments with Characteristics of Both Liabilities
and Equity which establishes standards for how an issuer
of financial instruments classifies and measures certain
financial instruments with characteristics of both liabilities
and equity. It requires that an issuer classify a financial
instrument that is within its scope as a liability (or an asset
in some circumstances) if, at inception, the monetary value of
the obligation is based solely or predominantly on a fixed
monetary amount known at inception, variations in something
other than the fair value of the issuers equity shares or
variations inversely related to changes in the fair value of the
issuers equity shares. SFAS No. 150 is effective
for financial instruments entered into or modified after
May 31, 2003, and otherwise is effective at the beginning
of the first interim period beginning after June 15, 2003.
The adoption of SFAS No. 150 did not have a material
impact on our financial position or results of operations.

In April 2003, the FASB issued
SFAS No. 149, Amendment of Statement 133 on
Derivative Instruments and Hedging Activities.
SFAS No. 149 amends and clarifies financial accounting
and reporting for derivative instruments, including certain
derivative instruments embedded in other contracts (collectively
referred to as derivatives) and for hedging activities under
SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities. This statement is
effective for contracts entered into or modified after
June 30, 2003, and did not have a material impact on our
financial position or results of operations.

In January 2003, the FASB issued Interpretation
No. 46, Consolidation of Variable Interest
Entities, which was revised in December 2003.
Interpretation No. 46, as revised, clarifies the
application of Accounting Research Bulletin No. 51 and
applies immediately to any variable interest entities created
after January 31, 2003 and to variable interest entities in
which an interest is obtained after that date. This
Interpretation is applicable in the quarter ending
March 31, 2004, for interests acquired in variable interest
entities prior to February 1, 2003. This Interpretation
requires variable interest entities to be consolidated if the
equity investment at risk is not sufficient to permit an entity
to finance its activities without support from other parties or
the equity investors lack specified characteristics. The
adoption of Interpretation No. 46, as revised, is not
expected to have a material impact on our financial position or
results of operations.

In November 2002, the EITF reached a consensus on
Issue No. 00-21, Revenue Arrangements with Multiple
Deliverables. EITF Issue No. 00-21 provides guidance
on how to account for certain arrangements that involve the
delivery or performance of multiple products, services and/or
rights to use assets. The provisions of EITF Issue
No. 00-21 apply to revenue arrangements entered into in
fiscal periods beginning after June 15, 2003. The adoption
of EITF Issue No. 00-21did not have any significant impact
on our financial position or results of operations.

In July 2002, the Financial Accounting Standards
Board issued Statement of Financial Accounting Standard
No. 146, Accounting for Costs Associated with Exit or
Disposal Activities (FAS 146). FAS 146

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addresses the financial accounting and reporting
for costs associated with exit or disposal activities, and
supersedes Emerging Issues Task Force Issue No. 94-3,
Liability Recognition for Certain Employee Termination Benefits
and Other Costs to Exit an Activity, including Certain Costs
Incurred in a Restructuring (EITF 94-3). FAS 146 requires
companies to recognize costs associated with exit or disposal
activities when they are incurred rather than at the date of a
commitment to an exit or disposal plan. In addition, FAS
No. 146 establishes that fair value is the objective for
initial measurement of the liability. FAS 146 is effective for
exit or disposal activities initiated after December 31,
2002. The adoption of FAS 146 did not have any significant
impact on our financial position or results of operations.


In June 2001, the FASB issued SFAS No. 142,
Goodwill and Other Intangible Assets (SFAS
No. 142). SFAS No. 142 prohibits the amortization of
goodwill and intangible assets with indefinite useful lives.
SFAS No. 142 requires that these assets be reviewed for
impairment at least annually. Intangible assets with definite
lives will continue to be amortized over their estimated useful
lives. Additionally, SFAS No. 142 requires that goodwill
included in the carrying value of equity method investments no
longer be amortized.

We adopted SFAS No. 142 on
January 1, 2002.Identifiable
intangible assets with indefinite lives were reclassified, as
defined by SFAS No. 142, to goodwill at the date of
adoption. We tested goodwill for impairment using the two-step
process prescribed in SFAS No. 142. The first step is a
screen for potential impairment, while the second step measures
the amount of the impairment, if any. See Note 5.

The following pro forma information reflects the
impact on net loss and basic and diluted net loss per share
assuming the adoption of SFAS No. 142 had occurred on
January 1, 2001 (in thousands):

|                                               |                                                                                                |                          |         |       |   |             |         |       |   |   |          |        |  
|---------------------------------------------- | ---------------------------------------------------------------------------------------------- | ------------------------ | ------- | ----- | - | ----------- | ------- | ----- | - | - | -------- | ------ | -
|                                               |                                                                                                |                         
|                                               |                                                                                                | Years ended December 31,
|                                               |                                                                                                |                         
|                                               |                                                                                                | 2003                     |         | 2002  |   | 2001       
|                                               |                                                                                                |                          |         |       |   |            
|                                               |                                                                                                |                          |         |       |   | (Pro forma)
|                                               |                                                                                                |                          |         |       |   |            
|Reported net loss                              |                                                                                                | $                        | (50,353 | )     |   | $           | (44,213 | )     |   | $ | (563,846 | )     
|                                               | Amortization of goodwill and intangible assets
    with indefinite lives                       |                          |         |      |   |             |         |      |   |   |          | 53,846 |  
|                                               |                                                                                                |                          |         |       |   |             |         |       |   |   |          |       
|Pro forma net loss                             |                                                                                                | $                        | (50,353 | )     |   | $           | (44,213 | )     |   | $ | (510,000 | )     
|                                               |                                                                                                |                          |         |       |   |             |         |       |   |   |          |       
|Basic and diluted net loss per share:          |                                                                                                |                          |         |       |   |             |         |       |   |   |          |       
|                                               | Reported net loss                                                                              |                          | $       | (0.68 | ) |             | $       | (0.61 | ) |   | $        | (8.25  | )
|                                               | Adjustment related to amortization of goodwill
    and intangible assets with indefinite lives |                          |         |      |   |             |         |      |   |   |          | 0.79   |  
|                                               |                                                                                                |                          |         |       |   |             |         |       |   |   |          |       
|Pro forma basic and diluted net loss per share |                                                                                                | $                        | (0.68   | )     |   | $           | (0.61   | )     |   | $ | (7.46    | )     

RISK FACTORS

You should carefully consider the risks
described below before making an investment decision. The risks
and uncertainties described below are not the only ones facing
us. Additional risks and uncertainties not presently known to us
or that we currently deem immaterial also may impair our
business operations. If any of the following risks actually
occur, our business could be harmed. In such case, the trading
price of our common stock could decline, and you may lose all or
part of your investment.

Risks Related to Our Business



| |                                                                                
| | -------------------------------------------------------------------------------
| | We have a history of losses and may
    continue to incur losses in the future.

It is difficult to predict our future operating
results. We began shipping products commercially in June 1997,
and we have been shipping products in volume since the first
quarter of 1998. As of December 31, 2003, we had an
accumulated deficit of $987.6 million. We believe that we
will continue to experience challenges in selling our products
at a profit and may continue to operate with net losses for the
foreseeable future. Moreover, from 2000 to 2002, we have had
declining revenue year over year. Although our revenues
increased in 2003 as compared to 2002, we still incurred losses
of $50.4 million in 2003. As a result of the operating
deficiencies, we have had to use available cash and cash
equivalents to supplement the operation of our

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business. Cash, cash equivalents and short term
investments used in the twelve months ended December 31,
2003 was $67.9 million as compared to $127.4 million
used in the same period in 2002. At December 31, 2003, we
had approximately $138.6 million in cash, cash equivalents
and short-term investments as compared to approximately
$206.5 million at December 31, 2002. Additionally, we
generally are unable to significantly reduce our short-term
expenses in order to compensate for unexpected decreases in
anticipated revenues or delays in generating anticipated
revenues. For example, we have fixed commitments with some of
our suppliers that require us to purchase minimum quantities of
their products at a specified price irrespective of whether we
can subsequently use such quantities in our products. Further,
we have been experiencing and will continue to experience
declining average selling prices (ASPs) of our products. We
record an inventory charge to reduce our inventory to the lower
of cost or market if average selling prices fall below the cost
of these products. In addition, we have significant operating
lease commitments for facilities and equipment that generally
cannot be cancelled in the short-term without substantial
penalties.


Our business may be adversely affected by delays
in, or our failure to, commercialize new products, or reduce the
cost of manufacturing our current products. Moreover, given the
conditions in the broadband equipment market, the profit
potential of our business remains unproven.



| |                                                                                                                  
| | -----------------------------------------------------------------------------------------------------------------
| | We may experience fluctuations in our
    operating results and face unpredictability in our future
    revenues.

Our quarterly revenues have fluctuated and are
likely to continue to fluctuate significantly in the future due
to a number of factors, many of which are outside our control.
Factors that affect our revenues include, among others, the
following:



| |   |                                                                                                                                                                                         
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | variations in the timing of orders and shipments
    of our products;                                                                                                                   
|
| |  | variations in the size of the orders by our
    customers and pricing concessions on volume sales;                                                                                      
|
| |  | competitive market conditions;                                                                                                                                                          
|
| |  | unpredictable sales cycles;                                                                                                                                                             
|
| |  | new product introductions by competitors or by us;                                                                                                                                      
|
| |  | delays in our introduction of new products;                                                                                                                                             
|
| |  | delays in our introduction of added features to
    our products;                                                                                                                       
|
| |  | delays in the commercialization of products that
    are competitive in the marketplace;                                                                                                
|
| |  | delays in our receipt of and cancellation of
    orders forecasted by customers;                                                                                                        
|
| |  | variations in capital spending budgets of cable
    operators and other broadband service providers;                                                                                    
|
| |  | international conflicts, including the continuing
    conflict in Iraq, and acts of terrorism and the impact of
    adverse economic, market and political conditions
    worldwide; and
|
| |  | ability of our products to be qualified or
    certified as meeting industry standards.                                                                                                 

A variety of factors affecting our gross margin
include, among others, the following:



| |   |                                                                         
| | - | ------------------------------------------------------------------------
| |  | the sales mix of our products;                                          
|
| |  | the volume of products manufactured;                                    
|
| |  | the type of distribution channel through which we
    sell our products;
|
| |  | the ASPs of our products;                                               
|
| |  | the ability to manage excess an obsolete
    inventory;                 
|
| |  | delays in reducing the cost of our products;                            

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| |   |                                                  
| | - | -------------------------------------------------
| |  | the costs of manufacturing our products; and     
|
| |  | the effectiveness of our cost reduction measures.

We often recognize a substantial portion of our
revenues in the last month of the quarter. We establish our
expenditure levels for product development and other operating
expenses based on projected sales levels, and expenses are
relatively fixed, particularly in the short term. For example, a
significant percentage of these operating expenses are fixed due
to operating leases for our facilities and equipment. Also, we
have fixed commitments with some of our suppliers that require
us to purchase minimum quantities of their products at a
specified price. Because in the past, we have been unable to use
all of the products that we purchased from our suppliers, we
have taken vendor cancellation charges as a result of these
fixed commitments, and we may have to take additional charges in
the future if we are unable to use all of the products that we
purchase from our suppliers. Recently, we have begun to
negotiate clauses with vendors to push-out or reschedule
inventory purchases at our discretion. These clauses should help
to minimize the impact of vendor cancellation charges in the
future. As of December 31, 2003, $54.4 million of
purchase obligations were outstanding. Accordingly, variations
in timing of sales can cause significant fluctuations in
operating results. In addition, because a significant portion of
our business is derived from orders placed by a limited number
of large customers, the timing of such orders can also cause
significant fluctuations in our operating results. Our expenses
for any given quarter are typically based on expected sales and
if sales are below expectations, our operating results may be
adversely impacted by our inability to adjust spending to
compensate for the shortfall. Moreover, our research and
development expenses fluctuate in response to new product
development, and changing industry requirements and customer
demands.

Additionally, the unit ASPs of our products
declined considerably in 2002 and 2003, and we anticipate that
unit ASPs of our products may continue to decline in the future.
This has caused and will continue to cause a decrease in our
gross margins if we are unable to off-set the decline in ASPs
with cost reduction measures. In addition, the gross margins we
realize from the sale of our products are affected by the mix of
product sales between higher margin, lower volume head-end
equipment, such as Cable Modem Termination Systems (CMTSs) and
digital video management systems, and lower margin, higher
volume Customer Premise Equipment (CPE) products, such as
modems. In 2004, we expect that sales of our low-margin CPE will
continue to make up a significant portion of our revenues.



| |                                                                                                                                                                              
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We are dependent on a small number of
    customers and our business could be harmed by the loss of any of
    these customers or reductions in their purchasing
    volumes.

Our customers have undergone and continue to
undergo significant consolidation in both North America and
internationally, as a limited number of cable operators control
an increasing number of systems. For example, the top nine cable
operators in the United States operate systems that service
approximately 90% of homes that receive cable services in the
United States. As a result of the consolidation among cable
operators, our revenue has been and will continue to be
dependent on sales to the few leading cable operators worldwide
and the continued consolidation may also reduce the number of
potential customers. For example, three customers, Adelphia,
Cross Beam Networks, a subsidiary of Sumitomo, and Comcast each
accounted for more than 10% of our total revenues for the year
ended December 31, 2003 (22%, 16%, and 13%). One customer,
related to the Cable segment, Cross Beam Networks, accounted for
more than 10% of our total revenues for the year ended
December 31, 2002 (28%). Two customers, Shaw and Cross Beam
Networks, both related to the Cable segment, accounted for 10%
or more of the total revenues for the year ended
December 31, 2001 (33% and 13%). Two customers accounted
for 10% or more of total accounts receivable for the year ended
December 31, 2003 (24% and 20%). One customer, related to
the Cable segment, accounted for 10% or more of total accounts
receivable for the year ended December 31, 2002 (23%).

As is common in our industry, we typically do not
enter into contracts with our customers in which they commit to
purchase products from us. Typically, our customers purchase
products from us on a purchase order basis. We may not succeed
in attracting new customers as many of our potential customers
have pre-existing relationships with our current or potential
competitors and the continued consolidation of the cable
industry reduces the number of potential customers. To attract
new customers, we may be faced with intense price

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competition, which may affect our gross margins.
Our sales are made on a purchase order or system contract basis,
and none of our customers has entered into a long-term agreement
requiring it to purchase our products. Moreover, we do not
typically require our customers to purchase a minimum quantity
of our products, and our customers can generally cancel their
orders on short notice without significant penalties. The loss
of any of our customers can have a material adverse effect on
our results of operations. Further, any reduction in orders from
a given customer can likewise have a material adverse affect on
our results of operations.




| |                                                                                                                                      
| | -------------------------------------------------------------------------------------------------------------------------------------
| | The sales cycle for certain of our products
    is lengthy, which makes forecasting of our customer orders and
    revenue difficult.

The sales cycle for certain of our products, such
as our CMTSs, is lengthy, often lasting nine months to more than
a year. Our customers generally conduct significant technical
evaluations, including customer trials, of our products as well
as competing products prior to making a purchasing decision. In
addition, purchasing decisions may also be delayed because of a
customers internal budget approval processes. Because of
the lengthy sales cycle and the size of customer orders, if
orders forecasted for a specific customer for a particular
period do not occur in that period, our revenues and operating
results for that particular quarter could suffer. Moreover, a
portion of our expenses related to an anticipated order is fixed
and difficult to reduce or change, which may further impact our
revenues and operating results for a particular period.



| |                                                                                  
| | ---------------------------------------------------------------------------------
| | There are many risks associated with our
    participation in industry standards.

In connection with the development of the DOCSIS
2.0 specification by Cable Television Laboratories, Inc., a
cable industry consortium that establishes cable technology
standards and administers compliance testing (CableLabs), we
entered into an agreement with CableLabs whereby we licensed to
CableLabs on a royalty-free basis any of our intellectual
property rights, including rights to our proprietary S-CDMA
technology, to the extent that such rights may be asserted
against a party desiring to design, manufacture or sell DOCSIS
based products, including DOCSIS 2.0 based products. This
license agreement grants to CableLabs the right to sublicense
our intellectual property, including our intellectual property
rights in our S-CDMA patents, to manufacturers that compete with
us in the marketplace for DOCSIS based products. As a result of
this license to CableLabs, our competitors that produce
DOCSIS-based products have access to our technology without
having to pay us any royalties or other compensation for the use
of our technology. As a result of our contribution of technology
to the DOCSIS intellectual property pool, we may have foregone
significant revenue from the potential licensing of our
proprietary technology, and we may be unable to recoup the
investment in the research and development of intellectual
property contributed to the DOCSIS technology pool.

Additionally, the agreement that we signed with
CableLabs to participate in the DOCSIS intellectual property
pool may make it difficult for us to enforce our intellectual
property rights against other companies. Certain cable equipment
vendors manufacture and sell DOCSIS based and DOCSIS certified
and qualified products without sublicensing from CableLabs the
technology in the CableLabs intellectual property pool. Due to
the interests of cable operators in having as many equipment
vendors as possible, we may feel constrained by competitive
pressures from pursuing the enforcement of our intellectual
property rights against our competitors that have not entered
into sublicenses with CableLabs. Moreover, if we seek to enforce
our intellectual property rights against other equipment
manufacturers that access technology from the CableLabs
intellectual property pool, our license to the technology in the
pool may be jeopardized. Certain contributors of technology to
the CableLabs intellectual property pool are our competitors and
may elect to revoke our license to their technology if we
attempt to enforce our intellectual property rights against them.

We may have lost any competitive advantage that
our proprietary S-CDMA technology may have provided us in the
marketplace by licensing it to CableLabs, and we may face
increased competition because our competitors have the ability
to incorporate our technology into their products. We believe
that this increased competition could come from existing
competitors or from new competitors who enter the market and
that such competition is likely to result in lower product ASPs,
which could harm our revenues and gross margins. Additionally,
because our competitors will be able to incorporate our
technology into their products, our current customers may choose
alternate suppliers or choose to purchase DOCSIS-compliant
products

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from multiple suppliers. We may be unable to
effectively compete with the other vendors if we cannot produce
DOCSIS compliant cable products more quickly or at lower cost
than our competitors.


DOCSIS specifications have not yet been accepted
in Europe and Asia, although an increasing number of Asian cable
operators are requiring product to be DOCSIS qualified or
certified. An alternate specification for cable products, called
the Euro-DOCSIS specification, has been formalized by TComLabs,
a cable technology consortium of European cable operators, and
some European and Asian cable operators have embraced it. We
have contributed certain of our technologies, including our
proprietary S-CDMA technology, to the Euro-DOCSIS specification.
We may develop and sell products that comply with the
Euro-DOCSIS specification, and we may be unsuccessful in these
efforts. Even if we are successful in our efforts, we may face
some of the same risks associated with our contribution of
intellectual property to the CableLabs DOCSIS intellectual
property pool.



| |                                                                                                                                     
| | ------------------------------------------------------------------------------------------------------------------------------------
| | We need to certify and qualify our new and
    existing products to meet industry specifications in order to
    remain competitive.

Major cable operators worldwide have endorsed the
DOCSIS, Euro-DOCSIS and PacketCable specifications and rarely
purchase equipment that is not certified or qualified as
compliant with these specifications. Cable operators have chosen
to purchase only products meeting industry specifications
because the specifications enable interoperability among
products from multiple vendors, which leads to increased
competition among equipment manufacturers and consequently
lowers product ASPs. Consequently, our future success depends on
our ability to compete effectively in this marketplace by
developing, marketing and selling products that are certified
and qualified to industry standards in a timely fashion and in a
cost effective manner.

The DOCSIS and PacketCable specifications are
promulgated by CableLabs. Currently these specifications have
been widely adopted by cable operators in North America and by
some cable operators in Asia, Latin America and Europe. The
Euro-DOCSIS specifications have been developed by TComLabs
specifically to meet the requirements of European operators, and
have found some acceptance in China as well. There is no
guarantee that our products will be DOCSIS, EuroDOCSIS or
PacketCable certified or qualified. If we are unable to certify
or qualify our products as DOCSIS, EuroDOCSIS or PacketCable
compliant in a timely manner, we may be unable to sell our
products and may lose some or all of any advantage we might
otherwise have had, and our future operating results may be
adversely affected.

Although we sell certified and qualified
products, there have been and may continue to be instances where
our existing customers and potential new customers elect to
purchase products from one or more of our competitors rather
than from us. In response to this situation, we have reduced our
prices and continue to experience customer demand to further
reduce our prices in order to promote sales of our current
products. This has had and may continue to have an adverse
impact on our revenues, operating results and gross margin.

Developing products to meet these various
industry specifications has several risks. The first is the cost
and effort to engineer standards-based products and to then
prepare them for compliance testing. Not only do we have to
certify or qualify new products, but any of our currently
certified or qualified products must be re-certified or
re-qualified should they be changed in any way. Second, there is
no guarantee that these products will be certified or qualified
as meeting these specifications in a timely fashion, if ever.
Because most cable operators purchase only those products that
have been certified or qualified as meeting these
specifications, it is highly unlikely that we will be able to
sell our products until they achieve certification or
qualification, which can be a lengthy process. As a result, we
may incur significant research and development expenses to
develop new products that may not receive certification or
qualification and we cannot recoup the costs of these research
and development expenses by marketing uncertified or unqualified
products. Moreover, a consequence of cable operators only
purchasing products certified or qualified as meeting industry
specifications is the increased competition between equipment
vendors, which has resulted in a steady and ongoing decline in
equipment prices as vendors compete for cable operators
business. Third, there is no guarantee that we will be able to
support all future cable industry specifications, which will
likely have an adverse impact on our future revenues.

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| |                                                                                                                  
| | -----------------------------------------------------------------------------------------------------------------
| | Average selling prices of broadband
    equipment continue to decline, which is decreasing our gross
    margins.

The broadband equipment market has been
characterized by erosion of product ASPs, particularly for CPE
devices. We expect this erosion to continue. The ASPs for our
products are likely to continue to decline due to competitive
pricing pressures, promotional programs and customers possessing
strong negotiating positions who require price reductions as a
condition of purchase. In addition, we believe that the
widespread adoption of industry specifications, such as the
DOCSIS and EuroDOCSIS specifications, is further eroding ASPs as
cable modems and other similar CPE become commodity products.
Decreasing ASPs could result in decreased revenues even if the
number of units sold increases. Decreasing ASPs may also require
us to sell our products at much lower gross margin than in the
past, and in fact, we may sell products at a loss. The primary
reason that our gross profits have declined year-over year is
the decline in product ASPs. As a result, we may experience
substantial period-to-period fluctuations in future revenue,
gross margin and operating results due to ASP erosion.
Therefore, we must continue to develop and introduce on a timely
basis and a cost-effective manner new products or
next-generation products with enhanced functionalities that can
be sold at higher gross margins. Our failure to do this could
cause our revenues and gross margin to decline further.



| |                                                             
| | ------------------------------------------------------------
| | We must achieve cost reductions to attain
    profitability.

As product ASPs and revenue have declined in
recent years, we have not sufficiently decreased our costs,
including operating expenses and the costs associated with our
products, to offset declining ASPs and revenue. This has
resulted in increased losses and made it difficult for us to
attain profitability. We have experienced a decrease in revenue,
which was, in large part, due to declining product ASPs and a
drop in CMTS volume due to our transition from a proprietary
platform to the DOCSIS standards platform. In order to achieve
profitability, we must significantly increase our revenues,
reduce the cost of our products, and maintain or reduce our
operating expenses.

We have undertaken several actions to lower our
operating expenses. Although we have implemented expense
reduction and restructuring plans in the past, including the
latest restructuring in January 2004, that have focused on cost
reductions and operating efficiencies, our operating expenses
are still higher than our gross margins. A large portion of our
expenses, including rent, and operating lease expenditures, is
fixed and difficult to reduce or change. Accordingly, if our
revenue does not meet our expectations, we may not be able to
adjust our expenses quickly enough to compensate for the
shortfall in revenue. In that event, our business, financial
condition and results of operations could be materially and
adversely affected.

As product ASPs rapidly decline, we need to
reduce the cost of our products through design and engineering
changes. We may not be successful in redesigning our products,
and, even if we are successful, our efforts may be delayed or
our redesigned products may contain significant errors and
product defects. In addition, any redesign may not result in
sufficient cost reductions to allow us to reduce significantly
the prices of our products or improve our gross margin.
Reductions in our product costs may require us to use
lower-priced components that are highly integrated in future
products and may require us to enter into high volume or
long-term purchase or manufacturing agreements. Volume purchase
or manufacturing agreements may not be available on acceptable
terms, if at all, and we could incur significant expenses
without related revenues if we cannot use the products or
services offered by such agreements. We have incurred
significant cancellation charges related to volume purchase and
manufacturing agreements in the past and may incur such charges
in the future.



| |                                                                                                                                                     
| | ----------------------------------------------------------------------------------------------------------------------------------------------------
| | Broadband services delivered by cable
    operators have not achieved widespread market acceptance, and
    other competing service providers exist.

Our success will depend upon the widespread
acceptance of broadband services delivered by cable television
operators. The markets for these services are growing, but are
not fully developed nor exploited. Additionally, these markets
may not grow as cable operators may elect not to increase
available bandwidth over which they can offer new services, such
as high-speed Internet access, High Definition Television
(HDTV), Video on Demand, and telephony. Cable operators may
elect not to provide any or all of these new

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services to their customers or may not
aggressively market these services to their customers. If cable
operators elect not to deploy such new services or if customers
elect not to subscribe to such services, it may affect our
ability to sell products to cable operators as their existing
equipment may meet their current infrastructure demands. We
depend on cable operators to provide new services and maintain
their infrastructure in such a manner that allows us to continue
to sell products to them.


Cable operators must also compete with other
service providers in the delivery of services to their
customers. RBOCs, CLECs, ILECs, satellite TV and other
broadband service providers are aggressively competing with the
cable industry to deliver broadband services via DSL or
satellite broadcast technologies. We cannot accurately predict
the future growth rate or the ultimate size of the market for
broadband services delivered via cable. The success of RBOCs,
CLECs, ILECs, satellite TV and other broadband service
providers may slow or hamper the continued acceptance of cable
operators in delivering broadband services, which in turn may
impact demand for our products by cable operators.



| |                                                                                         
| | ----------------------------------------------------------------------------------------
| | We need to develop additional distribution
    channels to market and sell our products.

The vast majority of our sales are to large cable
operators. However, we currently have limited access to smaller
or geographically diverse cable operators. Although we intend to
establish strategic relationships with leading distributors
worldwide to access these customers, we may not succeed in
establishing these relationships. Even if we do establish these
relationships, the distributors may not succeed in marketing our
products to their customers. Some of our competitors have
established, long-standing relationships with these cable
operators that may limit our and our distributors ability
to sell our products to those customers. Even if we were to sell
our products to those customers, it would likely not be based on
long-term commitments, and those customers would be able to
terminate their relationships with us at any time without
significant penalties.



| |                                                                                                                                                                                                                                              
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We depend on cable industry capital
    spending for a substantial portion of our revenue and any
    decrease or delay in capital spending by cable operators would
    negatively impact our operating results and financial
    condition.

Historically, almost all of our sales had been
derived from sales to cable operators, and we expect these sales
to constitute a significant portion of net sales for the
foreseeable future. Demand for our products will depend on the
magnitude and timing of capital spending by cable television
operators. These capital spending patterns are dependent on a
variety of factors including:



| |   |                                                                                                                            
| | - | ---------------------------------------------------------------------------------------------------------------------------
| |  | the availability of financing;                                                                                             
|
| |  | annual budget cycles, as well as the typical
    reduction in upgrade projects during the winter months;                   
|
| |  | the status of federal, local and foreign
    government regulation and deregulation of the telecommunications
    industry;
|
| |  | overall demand for broadband services and the
    acceptance of new data, video and voice services;                        
|
| |  | evolving industry standards and network
    architectures;                                                                 
|
| |  | competitive pressures (including the availability
    of alternative data transmission and access technologies);           
|
| |  | discretionary consumer spending patterns; and                                                                              
|
| |  | general economic conditions.                                                                                               

In recent years, the cable market has been
characterized by consolidation. For example, Comcast acquired
AT&T Broadband in 2003. Furthermore, cable operators may
undertake additional business combinations to expand their
business as evidenced by the recent unsolicited stock offering
by Comcast of the Disney Corporation. We cannot predict the
effect, if any, that such consolidations and business
combinations will have on overall capital spending patterns by
cable operators. The effect on our business of further industry
consolidations and combinations also is uncertain.

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The timing of deployment of our equipment can be
subject to a number of other risks, including the availability
of skilled engineering and technical personnel, the availability
of other equipment such as fiber optic cable, and the need for
local zoning and licensing approvals. We believe that changes in
our customers deployment plans have, and may in the future
delay, the receipt of new orders. Since the majority of our
sales have been to relatively few customers, a delay in
equipment deployment at any one customer has in the past, and
could in the future, have a material adverse effect on our sales
in a particular quarter.



| |                                                                         
| | ------------------------------------------------------------------------
| | We may fail to accurately forecast customer
    demand for our products.

The nature of the cable industry makes it
difficult for us to accurately forecast demand for our products.
Our inability to forecast accurately the actual demand for our
products may result in too much or too little supply of products
or an over/under capacity of manufacturing or testing resources
at any given point in time. The existence of any one or more of
these situations could have a negative impact on our business,
operating results or financial condition. We had purchase
obligations of approximately $54.4 million as of
December 31, 2003, primarily to purchase minimum quantities
of materials and components used to manufacture our products. We
may be obligated to fulfill these even if demand for our
products is lower than we anticipate.



| |                                                                                                                       
| | ----------------------------------------------------------------------------------------------------------------------
| | We may not be able to manage expenses and
    inventory risks associated with meeting the demand of our
    customers.

From time to time, we receive indications from
our customers as to their future plans and requirements to
ensure that we will be prepared to meet their demand for our
products. If actual orders differ materially from these
indications, our ability to manage inventory and expenses may be
affected. In addition, if we fail to meet customers supply
expectations, we may lose business from such customers. If we
enter into purchase commitments to acquire materials, or expend
resources to manufacture products and such products are not
purchased by our customers, our business and operating results
could suffer.



| |                                                  
| | -------------------------------------------------
| | We may have financial exposure to
    litigation.

We and/or our directors and officers are
defendants in a number of lawsuits, including securities
litigation lawsuits. As a result, we may have financial exposure
to litigation as a defendant and because we are obligated to
indemnify our officers and members of our board of directors for
certain actions taken by our officers and directors on our
behalf.

In order to limit financial exposure arising from
litigation and/or our obligation to indemnify our officers and
directors, we have historically purchased directors and officers
insurance (D&O Insurance). However, the availability of
D&O Insurance is becoming more difficult for companies to
attain as a number of insurance underwriters no longer offer
D&O Insurance and the remaining insurance underwriters
offering D&O Insurance have significantly increased the
premiums of such coverage. In recent years, we have experienced
a significant increase in the cost of our D&O Insurance,
although the cost of our D&O insurance decreased in fiscal
year 2003. There can be no assurance that D&O Insurance will
be available to us in the future or, if D&O Insurance is
available, it may be prohibitively expensive. Additionally, some
insurance underwriters who offered D&O Insurance in the past
have been placed into liquidation or may be, at some future
point, placed into liquidation. In October 2001, one of the
insurance underwriters from which we purchased D&O
Insurance, Reliance Insurance Co. (Reliance), was placed into
liquidation by the state of Pennsylvania. Reliance was the
underwriter for one excess layer of our D&O Insurance for
the period covering the claims made against us and our officers
in the pending securities litigation. Because Reliance is in
liquidation, we paid for the amount insured under the Reliance
policy, which was $2.5 million.



| |                                                                                                                                                        
| | -------------------------------------------------------------------------------------------------------------------------------------------------------
| | We are dependent on key third-party
    suppliers and any failure by them to deliver components could
    limit our ability to satisfy customer demand.

We manufacture all of our products using
components or subassemblies procured from third-party suppliers,
including semiconductors. Some of these components are available
from a sole source and others are available from limited
sources. A majority of our sales are from products containing
one or more components

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that are available only from sole source
suppliers. Additionally, some of our components are custom parts
that are produced to our specifications, and it may be difficult
to move the manufacturing of such components from one vendor to
another vendor.


Any interruption in the operations of our vendors
of sole source or custom product parts could adversely affect
our ability to meet our scheduled product deliveries to
customers. If we are unable to obtain a sufficient supply of
components, including semiconductors, from our current sources,
we could experience difficulties in obtaining alternative
sources or in altering product designs to use alternative
components. Resulting delays or reductions in product shipments
could damage customer relationships and expose us to potential
damages that may arise from our inability to supply our
customers with products. Further, a significant increase in the
price of one or more of these components, such as our
semiconductor components, could harm our gross margin or
operating results. Additionally, we attempt to limit this risk
by maintaining safety stocks of these components, subassemblies
and modules. As a result of this investment in inventories, we
have in the past and in the future may be subject to risk of
excess and obsolete inventories, which could harm our business.
In this regard, our gross margins and operating results could be
adversely affected by excess and obsolete inventory.



| |                                                                                                                 
| | ----------------------------------------------------------------------------------------------------------------
| | We may be unable to migrate to new
    semiconductor process technologies successfully or on a timely
    basis.

Our future success will depend in part upon our
ability to develop products that utilize new semiconductor
process technologies. These technologies change rapidly and
require us to spend significant amounts on research and
development. We continuously evaluate the benefits of
redesigning our integrated circuits using smaller geometry
process technologies to improve performance and reduce costs.
The transition of our products to integrated circuits with
increasingly smaller geometries will be important to our
competitive position. Other companies have experienced
difficulty in migrating to new semiconductor processes and,
consequently, have suffered reduced yields, delays in product
deliveries and increased expense levels. Moreover, we depend on
our relationship with our third-party manufacturers to migrate
to smaller geometry processes successfully.



| |                                                                                                                                           
| | ------------------------------------------------------------------------------------------------------------------------------------------
| | Our ability to directly control product
    delivery schedules and product quality is dependent on
    third-party contract manufacturers.

Most of our products are assembled and tested by
contract manufacturers using testing equipment that we provide.
As a result of our dependence on these contract manufacturers
for the assembly and testing of our products, we do not directly
control product delivery schedules or product quality. Any
product shortages or quality assurance problems could increase
the costs of manufacturing, assembling or testing our products.
In addition, as manufacturing volume increases, we will need to
procure and assemble additional testing equipment and provide it
to our contract manufacturers. The production and assembly of
testing equipment typically requires significant lead times. We
could experience significant delays in the shipment of our
products if we are unable to provide this testing equipment to
our contract manufacturers in a timely manner.



| |                                                                                                                     
| | --------------------------------------------------------------------------------------------------------------------
| | We are dependent upon international sales
    and there are many risks associated with international
    operations.

We expect sales to customers outside of the
United States to continue to represent a significant percentage
of our revenues for the foreseeable future. For the twelve
months ended December 31, 2003 and December 31, 2002,
approximately 44% and 68%, respectively, of our net revenues
were from customers outside of the U.S. International sales
are subject to a number of risks, including the following:



| |   |                                                                            
| | - | ---------------------------------------------------------------------------
| |  | changes in foreign government regulations and
    communications standards;
|
| |  | import and export license requirements, tariffs
    and taxes;             
|
| |  | trade barriers;                                                            
|
| |  | difficulty in protecting intellectual property;                            

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| |   |                                                                                                   
| | - | --------------------------------------------------------------------------------------------------
| |  | difficulty in collecting accounts receivable;                                                     
|
| |  | currency fluctuations;                                                                            
|
| |  | the burden of complying with a wide variety of
    foreign laws, treaties and technical standards;
|
| |  | difficulty in staffing and managing foreign
    operations; and                                   
|
| |  | political and economic instability.                                                               

If our customers are affected by currency
devaluations or general economic downturns their ability to
purchase our products could be reduced significantly. Payment
cycles for international customers typically are longer than
those for customers in North America.

While we generally invoice our foreign sales in
U.S. dollars, we invoice some of our sales in Europe in
Euros. Since we have also elected to take payment in Euros from
our customers in Europe and may elect to take payment in other
foreign currencies in the future, we are exposed to losses as
the result of foreign currency fluctuations. Additionally, we
have an Israel based operation whose expenses are denominated in
Israeli NIS. We currently do not engage in foreign currency
hedging transactions. We may in the future choose to limit our
exposure by the purchase of forward foreign exchange contracts
or through similar hedging strategies. No currency hedging
strategy can fully protect against exchange-related losses. In
addition, if the relative value of the U.S. dollar in
comparison to the currency of our foreign customers should
increase, the resulting effective price increase of our products
to those foreign customers could result in decreased sales.

Furthermore, foreign countries may decide to
prohibit, terminate or delay the construction of new cable
infrastructures for a variety of reasons. These reasons include
environmental issues, economic downturns and availability of
favorable pricing for other communications services or the
availability and cost of related equipment. Any such action by
foreign countries would reduce the market for our products.



| |                                                          
| | ---------------------------------------------------------
| | Our business may be affected by conditions
    in Israel.

We have significant operations in Israel. Our
operations in Israel consist primarily of research and
development, and to a lesser extent sales and manufacturing.
Revenues generated by our business in Israel were
$12.9 million and $8.3 million for the twelve months
ending December 31, 2003 and December 31, 2002,
respectively. Our research and development operations may be
significantly affected by conditions in Israel. Since the
establishment of the State of Israel in 1948, a number of armed
conflicts have taken place between Israel and its Arab neighbors
and a state of hostility, varying in degree and intensity, has
led to security and economic problems for Israel. Hostilities
within Israel have continued over the past year, which could
disrupt some of our operations. We could be adversely affected
by any major hostilities involving Israel. As a result of the
hostilities and unrest presently occurring within Israel, the
future of the peace efforts between Israel and its Arab
neighbors is uncertain. A number of our employees based in
Israel are currently obligated to perform annual military
reserve duty and are subject to being called to active duty at
any time under emergency circumstances. We cannot assess the
full impact of these requirements and the hostilities on our
workforce, business or operations if conditions should change,
and we cannot predict the effect of any expansion or reduction
of these obligations or the hostilities.



| |                                                           
| | ----------------------------------------------------------
| | We may be unable to provide adequate
    customer support.

Our ability to achieve our planned sales growth
and retain current and future customers will depend in part upon
the quality of our customer support operations. Our customers
generally require significant support and training with respect
to our products, particularly in the initial deployment and
implementation stages. Spikes in demand of our support services
may cause us to be unable to serve our customers. We may not
have adequate personnel to provide the levels of support that
our customers may require during initial product deployment or
on an ongoing basis especially during peak periods. Our
inability to provide sufficient support to our customers could
delay or prevent the successful deployment of our products. In
addition, our failure to provide adequate support could harm our
reputation and relationships with our customers and could
prevent us from selling product to existing customers or gaining
new customers.

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| |                                                                                          
| | -----------------------------------------------------------------------------------------
| | Our industry is highly competitive with
    many larger and more established competitors.

The market for our products is extremely
competitive and is characterized by rapid technological change.
Our direct competitors include Cisco Systems, ADC, Arris,
BigBand Networks, Motorola, Thomson Consumer Electronics (which
markets products under the brand name RCA), Scientific-Atlanta
and Toshiba. Additionally, we face competition from early stage
companies with access to significant financial backing that
improve existing technologies or develop new technologies. The
principal competitive factors in our market include the
following:



| |   |                                                           
| | - | ----------------------------------------------------------
| |  | product performance, features and reliability;            
|
| |  | price;                                                    
|
| |  | size and stability of operations;                         
|
| |  | breadth of product line;                                  
|
| |  | sales and distribution capabilities;                      
|
| |  | technical support and service;                            
|
| |  | relationships with providers of service
    providers; and
|
| |  | compliance with industry standards.                       

Some of these factors are outside of our control.
Conditions in the market could change rapidly and significantly
as a result of technological advancements. The development and
market acceptance of alternative technologies could decrease the
demand for our products or render them obsolete. Our competitors
may introduce products that are less costly, provide superior
performance or achieve greater market acceptance than our
products.

Many of our current and potential competitors
have greater financial, technical, marketing, distribution,
customer support and other resources, as well as better name
recognition and access to customers than we do. The widespread
adoption of DOCSIS and other industry standards has and is
likely to continue to cause increased price competition. We
believe that the adoption of these standards have resulted in
and are likely to continue to result in lower ASPs for our
products. Any increased price competition or reduction in sales
of our products, particularly our higher margin head-end
products, has resulted and will continue to result in decreased
revenue and downward pressure on our gross margin. These
competitive pressures have and are likely to continue to
adversely impact our business.



| |                                       
| | --------------------------------------
| | We are dependent on key
    personnel.

Due to the specialized nature of our business, we
are highly dependent on the continued service of, and on the
ability to attract and retain, qualified engineering, sales,
marketing and senior management personnel. The competition for
some of these personnel is intense. The loss of any of these
individuals may harm our business. In addition, if we are unable
to hire qualified personnel as needed, we may be unable to
adequately manage and grow our business.

Highly skilled employees with the education and
training that we require, especially employees with significant
experience and expertise in video, data networking and radio
frequency design, are in high demand. We may be unable to
continue to attract and retain qualified personnel necessary for
the development of our business. We do not have key person
insurance coverage for the loss of any of our employees. Any
officer or employee can terminate his or her relationship with
us at any time. Our employees are not bound by non-competition
agreements with us.

Furthermore, in 2003, we hired a new Chief
Financial Officer and a new Chief Operating Officer. Although
the addition of these two executive officers has offered us an
opportunity to expand our management team with persons that can
assist in implementing our new direction, turnover in personnel
and the recruitment and retention of a new executive staff may
create a number of transitional challenges for us.

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| |                                                                                                        
| | -------------------------------------------------------------------------------------------------------
| | Our business is subject to the risks of
    product returns, product liability and product
    defects.

Products like ours are very complex and can
frequently contain undetected errors or failures, especially
when first introduced or when new versions are released. Despite
testing, errors may occur. The occurrence of errors could result
in product returns and other losses to us and/or our customers.
This occurrence could result in the loss of or delay in market
acceptance of our products. We have limitation of liability
provisions in our standard terms and conditions of sale.
However, these terms and conditions may not be effective as a
result of federal, state or local laws or ordinances or
unfavorable judicial decisions in the United States or other
countries. The sale and support of our products entails the risk
of product liability claims. In addition, any failure by our
products to properly perform could result in claims against us
by our customers. We maintain insurance to protect against
certain claims associated with the use of our products, but our
insurance coverage may not adequately cover any claim asserted
against us. In addition, even claims that ultimately are
unsuccessful could result in our expenditure of funds in
litigation and divert managements time and other resources.



| |                                                                                        
| | ---------------------------------------------------------------------------------------
| | We may be unable to adequately protect or
    enforce our intellectual property rights.

We rely on a combination of patent, trade secret,
copyright and trademark laws and contractual restrictions to
establish and protect proprietary rights in our products. Even
though we seek to establish and protect proprietary rights in
our products, there are risks. We cannot be assured that any
patent, trademark, copyright or other intellectual property
rights owned by us will not be invalidated, circumvented or
challenged, that such intellectual property rights will provide
competitive advantages to us or that any of our pending or
future patent applications will be issued with the scope of the
claims sought by us, if at all. We cannot be assured that others
will not develop technologies that are similar or superior to
our technology, duplicate our technology or design around the
patents that we own. In addition, effective patent, copyright
and trade secret protection may be unavailable or limited in
certain foreign countries in which we do business or may do
business in the future.

Our pending patent applications may not be
granted. Even if they are granted, the claims covered by any
patent may be reduced from those included in our applications.
Any patent might be subject to challenge in court and, whether
or not challenged, might not be broad enough to prevent third
parties from developing equivalent technologies or products
without a license from us.

We believe that the future success of our
business will depend on our ability to translate the
technological expertise and innovation of our employees into new
and enhanced products. We have entered into confidentiality and
invention assignment agreements with our employees, and we enter
into non-disclosure agreements with many of our suppliers,
distributors and appropriate customers so as to limit access to
and disclosure of our proprietary information. These contractual
arrangements, as well as statutory protections, may not prove
sufficient to prevent misappropriation of our trade secrets or
technology or deter independent third-party development of
similar technologies. In addition, the laws of some foreign
countries may not protect our intellectual property rights to
the same extent as do the laws of the United States. We may, in
the future, take legal action to enforce our patents and other
intellectual property rights, to protect our trade secrets, to
determine the validity and scope of the proprietary rights of
others, or to defend against claims of infringement or
invalidity. Such litigation could result in substantial costs
and diversion of resources and could negatively effect our
business, operating results, financial position and liquidity.

CableLabs DOCSIS 2.0 specification includes two
modulation techniques, S-CDMA and A-TDMA. In connection with the
development of the DOCSIS 2.0 specification by CableLabs, we
entered into an agreement with CableLabs, on a royalty-free
basis, whereby we licensed to CableLabs many of our intellectual
property rights to the extent that such rights may be asserted
against a party desiring to design, manufacture or sell
DOCSIS-based products, including DOCSIS 2.0-based products. This
license agreement grants to CableLabs the right to sublicense
our intellectual property, including our intellectual property
rights in our S-CDMA patents, to manufacturers that compete with
us in the marketplace for DOCSIS based products.

We pursue the registration of our trademarks in
the United States and have applications pending to register
several of our trademarks throughout the world. However, the
laws of certain foreign countries might

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not protect our products or intellectual property
rights to the same extent as the laws of the United States.
Effective trademark, copyright, trade secret and patent
protection may not be available in every country in which our
products may be manufactured, marketed or sold.




| |                                                                                                                                                                                                                                                                                     
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Third party claims of infringement or other
    claims against us could adversely affect our ability to market
    our products, require us to redesign our products or seek
    licenses from third parties, and seriously harm our operating
    results and disrupt our business.

As is typical in the industry in which we
operate, we have been and may from time to time be notified of
claims that we may be infringing patents or intellectual
property rights owned by third parties. We also believe that
companies may be increasingly subject to infringement claims as
distressed companies and individuals attempt to generate cash by
enforcing their patent portfolio against a wide range of
products. We have consulted with our patent counsel on the
claims we have received and are in the process of reviewing the
allegations made by such third parties. We cannot assure you
that, if the issues were to be submitted to a court, such court
will not find that our products infringe the third party
patents, nor that such third parties will not continue to allege
infringement. If we are found to have infringed such third
partys patents, we could be subject to substantial damages
and/or an injunction preventing us from conducting our business.
Additionally, we cannot assure you that other third parties will
not assert infringement claims against us in the future. Any
such claim, whether meritorious or not, could be time-consuming,
result in costly litigation, cause product shipment delays or
require us to enter into royalty or licensing agreements. Such
royalty or licensing agreements may not be available on terms
acceptable to us, if at all, which could have a material adverse
effect upon our business, operating results and financial
condition. Our failure to obtain a license for key intellectual
property rights from a third party for technology used by us
could cause us to incur substantial liabilities and to suspend
the manufacturing of products utilizing the technology.
Alternatively, we could be required to expend significant
resources to develop non-infringing technology. We cannot assure
you that we would be successful in developing non-infringing
technology.



| |                                                              
| | -------------------------------------------------------------
| | Our business and our customers are subject
    to regulation.

Our business and customers are subject to varying
degrees of regulation by regulatory bodies in the United States
and foreign countries. Although these regulations have not
materially restricted our operations to date or the operations
of our customers, future regulations applicable to our business
or customers could be adopted. The adoption of future
regulations may adversely affect our customers, our ability to
sell our products and therefore our operating results.



| |                                                                     
| | --------------------------------------------------------------------
| | Our products are subject to safety
    approvals and certifications.

In the United States, our products are required
to meet certain safety requirements. For example, we are
required to have our products certified by Underwriters
Laboratory in order to meet federal requirements relating to
electrical appliances to be used inside the home. Outside the
United States, our products are subject to the regulatory
requirements of each country in which the products are
manufactured or sold. These requirements are likely to vary
widely. We may be unable to obtain on a timely basis or at all
the regulatory approvals that may be required for the
manufacture, marketing and sale of our products.



| |                                                                                                                     
| | --------------------------------------------------------------------------------------------------------------------
| | We are vulnerable to earthquakes,
    disruptions to our power supply, labor issues and other
    unexpected events.

Our corporate headquarters, as well as the
majority of our research and development activities and some
manufacturing operations are located in California, an area
known for seismic activity. In addition, the operations of some
of our key suppliers are also located in this area and in other
areas known for seismic activity, such as Taiwan. An earthquake,
or other significant natural disaster, could result in an
interruption in our business or the operations of one or more of
our key suppliers. Our California operations may also be subject
to disruptions in power supply, such as occurred in 2001. Our
business may also be impacted by labor issues related to our
operations and/or those of our suppliers, service providers, or
customers. Such an

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interruption could harm our operating results. We
may not carry sufficient business interruption insurance to
compensate for any losses that we may sustain as a result of any
natural disasters or other unexpected events.




| |                                                                                                               
| | --------------------------------------------------------------------------------------------------------------
| | Our indebtedness could adversely affect our
    financial condition; we may incur substantially more
    debt.

As of December 31, 2003, we had
approximately $68.4 million of long-term obligations of
which $65.1 million is long-term debt associated with our
Notes. This level of indebtedness may adversely affect our
stockholders by:



| |   |                                                                                                                                                                                                                                                                                                                                      
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | making it more difficult for us to satisfy our
    obligations with respect to our indebtedness;                                                                                                                                                                                                                                     
|
| |  | increasing our vulnerability to general adverse
    economic and industry conditions;                                                                                                                                                                                                                                                
|
| |  | limiting our ability to obtain additional
    financing;                                                                                                                                                                                                                                                                             
|
| |  | requiring the dedication of a substantial portion
    of our cash flow from operations to the payment of principal of,
    and interest on, our indebtedness, thereby reducing the
    availability of our cash flow to fund our growth strategy,
    working capital, capital expenditures and other general
    corporate purposes;
|
| |  | limiting our flexibility in planning for, or
    reacting to, changes in our business and the industry; and                                                                                                                                                                                                                          
|
| |  | placing us at a competitive disadvantage relative
    to our competitors with less debt.                                                                                                                                                                                                                                             

We may incur substantial additional debt in the
future. The terms of our outstanding debt do not fully prohibit
us from doing so. If new debt is added to our current levels,
the related risks described above could intensify.



| |                                                                                     
| | ------------------------------------------------------------------------------------
| | We may not be able to raise additional
    funds to continue operating our business.

Our main source of liquidity continues to be our
unrestricted cash on hand. In addition and as a result of our
history of operating losses, we expect to continue to use our
unrestricted cash to fund operating losses in the future. Our
cash and cash equivalents decreased to $30.2 million at
December 31, 2003, from $117.0 million at
December 31, 2002. If our operating losses are more severe
than expected or continue longer than expected, we may find it
necessary to seek other sources of financing to support our
capital needs and provide available funds for working capital.
Given the capital markets, there are few sources of financing
available to us. Commercial bank financing may not be available
to us on acceptable terms. Accordingly, any plan to raise
additional capital, if available to us, would likely involve an
equity-based or equity-linked financing, such as the issuance of
convertible debt, common stock or preferred stock, which would
be dilutive to our stockholders. If we are unable to procure
additional working capital, as necessary, we may be unable to
continue operations.

On October 7, 2003, we filed a registration
statement on Form S-3 with the Securities and Exchange
Commission. This shelf registration statement, which was
declared effective by the SEC on November 4, 2003, will
allow us to issue various types of securities, including common
stock, preferred stock, debt securities and warrants to purchase
common stock, from time to time up to an aggregate of
$125.0 million, subject to market conditions and our
capital needs. On November 7, 2003, we filed a prospectus
supplement with reference to our intention to offer
10,800,000 shares of common stock, which would result in
gross proceeds of $75.0 million. On November 14, 2003,
we withdrew our previously announced public offering of
10,800,000 shares of common stock under the shelf
registration statement.



| |                                                                                                                           
| | --------------------------------------------------------------------------------------------------------------------------
| | Threatened terrorist attacks may negatively
    impact all aspects of our operations, revenues, costs and stock
    price.

The events of September 11, 2001, as well as
future events occurring in response to or in connection with
them, including, without limitation, future terrorist attacks
against United States targets, or military or trade disruptions
impacting our domestic or foreign suppliers of components
required for the manufacturing of our products, may cause delays
or losses of customer orders. More generally, any of these
events could cause consumer confidence and spending to decrease
or result in increased volatility in the United States and

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worldwide financial markets. They also could
result in economic recession in the United States or abroad. Any
of these occurrences could have a significant impact on our
operating results, revenues and costs.




| |                                                                                                                                                                                                                                   
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our restructuring efforts could result in
    the erosion of employee morale, legal actions against us and
    management distractions, and could impair our ability to respond
    rapidly to growth opportunities in the future.

As a result of the significant economic downturn
and the related uncertainties in the technology sector, we have
implemented a number of restructuring plans, including the most
recent in the first quarter of 2004, which has resulted in
personnel reduction. These reductions could result in an erosion
of morale, and affect the focus and productivity of our
remaining employees, including those directly responsible for
revenue generation, which in turn may affect our revenue in the
future. Additionally, employees directly affected by the
reductions may seek future employment with our business
partners, customers or competitors. Although all employees are
required to sign a proprietary information agreement with us at
the time of hire, there can be no assurances that the
confidential nature of our proprietary information will be
maintained in the course of such future employment. Our
employees are not bound by non-competition agreements with us.
Additionally, we may face wrongful termination, discrimination,
or other claims from employees affected by the reduction related
to their employment and termination. We could incur substantial
costs in defending ourselves or our employees against such
claims, regardless of the merits of such actions. Furthermore,
such matters could divert the attention of our employees,
including management, away from our operations, harm
productivity, harm our reputation and increase our expenses. We
cannot assure you that our restructuring efforts will be
successful, and we may need to take additional restructuring
efforts, including additional personnel reduction, in the future.



| |                                                                                             
| | --------------------------------------------------------------------------------------------
| | We may dispose of existing product lines,
    which may adversely impact our future results.

On an ongoing basis, we evaluate our various
product offerings in order to determine whether any should be
discontinued or, to the extent possible, divested. Moreover, the
worldwide downturn in the telecommunications industry led us to
reassess our business strategy, which in turn caused us to
discontinue investment in certain product lines. Specifically,
we have reduced our investment in the telecom and satellite
spaces. Beginning in July 2003, we entered into two transactions
to further decrease our telecom business. In July 2003, we
discontinued our Mainsail line of products and entered into an
agreement with a third party to supply warranty services for the
Mainsail products. In July 2003, we entered into an agreement
with Verilink Corporation (Verilink) to sell certain telecom
assets associated with the Miniplex product line to Verilink.
Additionally, Verilink agreed to purchase related inventory from
us and assume all telecom warranty obligations with the
exception of $2.4 million, which will continue to be our
responsibility.

We cannot assure you that we correctly forecasted
the right product lines to discontinue or that our decision to
discontinue various investments and product lines is prudent if
market conditions change. In addition, we cannot assure you that
the discontinuance of various product lines will reduce our
operating expenses. Furthermore, future plans to discontinue
existing product lines entail various risks, including the risks
that we will not be able to find a buyer for a product line or
the purchase price obtained will not be equal to the book value
of the assets for the product line.



| |                                                                                                             
| | ------------------------------------------------------------------------------------------------------------
| | We need to develop and introduce new and
    enhanced products in a timely manner to remain
    competitive.

The markets in which we operate are characterized
by rapidly changing technologies, evolving industry standards,
frequent new product introductions and relatively short product
life. The pursuit of necessary technological advances and the
development of new products require substantial time and
expense. For example, we made ten acquisitions during the period
between 1999 and 2000. Due to various economic conditions, none
of the products from our acquired businesses have achieved the
level of market acceptance that was forecasted at the time of
their acquisitions. Additionally, certain product groups have
not achieved the level of technological development needed to be
marketable or to expand the market. As a result, we recorded an
aggregate of approximately $576.8 million related to
impairment charges and write-down of in-

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process research and development related to the
acquired technologies, both of which negatively impacted our
operating results.


To compete successfully in the markets in which
we operate, we must design, develop, manufacture and sell new or
enhanced products that provide increasingly higher levels of
performance and reliability. However, we may not be able to
successfully develop or introduce these products, if our
products are not (i) cost effective, (ii) brought to
market in a timely manner, (iii) in accordance with
evolving industry standards and architecture or (iv) fail
to achieve market acceptance. There is no assurance that the
technologies we are currently developing or intend to develop
will achieve feasibility, or that even if we are successful, the
developed product will be accepted by the market. We may not be
able to recover the costs of existing and future product
developments and our failure to do so may materially and
adversely impact our business, financial condition and results
of operations.



| |                                                                                                                                               
| | ----------------------------------------------------------------------------------------------------------------------------------------------
| | We are exposed to the credit risk of our
    customers and to credit exposures in weakened markets, which
    could result in material losses.

Most of our sales are on an open credit basis,
with payment terms of 30 to 60 days typically in the United
States, and because of local customs or conditions, longer in
some markets outside the United States. Beyond our open credit
arrangements, we have also experienced a request for customer
financing and facilitation of leasing arrangements, which we
have not provided to date and do not expect to provide in the
future. We expect demand for enhanced open credit terms, for
example, longer payment terms, customer financing and leasing
arrangements to continue and believe that such arrangements are
a competitive factor in obtaining business. Our decision not to
provide these types of financing arrangements may adversely
affect our ability to sell product, and therefore, our revenue,
operations and business.

Because of the current condition in the global
economy, our exposure to credit risks relating to sales on an
open-credit basis has increased. Although we monitor and attempt
to mitigate the associated risk, there can be no assurance that
our efforts will be effective in reducing credit risk.
Additionally, there have been significant insolvencies and
bankruptcies among our customers, which have and may continue to
cause us to incur economic and financial losses. There can be no
assurance that additional losses would not be incurred and that
such losses would not be material. Although these losses have
generally not been material to date, future losses, if incurred,
could harm our business and have a material adverse effect on
our operating results and financial condition.



| |                                                                                                                                                                    
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We have and we may seek to expand our
    business through acquisitions; acquisitions could disrupt our
    business operations and harm our operating
    results.

In order to expand our business, we may make
strategic acquisitions of other companies or certain assets. We
plan to continue to evaluate opportunities for strategic
acquisitions from time to time, and may make an acquisition at
some future point. However, the current volatility in the stock
market and the current price of our common stock may adversely
affect our ability to make such acquisitions. Any acquisition
that we make involves substantial risks, including the following:



| |   |                                                                                                                                                                      
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | difficulties in integrating the operations,
    technologies, products and personnel of an acquired company;                                                         
|
| |  | diversion of managements attention from
    normal daily operations of the business;                                                                                
|
| |  | potential difficulties in completing projects
    associated with in-process research and development;                                                               
|
| |  | difficulties in entering markets in which we have
    no or limited direct prior experience and where competitors in
    such markets have stronger market positions;
|
| |  | initial dependence on unfamiliar supply chains or
    relatively small supply partners;                                                                              
|
| |  | insufficient revenues to offset increased
    expenses associated with acquisitions; and                                                                             
|
| |  | the potential loss of key employees of the
    acquired companies.                                                                                                   

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Acquisitions may also cause us to:



| |   |                                                                                                                                                    
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------
| |  | issue common stock that would dilute our current
    stockholders percentage ownership;                                                           
|
| |  | assume liabilities;                                                                                                                                
|
| |  | record goodwill and non-amortizable intangible
    assets that will be subject to impairment testing and potential
    periodic impairment charges;
|
| |  | incur amortization expenses related to certain
    intangible assets;                                                                              
|
| |  | incur large and immediate write-offs; or                                                                                                           
|
| |  | become subject to litigation.                                                                                                                      

Mergers and acquisitions of high-technology
companies are inherently risky, and no assurance can be given
that our future acquisitions will be successful and will not
materially adversely affect our business, operating results or
financial condition. Failure to manage and successfully
integrate acquisitions we make could harm our business and
operating results in a material way. Even when an acquired
company has already developed and marketed products, there can
be no assurance that product enhancements will be made in a
timely fashion or that all pre-acquisition due diligence will
have identified all possible issues that might arise with
respect to such products.

We made ten acquisitions during the period
between 1999 and 2000. Due to various economic conditions, none
of the products from our acquired businesses have achieved the
level of market acceptance that was forecasted at the time of
their acquisitions. Additionally, certain product groups have
not achieved the level of technological development needed to be
marketable or to expand the market. We recorded impairment
losses of approximately $4.0 million and
$572.8 million of intangible assets related to these
acquisitions in December 31, 2002 and 2001. As of
December 31, 2003, no intangible assets from these
acquisitions remained.



| |                                                                                                                                                                           
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Various export licensing requirements could
    materially and adversely affect our business or require us to
    significantly modify our current business
    practices.

Various government export regulations may apply
to the encryption or other features of our products. We may have
to make certain filings with the government in order to obtain
permission to export certain of our products. In the past, we
may have inadvertently failed to file certain export
applications and notices, and we may have to make certain
filings and request permission to continue exportation of any
affected products without interruption while these applications
are pending. If we do have to make such filings, we cannot
assure you that we will obtain permission to continue exporting
the affected products or that we will obtain any required export
approvals now or in the future. If we do not receive the
required export approvals, we may be unable to ship those
products to certain customers located outside of the United
States. In addition, we may be subject to fines or other
penalties due to the failure to file certain export applications
and notices.



| |                                                                                                                                                                                                                      
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | New laws and regulations affecting
    corporate governance may impede our ability to retain and
    attract board members and executive officers, and increase the
    costs associated with being a public company.

On July 30, 2002, President George W. Bush
signed into law the Sarbanes-Oxley Act of 2002. The new act is
designed to enhance corporate responsibility through new
corporate governance and disclosure obligations, increase
auditor independence, and tougher penalties for securities
fraud. In addition, the Securities and Exchange Commission and
Nasdaq have adopted rules in furtherance of the act and are
considering adopting others. This act and the related new rules
and regulations will likely have the effect of increasing the
complexity and cost of our companys corporate governance
and the time our executive officers spend on such issues, and
may increase the risk of personal liability for our board
members, chief executive officer, chief financial officer and
other executives involved in our companys corporate
governance process. As a result, it may become more difficult
for us to attract and retain board members and executive
officers involved in the corporate governance process. In
addition, we have experienced, and will continue to

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experience, increased costs associated with being
a public company, including additional professional and
independent auditor fees.




| |                                                                              
| | -----------------------------------------------------------------------------
| | Our stock price has been and is likely to
    continue to be highly volatile.

The trading price of our common stock has been
and is likely to continue to be highly volatile. Our stock price
could be subject to extreme fluctuations in response to a
variety of factors, including the following:



| |   |                                                                                                                                  
| | - | ---------------------------------------------------------------------------------------------------------------------------------
| |  | actual or anticipated variations in quarterly
    operating results;                                                             
|
| |  | announcements of technological innovations;                                                                                      
|
| |  | new products or services offered by us or our
    competitors;                                                                   
|
| |  | changes in financial estimates by securities
    analysts;                                                                       
|
| |  | conditions or trends in the broadband services
    industry;                                                                     
|
| |  | changes in the economic performance and/or market
    valuations of Internet, online service or broadband service
    industries;
|
| |  | our announcement of significant acquisitions,
    strategic partnerships, joint ventures or capital commitments;                 
|
| |  | adoption of industry standards and the inclusion
    or compatibility of our technology with such standards;                     
|
| |  | adverse or unfavorable publicity regarding us or
    our products;                                                               
|
| |  | additions or departures of key personnel;                                                                                        
|
| |  | sales of common stock; and                                                                                                       
|
| |  | other events or factors that may be beyond our
    control.                                                                      

In addition, the stock markets in general, and
the Nasdaq National Market and the stock price of broadband
services and technology companies in particular, have
experienced extreme price and volume volatility. This volatility
and decline has affected many companies irrespective of or
disproportionately to the operating performance of these
companies. Additionally, industry factors may materially
adversely affect the market price of our common stock,
regardless of our actual operating performance.



| |                                                                                                                                                                                                                          
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We have adopted a stockholder rights plan,
    which, together with provisions in our charter documents and
    Delaware law, may delay or prevent an acquisition of us, which
    could decrease the value of our stock.

We adopted a stockholder rights plan pursuant to
which we distributed one right for each outstanding share of
common stock held by stockholders of record as of
February 20, 2001. Because the rights may substantially
dilute the stock ownership of a person or group attempting a
take-over of us, even if such a change in control is beneficial
to our stockholders, without the approval of our board of
directors, the plan could make it more difficult for a third
party to acquire us, or a significant percentage of our
outstanding capital stock, without first negotiating with our
board of directors. Additionally, provisions of our Certificate
of Incorporation and our Bylaws could make it more difficult for
a third party to acquire control of us in a transaction not
approved by our Board of Directors, and we are subject to the
anti-takeover provisions of Section 203 of the Delaware
General Corporation Law, which could also have the effect of
delaying or preventing our acquisition by a third party.



| |                                                                                  
| | ---------------------------------------------------------------------------------
| | Future sales of shares by existing
    stockholders could affect our stock price.

The shares held by our stockholders, including
our executive officers and directors, may be sold in the public
market at any time and from time to time subject in certain
cases to volume limitations under Rule 144 of the
Securities Act of 1933 and various vesting agreements. If any of
these stockholders sell substantial amounts of our common stock
in the public market, the market price of our common stock could
decline. In

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addition, shares subject to outstanding options
and shares reserved for future issuance under our stock option
and purchase plans will continue to become eligible for sale in
the public market to the extent permitted by the provisions of
the various vesting agreements and the securities rules and
regulations applicable to these shares.







|         |                                       
|-------- | --------------------------------------
|Item 7A. | Market Risk Disclosure
    Information

Interest Rate Risk.Our exposure to market risk for changes in interest rates
relates primarily to our investment portfolio. The primary
objective of our investment activities is to preserve principal
while maximizing yields without significantly increasing risk.
This is accomplished by investing in widely diversified
short-term investments, consisting primarily of investment grade
securities, substantially all of which mature within the next
twenty-four months. A hypothetical 50 basis point increase
in interest rates would result in an approximate $217,000
decline (less than 1%) in the fair value of our
available-for-sale securities.

Foreign Currency
Risk.A substantial majority of our
revenue, expense and capital purchasing activity are transacted
in U.S. dollars. However, we do enter into transactions
from Belgium, United Kingdom, Hong Kong, Canada, and Israel. A
hypothetical adverse change of 10% in exchange rates would
result in a decline in income before taxes of approximately
$0.1 million. All of the potential changes noted above are
based on sensitivity analyses performed on our financial
positions at December 31, 2003. Actual results may differ
materially.

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|        |                                                
|------- | -----------------------------------------------
|Item 8. | Financial Statements and Supplementary
    Data

TERAYON COMMUNICATION
SYSTEMS, INC.

INDEX TO CONSOLIDATED FINANCIAL
STATEMENTS

|                                                      |  |      |    | 
|----------------------------------------------------- |  | ---- | -- | 
|                                                      |  | Page
|                                                      |  |     
|Report of Ernst & Young
    LLP, Independent Auditors |  |      | 54 | 
|Consolidated Balance Sheets                           |  |      | 55 | 
|Consolidated Statements of Operations                 |  |      | 56 | 
|Consolidated Statements of Stockholders
    Equity   |  |      | 57 | 
|Consolidated Statements of Cash Flows                 |  |      | 58 | 
|Notes to Consolidated Financial Statements            |  |      | 59 | 

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REPORT OF ERNST & YOUNG
LLP, INDEPENDENT AUDITORS

The Board of Directors and Stockholders

Terayon Communication Systems, Inc.


We have audited the accompanying consolidated
balance sheets of Terayon Communication Systems, Inc. as of
December 31, 2003 and 2002, and the related consolidated
statements of operations, stockholders equity, and cash
flows for each of the three years in the period ended
December 31, 2003. Our audits also included the financial
statement schedule listed in the index at Item 15(a)(2).
These financial statements and schedule are the responsibility
of the Companys management. Our responsibility is to
express an opinion on these financial statements and schedule
based on our audits.

We conducted our audits in accordance with
auditing standards generally accepted in the United States.
Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits
provide a reasonable basis for our opinion.

In our opinion, the consolidated financial
statements referred to above present fairly, in all material
respects, the consolidated financial position of Terayon
Communication Systems, Inc. at December 31, 2003 and
2002, and the consolidated results of its operations and its
cash flows for each of the three years in the period ended
December 31, 2003, in conformity with accounting principles
generally accepted in the United States. Also, in our opinion,
the related financial statement schedule, when considered in
relation to the basic financial statements taken as a whole,
presents fairly, in all material respects, the information set
forth therein.

As discussed in Note 1 to the consolidated
financial statements, effective January 1, 2002, the
Company adopted Statement of Financial Accounting Standards
No. 142, Goodwill and Other Intangible Assets
and Statement of Financial Accounting Standards No. 145,
Rescission of FASB Statements No. 4, 44 and 64,
Amendment of FASB Statement No. 13, and Technical
Corrections (SFAS No. 145).



| |                      
| | ---------------------
| | /s/ ERNST & YOUNG LLP

Palo Alto, California

January 23, 2004


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TERAYON COMMUNICATION
SYSTEMS, INC.

CONSOLIDATED BALANCE SHEETS

|                                               |                                                                                                    |                                                             |                           |           |    |         |        |           |    |         | 
|---------------------------------------------- | -------------------------------------------------------------------------------------------------- | ----------------------------------------------------------- | ------------------------- | --------- | -- | ------- | ------ | --------- | -- | ------- | 
|                                               |                                                                                                    |                                                            
|                                               |                                                                                                    | December 31,                                               
|                                               |                                                                                                    |                                                            
|                                               |                                                                                                    | 2003                                                        |                           | 2002     
|                                               |                                                                                                    |                                                             |                           |          
|                                               |                                                                                                    |                                                            
|                                               |                                                                                                    | (In thousands,                                             
|                                               |                                                                                                    | except share data)                                         
|ASSETS                                        
|Current assets:                                |                                                                                                    |                                                             |                           |           |    |         |        |          
|                                               | Cash and cash equivalents                                                                          |                                                             | $                         | 30,188    |    |         | $      | 117,079   |   
|                                               | Short-term investments                                                                             |                                                             |                           | 108,452   |    |         |        | 89,424    |   
|                                               | Accounts receivable, less allowance for doubtful
    accounts of $3,591 in 2003 and $3,519 in 2002 |                                                             |                           | 29,199    |    |         |        | 16,355    |   
|                                               | Accounts receivable from related parties                                                           |                                                             |                           | 600       |    |         |        | 842       |   
|                                               | Other current receivables                                                                          |                                                             |                           | 3,662     |    |         |        | 2,597     |   
|                                               | Inventory                                                                                          |                                                             |                           | 16,364    |    |         |        | 8,257     |   
|                                               | Other current assets                                                                               |                                                             |                           | 2,883     |    |         |        | 8,263     |   
|                                               |                                                                                                    |                                                             |                           |           |    |         |        |          
|                                               |                                                                                                    |                                                             | Total current assets      |           |    | 191,348 |        |           |    | 242,817 | 
|Property and equipment, net                    |                                                                                                    |                                                             | 11,871                    |           |    |         | 17,906 |          
|Restricted cash                                |                                                                                                    |                                                             | 9,212                     |           |    |         | 9,945  |          
|Prepaid expenses and other assets, net         |                                                                                                    |                                                             | 2,809                     |           |    |         | 5,042  |          
|                                               |                                                                                                    |                                                             |                           |           |    |         |        |          
|                                               |                                                                                                    |                                                             | Total assets              |           | $  | 215,240 |        |           | $  | 275,710 | 
|                                               |                                                                                                    |                                                             |                           |           |    |         |        |          
|                                              
|LIABILITIES AND STOCKHOLDERS
    EQUITY      
|                                              
|Current liabilities:                           |                                                                                                    |                                                             |                           |           |    |         |        |          
|                                               | Accounts payable                                                                                   |                                                             | $                         | 26,049    |    |         | $      | 23,920    |   
|                                               | Accrued payroll and related expenses                                                               |                                                             |                           | 6,537     |    |         |        | 6,227     |   
|                                               | Deferred revenues                                                                                  |                                                             |                           | 3,423     |    |         |        | 497       |   
|                                               | Warranty reserves                                                                                  |                                                             |                           | 5,509     |    |         |        | 8,607     |   
|                                               | Accrued restructuring charges                                                                      |                                                             |                           | 4,500     |    |         |        | 6,754     |   
|                                               | Accrued vendor cancellation charges                                                                |                                                             |                           | 2,869     |    |         |        | 13,865    |   
|                                               | Other accrued liabilities                                                                          |                                                             |                           | 5,036     |    |         |        | 8,609     |   
|                                               | Interest payable and current portion of long-term
    debt                                         |                                                             |                           | 1,358     |    |         |        | 1,355     |   
|                                               | Current portion of capital lease obligations                                                       |                                                             |                           | 124       |    |         |        | 154       |   
|                                               |                                                                                                    |                                                             |                           |           |    |         |        |          
|                                               |                                                                                                    |                                                             | Total current liabilities |           |    | 55,405  |        |           |    | 69,988  | 
|Long-term obligations                          |                                                                                                    |                                                             | 3,366                     |           |    |         | 3,421  |          
|Long-term portion of capital lease obligations |                                                                                                    |                                                             |                          |           |    |         | 78     |          
|Convertible subordinated notes                 |                                                                                                    |                                                             | 65,081                    |           |    |         | 65,081 |          
|Commitments and contingencies                  |                                                                                                    |                                                             |                           |           |    |         |        |          
|Stockholders equity:                          |                                                                                                    |                                                             |                           |           |    |         |        |          
|                                               | Preferred stock, $0.001 par value:                                                                 |                                                             |                           |           |    |         |        |           |   
|                                               |                                                                                                    | Authorized shares  5,000,000                               |                           |           |    |         |        |           |    |        
|                                               |                                                                                                    | Issued and outstanding shares  none in
    2003 and 2002   |                           |           |   |         |        |           |   |        
|                                               | Common stock, $0.001 par value:                                                                    |                                                             |                           |           |    |         |        |           |   
|                                               |                                                                                                    | Authorized shares  200,000,000                             |                           |           |    |         |        |           |    |        
|                                               |                                                                                                    | Issued  75,031,097 in 2003 and
    73,240,054 in 2002      |                           |           |    |         |        |           |    |        
|                                               |                                                                                                    | Outstanding  74,875,088 in 2003 and
    73,084,045 in 2002 |                           |           | 75 |         |        |           | 73 |        
|                                               | Additional paid in capital                                                                         |                                                             |                           | 1,082,036 |    |         |        | 1,078,144 |   
|                                               | Accumulated deficit                                                                                |                                                             |                           | (987,560  | )  |         |        | (937,207  | ) 
|                                               | Deferred compensation                                                                              |                                                             |                           | (22       | )  |         |        | (25       | ) 
|                                               | Treasury stock, at cost; 156,009 shares in
    2003 and 2002                                       |                                                             |                           | (773      | )  |         |        | (773      | ) 
|                                               | Accumulated other comprehensive loss                                                               |                                                             |                           | (2,368    | )  |         |        | (3,070    | ) 
|                                               |                                                                                                    |                                                             |                           |           |    |         |        |          
|                                               | Total stockholders equity                                                                         |                                                             |                           | 91,388    |    |         |        | 137,142   |   
|                                               |                                                                                                    |                                                             |                           |           |    |         |        |          
|                                               | Total liabilities and stockholders equity                                                         |                                                             | $                         | 215,240   |    |         | $      | 275,710   |   
|                                               |                                                                                                    |                                                             |                           |           |    |         |        |          

See accompanying notes.

55



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##### Table of Contents



TERAYON COMMUNICATION
SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF
OPERATIONS

|                                                                  |                                          |                                       |         |         |         |      |         |         |         |   |          |         |         | 
|----------------------------------------------------------------- | ---------------------------------------- | ------------------------------------- | ------- | ------- | ------- | ---- | ------- | ------- | ------- | - | -------- | ------- | ------- | 
|                                                                  |                                          |                                      
|                                                                  |                                          | Years Ended December 31,             
|                                                                  |                                          |                                      
|                                                                  |                                          | 2003                                  |         | 2002    |         | 2001
|                                                                  |                                          |                                       |         |         |         |     
|                                                                  |                                          |                                      
|                                                                  |                                          | (In thousands, except per share data)
|Revenues:                                                         |                                          |                                       |         |         |         |      |         |         |         |   |          |        
|                                                                  | Product revenues                         |                                       | $       | 128,791 |         |      | $       | 120,306 |         |   | $        | 227,036 |        
|                                                                  | Related party product revenues           |                                       |         | 4,694   |         |      |         | 9,097   |         |   |          | 52,445  |        
|                                                                  |                                          |                                       |         |         |         |      |         |         |         |   |          |        
|                                                                  |                                          | Total revenues                        |         |         | 133,485 |      |         |         | 129,403 |   |          |         | 279,481 | 
|Cost of goods sold:                                               |                                          |                                       |         |         |         |      |         |         |         |   |          |        
|                                                                  | Cost of product revenues                 |                                       |         | 99,261  |         |      |         | 92,497  |         |   |          | 229,936 |        
|                                                                  | Cost of related party product revenues   |                                       |         | 1,773   |         |      |         | 8,452   |         |   |          | 33,181  |        
|                                                                  |                                          |                                       |         |         |         |      |         |         |         |   |          |        
|                                                                  |                                          | Total cost of goods sold              |         |         | 101,034 |      |         |         | 100,949 |   |          |         | 263,117 | 
|                                                                  |                                          |                                       |         |         |         |      |         |         |         |   |          |        
|Gross profit                                                      |                                          |                                       | 32,451  |         |         |      | 28,454  |         |         |   | 16,364   |        
|Operating expenses:                                               |                                          |                                       |         |         |         |      |         |         |         |   |          |        
|                                                                  | Research and development                 |                                       |         | 42,839  |         |      |         | 58,696  |         |   |          | 79,927  |        
|                                                                  | Sales and marketing                      |                                       |         | 26,781  |         |      |         | 35,704  |         |   |          | 55,701  |        
|                                                                  | General and administrative               |                                       |         | 12,127  |         |      |         | 14,715  |         |   |          | 31,309  |        
|                                                                  | Goodwill amortization                    |                                       |         |        |         |      |         |        |         |   |          | 25,410  |        
|                                                                  | Restructuring costs and asset write-offs |                                       |         | 2,803   |         |      |         | 8,922   |         |   |          | 587,149 |        
|                                                                  |                                          |                                       |         |         |         |      |         |         |         |   |          |        
|                                                                  |                                          | Total operating expenses              |         |         | 84,550  |      |         |         | 118,037 |   |          |         | 779,496 | 
|                                                                  |                                          |                                       |         |         |         |      |         |         |         |   |          |        
|Loss from operations                                              |                                          |                                       | (52,099 | )       |         |      | (89,583 | )       |         |   | (763,132 | )      
|Interest income                                                   |                                          |                                       | 2,917   |         |         |      | 6,838   |         |         |   | 18,132   |        
|Interest expense                                                  |                                          |                                       | (3,279  | )       |         |      | (6,174  | )       |         |   | (15,224  | )      
|Other income (expense)                                            |                                          |                                       | 2,424   |         |         |      | (4,145  | )       |         |   | (2,864   | )      
|Gain on early retirement of debt                                  |                                          |                                       |        |         |         |      | 49,089  |         |         |   | 185,327  |        
|                                                                  |                                          |                                       |         |         |         |      |         |         |         |   |          |        
|Loss before tax (expense) benefit                                 |                                          |                                       | (50,037 | )       |         |      | (43,975 | )       |         |   | (577,761 | )      
|Income tax (expense) benefit                                      |                                          |                                       | (316    | )       |         |      | (238    | )       |         |   | 13,915   |        
|                                                                  |                                          |                                       |         |         |         |      |         |         |         |   |          |        
|Net loss                                                          |                                          | $                                     | (50,353 | )       |         | $    | (44,213 | )       |         | $ | (563,846 | )      
|                                                                  |                                          |                                       |         |         |         |      |         |         |         |   |          |        
|Basic and diluted net loss per share                              |                                          | $                                     | (0.68   | )       |         | $    | (0.61   | )       |         | $ | (8.25    | )      
|                                                                  |                                          |                                       |         |         |         |      |         |         |         |   |          |        
|Shares used in computing basic and diluted net
    loss per share |                                          |                                       | 74,212  |         |         |      | 72,803  |         |         |   | 68,331   |        
|                                                                  |                                          |                                       |         |         |         |      |         |         |         |   |          |        

See accompanying notes.

56



---



##### Table of Contents



TERAYON COMMUNICATION
SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS
EQUITY

|                                                                                     |                                   |                                      |            |            |  |             |    |          |  |               |           |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   |         |          |          |  
|------------------------------------------------------------------------------------ | --------------------------------- | ------------------------------------ | ---------- | ---------- |  | ----------- | -- | -------- |  | ------------- | --------- | ------------- |  | ------ | -------- | -------------- | - | ------ | ------ | ------ |  | - | -- | - |  | - | ------ | ------ | - |  | ------- |  |  | - | ---- | - |  | - | ------- | -------- | -------- | -
|                                                                                     |                                   |                                      |            |            |  |             |    |          |  |               |           |               |  |        |          |               
|                                                                                     |                                   |                                      |            |            |  |             |    |          |  |               |           |               |  |        |          | Treasury Stock
|                                                                                     |                                   |                                      |            |            |  |             |    |          |  |               |           | Accumulated   |  |       
|                                                                                     |                                   | Common Stock                         |            | Additional |  |             |    |          |  | Stockholders |           | Other         |  |        |          | Total         
|                                                                                     |                                   |                                      |            | Paid-in    |  | Accumulated |    | Deferred |  | Notes         |           | Comprehensive |  |        |          | Stockholders 
|                                                                                     |                                   | Shares                               |            | Amount     |  | Capital     |    | Deficit  |  | Compensation  |           | Receivable    |  | Income |          | Shares         |   | Amount |        | Equity
|                                                                                     |                                   |                                      |            |            |  |             |    |          |  |               |           |               |  |        |          |                |   |        |        |       
|                                                                                     |                                   |                                     
|                                                                                     |                                   | (In thousands, except share amounts)
|Balance at December 31, 2000                                                         |                                   |                                      | 67,266,986 |            |  | $           | 68 |          |  | $             | 1,037,964 |               |  | $      | (329,148 | )              |   | $      | (6,788 | )      |  | $ | (3 | ) |  | $ | 661    |        |   |  | 34,722  |  |  | $ | (73  | ) |  | $ | 702,681 |         
|Exercise of options for cash to purchase common
    stock                            |                                   |                                      | 2,507,582  |            |  |             | 4  |          |  |               | 12,494    |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   | 12,498  |         
|Repurchase of common stock                                                           |                                   |                                      | (93,117    | )          |  |             |    |          |  |               |           |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  | 93,117  |  |  |   | (695 | ) |  |   | (695    | )       
|Issuance of options                                                                  |                                   |                                      |            |            |  |             |    |          |  |               | 719       |               |  |        |          |                |   |        | (719   | )      |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   |        |         
|Amortization of deferred compensation                                                |                                   |                                      |            |            |  |             |    |          |  |               |           |               |  |        |          |                |   |        | 5,815  |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   | 5,815   |         
|Adjustments to deferred compensation due to
    employee terminations                |                                   |                                      |            |            |  |             |    |          |  |               | (1,234    | )             |  |        |          |                |   |        | 1,234  |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   |        |         
|Issuance of restricted common stock for services
    provided                        |                                   |                                      | 275,250    |            |  |             |    |          |  |               | 1,237     |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   | 1,237   |         
|Issuance of common stock for Employee Stock
    Purchase Plan                        |                                   |                                      | 381,428    |            |  |             |    |          |  |               | 1,966     |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   | 1,966   |         
|Issuance of warrants to purchase common stock                                        |                                   |                                      |            |            |  |             |    |          |  |               | 1,187     |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   | 1,187   |         
|Issuance of common stock for tender offer                                            |                                   |                                      | 141,442    |            |  |             |    |          |  |               | 2,001     |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   | 2,001   |         
|Issuance of common stock for retirement of debt                                      |                                   |                                      | 1,464,359  |            |  |             | 1  |          |  |               | 17,869    |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   | 17,870  |         
|Cash proceeds from payment on stockholders notes
    receivable                      |                                   |                                      |            |            |  |             |    |          |  |               |           |               |  |        |          |                |   |        |        |        |  |   | 3  |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   | 3       |         
|Comprehensive income:                                                                |                                   |                                      |            |            |  |             |    |          |  |               |           |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   |         |         
|Increase to unrealized gain on short-term
    investments                            |                                   |                                      |            |            |  |             |    |          |  |               |           |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   | 208    |        |   |  |         |  |  |   |      |   |  |   | 208     |         
|                                                                                     | Cumulative translation adjustment |                                      |            |            |  |             |    |          |  |               |           |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        | (621   | ) |  |         |  |  |   |      |   |  |   |         | (621     | )       
|                                                                                     | Net loss                          |                                      |            |            |  |             |    |          |  |               |           |               |  |        |          | (563,846       | ) |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   |         | (563,846 | )       
|                                                                                     |                                   |                                      |            |            |  |             |    |          |  |               |           |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   |         |         
|                                                                                     |                                   | Comprehensive loss                   |            |            |  |             |    |          |  |               |           |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   |         |          | (564,259 | )
|                                                                                     |                                   |                                      |            |            |  |             |    |          |  |               |           |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   |         |         
|Balance at December 31, 2001                                                         |                                   |                                      | 71,943,930 |            |  |             | 73 |          |  |               | 1,074,203 |               |  |        | (892,994 | )              |   |        | (458   | )      |  |   |   |   |  |   | 248    |        |   |  | 127,839 |  |  |   | (768 | ) |  |   | 180,304 |         
|                                                                                     |                                   |                                      |            |            |  |             |    |          |  |               |           |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   |         |         
|Balance at December 31, 2001(brought forward)                                        |                                   |                                      | 71,943,930 |            |  |             | 73 |          |  |               | 1,074,203 |               |  |        | (892,994 | )              |   |        | (458   | )      |  |   |   |   |  |   | 248    |        |   |  | 127,839 |  |  |   | (768 | ) |  |   | 180,304 |         
|Exercise of options for cash to purchase common
    stock                            |                                   |                                      | 422,073    |            |  |             |    |          |  |               | 1,721     |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   | 1,721   |         
|Repurchase or return of common stock                                                 |                                   |                                      | (1,068     | )          |  |             |    |          |  |               |           |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  | 28,170  |  |  |   | (5   | ) |  |   | (5      | )       
|Return of escrow shares from Telegate acquisition                                    |                                   |                                      | (25,077    | )          |  |             |    |          |  |               |           |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   |         |         
|Issuance of options to non-employees                                                 |                                   |                                      |            |            |  |             |    |          |  |               | 38        |               |  |        |          |                |   |        | (38    | )      |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   |        |         
|Amortization of deferred compensation                                                |                                   |                                      |            |            |  |             |    |          |  |               | 1         |               |  |        |          |                |   |        | 471    |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   | 472     |         
|Issuance of restricted common stock from stock
    option plan for services provided |                                   |                                      | 205,001    |            |  |             |    |          |  |               | 290       |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   | 290     |         
|Acceleration of vesting of employee stock options
    and stock protection payment   |                                   |                                      |            |            |  |             |    |          |  |               | 1         |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   | 1       |         
|Issuance of common stock for Employee Stock
    Purchase Plan                        |                                   |                                      | 539,186    |            |  |             |    |          |  |               | 1,864     |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   | 1,864   |         
|Issuance of warrant to purchase common stock                                         |                                   |                                      |            |            |  |             |    |          |  |               | 26        |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   | 26      |         
|Comprehensive income:                                                                |                                   |                                      |            |            |  |             |    |          |  |               |           |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   |         |         
|Increase to unrealized gain on short-term
    investments                            |                                   |                                      |            |            |  |             |    |          |  |               |           |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   | (519   | )      |   |  |         |  |  |   |      |   |  |   | (519    | )       
|                                                                                     | Cumulative translation adjustment |                                      |            |            |  |             |    |          |  |               |           |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        | (2,799 | ) |  |         |  |  |   |      |   |  |   |         | (2,799   | )       
|                                                                                     | Net loss                          |                                      |            |            |  |             |    |          |  |               |           |               |  |        |          | (44,213        | ) |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   |         | (44,213  | )       
|                                                                                     |                                   |                                      |            |            |  |             |    |          |  |               |           |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   |         |         
|                                                                                     |                                   | Comprehensive loss                   |            |            |  |             |    |          |  |               |           |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   |         |          | (47,531  | )
|                                                                                     |                                   |                                      |            |            |  |             |    |          |  |               |           |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   |         |         
|Balance at December 31, 2002                                                         |                                   |                                      | 73,084,045 |            |  |             | 73 |          |  |               | 1,078,144 |               |  |        | (937,207 | )              |   |        | (25    | )      |  |   |   |   |  |   | (3,070 | )      |   |  | 156,009 |  |  |   | (773 | ) |  |   | 137,142 |         
|                                                                                     |                                   |                                      |            |            |  |             |    |          |  |               |           |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   |         |         
|Balance at December 31, 2002 (brought
    forward)                                   |                                   |                                      | 73,084,045 |            |  |             | 73 |          |  |               | 1,078,144 |               |  |        | (937,207 | )              |   |        | (25    | )      |  |   |   |   |  |   | (3,070 | )      |   |  | 156,009 |  |  |   | (773 | ) |  |   | 137,142 |         
|Exercise of options for cash to purchase common
    stock                            |                                   |                                      | 579,233    |            |  |             | 1  |          |  |               | 2,533     |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   | 2,534   |         
|Re-valuation of options to non-employees                                             |                                   |                                      |            |            |  |             |    |          |  |               | 50        |               |  |        |          |                |   |        | (50    | )      |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   |         |         
|Amortization of deferred compensation                                                |                                   |                                      |            |            |  |             |    |          |  |               |           |               |  |        |          |                |   |        | 53     |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   | 53      |         
|Issuance of restricted common stock from stock
    option plan for services provided |                                   |                                      | 9,600      |            |  |             |    |          |  |               | 70        |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   | 70      |         
|Issuance of common stock for Employee Stock
    Purchase Plan                        |                                   |                                      | 1,202,210  |            |  |             | 1  |          |  |               | 1,194     |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   | 1,195   |         
|Issuance of warrant to purchase common stock                                         |                                   |                                      |            |            |  |             |    |          |  |               | 45        |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   | 45      |         
|Comprehensive income:                                                                |                                   |                                      |            |            |  |             |    |          |  |               |           |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   |         |         
|Increase to unrealized gain on short-term
    investments                            |                                   |                                      |            |            |  |             |    |          |  |               |           |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   | (470   | )      |   |  |         |  |  |   |      |   |  |   | (470    | )       
|                                                                                     | Cumulative translation adjustment |                                      |            |            |  |             |    |          |  |               |           |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        | 1,172  |   |  |         |  |  |   |      |   |  |   |         | 1,172    |         
|                                                                                     | Net loss                          |                                      |            |            |  |             |    |          |  |               |           |               |  |        |          | (50,353        | ) |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   |         | (50,353  | )       
|                                                                                     |                                   |                                      |            |            |  |             |    |          |  |               |           |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   |         |         
|                                                                                     |                                   | Comprehensive loss                   |            |            |  |             |    |          |  |               |           |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   |         |          | (49,651  | )
|                                                                                     |                                   |                                      |            |            |  |             |    |          |  |               |           |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   |         |         
|Balance at December 31, 2003                                                         |                                   |                                      | 74,875,088 |            |  | $           | 75 |          |  | $             | 1,082,036 |               |  | $      | (987,560 | )              |   | $      | (22    | )      |  | $ |   |   |  | $ | (2,368 | )      |   |  | 156,009 |  |  | $ | (773 | ) |  | $ | 91,388  |         
|                                                                                     |                                   |                                      |            |            |  |             |    |          |  |               |           |               |  |        |          |                |   |        |        |        |  |   |    |   |  |   |        |        |   |  |         |  |  |   |      |   |  |   |         |         

See accompanying notes.

57



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##### Table of Contents



TERAYON COMMUNICATION
SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF CASH
FLOWS

|                                                                                |                                                         |                                                         |          |         |       |      |          |         |         |   |          |          |          |  
|------------------------------------------------------------------------------- | ------------------------------------------------------- | ------------------------------------------------------- | -------- | ------- | ----- | ---- | -------- | ------- | ------- | - | -------- | -------- | -------- | -
|                                                                                |                                                         |                                                        
|                                                                                |                                                         | Years Ended December 31,                               
|                                                                                |                                                         |                                                        
|                                                                                |                                                         | 2003                                                    |          | 2002    |       | 2001
|                                                                                |                                                         |                                                         |          |         |       |     
|                                                                                |                                                         |                                                        
|                                                                                |                                                         | (In thousands)                                         
|Operating activities:                                                           |                                                         |                                                         |          |         |       |      |          |         |         |   |          |         
|Net loss                                                                        |                                                         | $                                                       | (50,353  | )       |       | $    | (44,213  | )       |         | $ | (563,846 | )       
|Adjustments to reconcile net loss to net cash
    used in operating activities: |                                                         |                                                         |          |         |       |      |          |         |         |   |          |         
|                                                                                | Settlement of Net Services account receivable           |                                                         |          |        |       |      |          | 1,118   |         |   |          |         |         
|                                                                                | Depreciation                                            |                                                         |          | 9,369   |       |      |          | 11,572  |         |   |          | 15,728   |         
|                                                                                | Write-off and amortization of intangible assets         |                                                         |          |        |       |      |          | 3,972   |         |   |          | 619,157  |         
|                                                                                | Amortization related to stock options                   |                                                         |          | 53      |       |      |          | 476     |         |   |          | 5,815    |         
|                                                                                | Gain on early retirement of debt                        |                                                         |          |        |       |      |          | (49,089 | )       |   |          | (185,327 | )       
|                                                                                | Lower of cost or market inventory provision             |                                                         |          | 4,086   |       |      |          | 6,109   |         |   |          |         |         
|                                                                                | Impairment of investment                                |                                                         |          |        |       |      |          | 4,500   |         |   |          |         |         
|                                                                                | Write-off of fixed assets                               |                                                         |          | 497     |       |      |          | 2,987   |         |   |          | 1,600    |         
|                                                                                | Compensation expense for issuance of common stock       |                                                         |          | 70      |       |      |          |        |         |   |          | 3,238    |         
|                                                                                | Value of common and preferred stock warrants
    issued |                                                         |          | 45      |       |      |          | 26      |         |   |          | 505      |         
|Changes in operating assets and liabilities:                                    |                                                         |                                                         |          |         |       |      |          |         |         |   |          |         
|                                                                                | Accounts receivable                                     |                                                         |          | (12,844 | )     |      |          | 26,211  |         |   |          | (5,614   | )       
|                                                                                | Accounts receivable from related parties                |                                                         |          | 242     |       |      |          | 3,164   |         |   |          | 13,448   |         
|                                                                                | Inventory                                               |                                                         |          | (12,193 | )     |      |          | 4,065   |         |   |          | 71,109   |         
|                                                                                | Other assets                                            |                                                         |          | 7,281   |       |      |          | 443     |         |   |          | 16,606   |         
|                                                                                | Accounts payable                                        |                                                         |          | 2,129   |       |      |          | (18,901 | )       |   |          | (81,173  | )       
|                                                                                | Accrued payroll and related expenses                    |                                                         |          | 310     |       |      |          | (3,214  | )       |   |          | (3,664   | )       
|                                                                                | Deferred revenues                                       |                                                         |          | 2,926   |       |      |          | (3,672  | )       |   |          | (829     | )       
|                                                                                | Warranty reserves                                       |                                                         |          | (3,098  | )     |      |          | 239     |         |   |          | 2,443    |         
|                                                                                | Accrued restructuring charges                           |                                                         |          | (2,254  | )     |      |          | (1,443  | )       |   |          | 8,197    |         
|                                                                                | Accrued vendor cancellation charges                     |                                                         |          | (12,335 | )     |      |          | (3,426  | )       |   |          | (1,709   | )       
|                                                                                | Other accrued liabilities                               |                                                         |          | (2,331  | )     |      |          | (6,725  | )       |   |          | 8,000    |         
|                                                                                | Deferred taxes                                          |                                                         |          |        |       |      |          |        |         |   |          | (18,565  | )       
|                                                                                | Interest payable                                        |                                                         |          | 3       |       |      |          | (1,918  | )       |   |          | (7,580   | )       
|                                                                                |                                                         |                                                         |          |         |       |      |          |         |         |   |          |         
|Net cash used in operating activities                                           |                                                         |                                                         | (68,397  | )       |       |      | (67,719  | )       |         |   | (102,461 | )       
|                                                                                |                                                         |                                                         |          |         |       |      |          |         |         |   |          |         
|Investing activities:                                                           |                                                         |                                                         |          |         |       |      |          |         |         |   |          |         
|Purchases of short-term investments                                             |                                                         |                                                         | (243,652 | )       |       |      | (288,186 | )       |         |   | (402,653 | )       
|Proceeds from sales and maturities of short-term
    investments                |                                                         |                                                         | 224,154  |         |       |      | 434,346  |         |         |   | 384,689  |         
|Purchases of property and equipment                                             |                                                         |                                                         | (3,831   | )       |       |      | (7,186   | )       |         |   | (9,074   | )       
|                                                                                |                                                         |                                                         |          |         |       |      |          |         |         |   |          |         
|Net cash (used in) provided by investing
    activities                         |                                                         |                                                         | (23,329  | )       |       |      | 138,974  |         |         |   | (27,038  | )       
|                                                                                |                                                         |                                                         |          |         |       |      |          |         |         |   |          |         
|Financing activities:                                                           |                                                         |                                                         |          |         |       |      |          |         |         |   |          |         
|Principal payments on capital leases                                            |                                                         |                                                         | (66      | )       |       |      | (127     | )       |         |   | (130     | )       
|Principal payments on debt                                                      |                                                         |                                                         |         |         |       |      |         |         |         |   | (16,835  | )       
|Payments on repurchase of common stock                                          |                                                         |                                                         |         |         |       |      | (5       | )       |         |   | (695     | )       
|Principal payments on stockholder notes receivable                              |                                                         |                                                         |         |         |       |      |         |         |         |   | 3        |         
|Repurchase of convertible subordinated notes                                    |                                                         |                                                         |         |         |       |      | (57,627  | )       |         |   | (113,428 | )       
|Proceeds from issuance of common stock                                          |                                                         |                                                         | 3,729    |         |       |      | 3,872    |         |         |   | 14,464   |         
|                                                                                |                                                         |                                                         |          |         |       |      |          |         |         |   |          |         
|                                                                                |                                                         | Net cash provided by (used in) financing
    activities |          |         | 3,663 |      |          |         | (53,887 | ) |          |          | (116,621 | )
|Effect of exchange rate changes                                                 |                                                         |                                                         | 1,172    |         |       |      | (563     | )       |         |   | (620     | )       
|                                                                                |                                                         |                                                         |          |         |       |      |          |         |         |   |          |         
|Net (decrease) increase in cash and cash
    equivalents                        |                                                         |                                                         | (86,891  | )       |       |      | 16,805   |         |         |   | (246,741 | )       
|Cash and cash equivalents at beginning of year                                  |                                                         |                                                         | 117,079  |         |       |      | 100,274  |         |         |   | 347,015  |         
|Cash and cash equivalents at end of year                                        |                                                         | $                                                       | 30,188   |         |       | $    | 117,079  |         |         | $ | 100,274  |         
|                                                                                |                                                         |                                                         |          |         |       |      |          |         |         |   |          |         
|Supplemental disclosures of cash flow information:                              |                                                         |                                                         |          |         |       |      |          |         |         |   |          |         
|Cash paid for income taxes                                                      |                                                         | $                                                       | 194      |         |       | $    | 714      |         |         | $ | 31       |         
|Cash paid for interest                                                          |                                                         | $                                                       | 3,262    |         |       | $    | 8,387    |         |         | $ | 20,810   |         
|Supplemental noncash investing and financing
    activities:                    |                                                         |                                                         |          |         |       |      |          |         |         |   |          |         
|Common shares issued for settlement of
    convertible debt                     |                                                         | $                                                       |         |         |       | $    |         |         |         | $ | 17,900   |         
|Deferred compensation relating to common stock
    issued to non-employees      |                                                         | $                                                       | 53       |         |       | $    | 38       |         |         | $ | 684      |         
|Reduction in deferred compensation due to
    termination of employees          |                                                         | $                                                       |         |         |       | $    |         |         |         | $ | 1,234    |         
|Issuance of warrants in connection with purchase
    of TrueChat                |                                                         | $                                                       |         |         |       | $    |         |         |         | $ | 682      |         

See accompanying notes.

58



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##### Table of Contents



TERAYON COMMUNICATION
SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS



|   |                                                                
|-- | ---------------------------------------------------------------
|1. | Organization and Summary of Significant
    Accounting Policies



| |                        
| | -----------------------
| | Description of Business

Terayon Communication Systems, Inc.
(Company) was incorporated under the laws of the State of
California on January 20, 1993. In June 1998, the Company
reincorporated in the State of Delaware.

The Company develops, markets and sells equipment
to broadband service providers who use the Companys
products to deliver broadband voice, video and data services to
residential and business subscribers.



| |                       
| | ----------------------
| | Basis of Consolidation

The consolidated financial statements include the
accounts of the Company and its wholly owned and majority-owned
subsidiaries. All intercompany balances and transactions have
been eliminated.



| |                 
| | ----------------
| | Use of Estimates

The preparation of the consolidated financial
statements in conformity with generally accepted accounting
principles in the United States requires management to make
estimates and assumptions that affect the amounts reported in
the consolidated financial statements and accompanying notes.
Estimates are based on historical experience, input from sources
outside of the Company, and other relevant facts and
circumstances. Actual results could differ from those estimates.
Areas that are particularly significant include the
Companys revenue recognition policy, the valuation of its
accounts receivable and inventory reserves, the assessment of
recoverability and the measurement of impairment of fixed
assets, and the recognition of restructuring reserves.



| |                  
| | -----------------
| | Accounting Change

Effective the beginning of 2002, the Company
adopted Statement of Financial Accounting Standards
(SFAS) No. 141, Business Combinations, and
SFAS No. 142, Goodwill and Other Intangible
Assets. As required by SFAS No. 142, the Company
discontinued amortizing the remaining balances of goodwill as of
the beginning of fiscal 2002. See Note 5.

In April 2002, the Company adopted
SFAS No. 145, Rescission of FASB Statements
No. 4, 44 and 64, Amendment of FASB Statement No. 13,
and Technical Corrections (SFAS No. 145).
SFAS No. 145 allows only those gains and losses on the
extinguishment of debt that meet the criteria of extraordinary
items to be treated as such in the consolidated financial
statements. Accordingly, the Company is now reporting the gain
from retirement of Convertible Notes in operating results. As a
result of adopting SFAS No. 145, the Company
reclassified the $185.3 million previously recorded in 2001
as extraordinary gain as a component of operating results.



| |                             
| | ----------------------------
| | Foreign Currency Translation

The Company records the effect of foreign
currency translation in accordance with SFAS No. 52,
Foreign Currency Translation. For operations outside
the United States that prepare financial statements in
currencies other than the U.S. dollar, results of
operations and cash flows are translated at average exchange
rates during the period, and assets and liabilities are
translated at end-of-period exchange rates. Translation
adjustments are included as a separate component of accumulated
other comprehensive loss in stockholders equity. For the
three years ended December 31, 2003, translation gains and
losses were not significant. Realized foreign currency
transaction gains and losses are included in results of
operations as incurred, and have not been significant to the
Companys operating results in any year presented.

59



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##### Table of Contents



TERAYON COMMUNICATION
SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |                                                                      
| | ---------------------------------------------------------------------
| | Concentrations of Credit Risk, Customers,
    Suppliers, and Products

The Company performs ongoing credit evaluations
of its customers and generally requires no collateral. Credit
losses have historically been within managements
expectations. The Company maintains a reserve for potentially
uncollectible accounts receivable based on an assessment of
collectibility. The Company assesses collectibility based on a
number of factors, including past history, the number of days an
amount is past due (based on invoice due date), changes in
credit ratings of customers, current events and circumstances
regarding the business of the Companys clients
customers and other factors that the Company believes are
relevant. Charges for uncollectible accounts are included as a
component of net revenue in the consolidated statement of
operations. At December 31, 2003 and 2002, the reserve for
potentially uncollectible accounts was $3.6 million and
$3.5 million, respectively. A relatively small number of
customers account for a significant percentage of the
Companys revenues and accounts receivable. The Company
expects the sale of its products to a limited number of
customers and resellers to continue to account for a high
percentage of revenues.

The Company relies on single source suppliers of
materials and labor for the significant majority of its product
inventory. Should the Companys current suppliers not
produce and deliver inventory for the Company to sell on a
timely basis, operating results may be adversely impacted.

The Company places its cash and cash equivalents
in several financial institutions and limits the amount of
credit exposure through diversification and by investing in only
high-grade government and commercial issuers.

The Company invests its excess cash in debt
instruments of governmental agencies, and corporations with
credit ratings of AA/AA- or better or A1/P1 or better,
respectively. The Company has established guidelines relative to
diversification and maturities that attempt to maintain safety
and liquidity. The Company has not experienced any significant
losses on its cash equivalents or short-term investments.



| |                    
| | -------------------
| | Revenue Recognition

The Company sells its products directly to
broadband service providers, and to a lesser extent resellers.
Revenues related to product sales are recognized in accordance
with SEC Staff Accounting Bulletin No. 101, Revenue
Recognition in Financial Statements (SAB 101), as
amended, when: (1) persuasive evidence that an arrangement
exists, (2) delivery has occurred or services have been
rendered, (3) the sellers price to the buyer is fixed
or determinable, and (4) collectibility is reasonably
assured. A provision is made for estimated product returns as
product shipments are made. The Companys existing
agreements typically do not grant return rights beyond those
provided by the warranty.

Determination of criteria (4) is based on
managements judgments regarding the collectibility of the
selling price. Should there be changes to managements
judgments, revenue recognized for any reporting period could be
adversely affected.

Contracts and customer purchase orders are
generally used to determine the existence of an arrangement.
Shipping documents and customer acceptance, when applicable, are
used to verify delivery. The Company assesses whether the fee is
fixed or determinable based on the payment terms associated with
the transaction and whether the sales price is subject to
adjustment. The Company assesses collectibility based primarily
on the creditworthiness of the customer as determined by credit
checks and analysis, as well as the customers payment
history.

Revenue arrangements with resellers are generally
recognized when product is shipped to the resellers as the
Company generally does not grant return rights beyond those
provided by the warranty.

60



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##### Table of Contents



TERAYON COMMUNICATION
SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |                                      
| | -------------------------------------
| | Research and Development
    Expenses

Research and development expenses are charged to
expense as incurred.



| |                            
| | ---------------------------
| | Shipping and Handling Costs

Costs related to shipping and handling are
included in cost of goods sold for all periods presented.



| |                     
| | --------------------
| | Advertising Expenses

The Company accounts for advertising costs as
expense in the period in which they are incurred. Advertising
expense for the years ended December 31, 2003, 2002 and
2001 were $0.1 million, $0.4 million, and
$2.3 million, respectively.

In December 2001, the Company entered into
co-marketing arrangements with Shaw Communications, Inc.
(Shaw) and Rogers Communications, Inc. (Rogers). The
Company paid $7.5 million to Shaw and $0.9 million to
Rogers, and recorded these amounts as other current assets. In
July 2002, the Company began amortizing these prepaid assets and
charging them against revenues in accordance with Emerging
Issues Task Force (EITF) 01-09, Accounting for
Consideration given by a Vendor to a Customer or Reseller in
Connection with the Purchase or Promotion of the Vendors
Products. Amounts charged against revenues in 2003 and
2002 totaled approximately $5.6 million and
$2.8 million, respectively. The Company charged the
amortization of these assets against revenues through the six
quarters ended in December 31, 2003, the term of the
related arrangement, at the rate of $1.4 million per
quarter. See Note 13.



| |                   
| | ------------------
| | Net Loss Per Share

Historical basic and diluted net loss per share
was computed using the weighted average number of common stock
outstanding. Options, warrants, restricted stock, preferred
stock, and convertible debt were not included in the computation
of historical diluted net loss per share because the effect
would be antidilutive.

Shares used in the calculation of basic and
diluted net loss per share are as follows (in thousands, except
per share data):

|                                                                  |  |                          |         |      |  |      |         |   |  |   |          |  
|----------------------------------------------------------------- |  | ------------------------ | ------- | ---- |  | ---- | ------- | - |  | - | -------- | -
|                                                                  |  |                         
|                                                                  |  | Years Ended December 31,
|                                                                  |  |                         
|                                                                  |  | 2003                     |         | 2002 |  | 2001
|                                                                  |  |                          |         |      |  |     
|Net loss                                                          |  | $                        | (50,353 | )    |  | $    | (44,213 | ) |  | $ | (563,846 | )
|                                                                  |  |                          |         |      |  |      |         |   |  |   |          |  
|Shares used in computing basic and diluted net
    loss per share |  |                          | 74,212  |      |  |      | 72,803  |   |  |   | 68,331   |  
|                                                                  |  |                          |         |      |  |      |         |   |  |   |          |  
|Basic and diluted net loss per share                              |  | $                        | (0.68   | )    |  | $    | (0.61   | ) |  | $ | (8.25    | )
|                                                                  |  |                          |         |      |  |      |         |   |  |   |          |  

Options to purchase 17,463,959, 14,635,025, and
20,007,686 shares of common stock were outstanding at
December 31, 2003, 2002 and 2001, respectively, and
warrants to purchase 200,000, 2,325,593, and
2,408,300 shares of common stock were outstanding at
December 31, 2003, 2002 and 2001, respectively, but were
not included in the computation of diluted net loss per share,
since the effect is antidilutive.



| |                                     
| | ------------------------------------
| | Derivative Financial
    Instruments

The Company recognizes all derivative financial
instruments, such as foreign exchange contracts, in the
consolidated financial statements at fair value regardless of
the purpose or the intent for holding the instrument. Changes in
the fair value of derivative financial instruments are either
recognized periodically in income or in stockholders
equity as a component of comprehensive income depending on
whether the derivative financial instrument qualifies for
hedging accounting, and if so, whether it qualifies as a fair
value

61



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##### Table of Contents



TERAYON COMMUNICATION
SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

hedge or cash flow hedge. Generally, changes in
fair values of derivatives accounted for as fair value hedges
are recorded in income along with the portions of the changes in
the fair values of the hedged items that relate to the hedged
risks. Changes in fair values of derivatives accounted for as
cash flow hedges, to the extent they are effective as hedges,
are recorded in other comprehensive income, net of deferred
taxes. Changes in fair value of derivatives used as hedges of
the net investment in foreign operations are reported in other
comprehensive income as part of the cumulative translation
adjustment. Changes in fair value of derivatives not qualifying
as hedges are reported in income.

The Company had no derivative financial
instruments outstanding as of December 31, 2003 or 2002.



| |                                                
| | -----------------------------------------------
| | Cash Equivalents and Short-Term
    Investments

The Company invests its excess cash in money
market accounts and debt instruments and considers all highly
liquid debt instruments purchased with an original maturity of
three months or less to be cash equivalents. Investments with an
original maturity at the time of purchase of over three months
are classified as short-term investments regardless of maturity
date as all investments are classified as available-for-sale and
can be readily liquidated to meet current operational needs.

The Company determines impairment related to its
equity investments in accordance with SFAS 115,
Accounting for Certain Investments in Debt and Equity
Securities, and Securities and Exchange Commission
(SEC) Staff Accounting Bulletin (SAB) 59,
Accounting for Noncurrent Marketable Equity
Securities, which provide guidance on determining when an
investment is other-than-temporarily impaired. Applying this
guidance requires judgment. In making this judgment, the Company
evaluates, among other factors, the duration and extent to which
the fair value of an investment is less than its cost; the
financial health of and business outlook for the investee,
including factors such as industry and sector performance,
changes in technology, and operational and financing cash flow,
available financial information, and the Companys intent
and ability to hold the investment.

The Companys short-term investments, which
consist primarily of commercial paper, U.S. government and
U.S. government agency obligations and fixed income
corporate securities, are classified as available-for-sale and
are carried at fair market value. Realized gains and losses and
declines in value judged to be other-than-temporary on
available-for-sale securities are included in interest income.
The cost of securities sold is based on the specific
identification method. The Company had no material investments
in short-term equity securities at December 31, 2003 or
2002.

During the third quarter of 2002, the Company
received approximately 35.9 million shares of Net
Servicos de Comunicacao SA (Net Servicos), a customer,
valued at approximately $2.5 million as settlement for all
outstanding accounts receivables due from Net Servicos. The
shares of Net Servicos are traded on the Sao Paulo Stock
Exchange. All revenue and the cost of sales relating to these
receivables had been deferred due to extended payment terms
offered in the original sales agreements. The Company recorded a
loss on the settlement of the Net Servicos receivables of
$0.9 million, which was charged to cost of goods sold in
the third quarter of 2002.

The Company liquidated 32.9 million of these
shares valued at $2.3 million in the fourth quarter of
2002. The Company liquidated 1.2 million of these shares
valued at $0.1 million in the first quarter of 2003. The
Company recorded revenue and the related cost of goods sold as
the shares were sold and cash was received. Additionally, in the
first quarter of 2003, 1.8 million shares of Net Servicos
were paid to a consultant in Brazil who provided marketing and
sales services to the Company. As of December 31, 2003, the
Company no longer owns any shares of Net Servicos.

62



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##### Table of Contents



TERAYON COMMUNICATION
SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |                
| | ---------------
| | Restricted Cash

Restricted cash at December 31, 2003 and
2002 primarily related to approximately $7.5 million and
$9.0 million, respectively to secure an aircraft lease, as
well as $0.7 million at December 31, 2003 to secure a
real estate lease.



| |          
| | ---------
| | Inventory

Inventory is stated at the lower of cost
(first-in, first-out) or market. The components of inventory are
as follows (in thousands):

|                |  |              |        |      |  |   |       | 
|--------------- |  | ------------ | ------ | ---- |  | - | ----- | 
|                |  |             
|                |  | December 31,
|                |  |             
|                |  | 2003         |        | 2002
|                |  |              |        |     
|Finished goods  |  | $            | 14,264 |      |  | $ | 5,915 | 
|Work-in process |  |              | 660    |      |  |   | 769   | 
|Raw materials   |  |              | 1,440  |      |  |   | 1,573 | 
|                |  |              |        |      |  |   |       | 
|                |  | $            | 16,364 |      |  | $ | 8,257 | 
|                |  |              |        |      |  |   |       | 

The Company records losses on commitments to
purchase inventory in accordance with Statement 10 of
Chapter 4 of Accounting Release Bulletin No. 43. The
Companys policy for valuation of inventory and commitments
to purchase inventory, including the determination of obsolete
or excess inventory, requires it to perform a detailed
assessment of inventory at each balance sheet date which
includes a review of, among other factors, an estimate of future
demand for products within specific time horizons, generally six
months or less as well as product lifecycle and product
development plans. Given the rapid change in the technology and
communications equipment industries as well as significant,
unpredictable changes in capital spending by the Companys
customers, the Company believes that assessing the value of
inventory using generally a six month time horizon is
appropriate.

The estimates of future demand that the Company
uses in the valuation of inventory are the basis for the revenue
forecast. Based on this analysis, the Company reduces the cost
of inventory that it specifically identifies and considers
obsolete or excessive to fulfill future sales estimates. The
Company defines excess inventory as inventory that will no
longer be used in the manufacturing process. Excess inventory is
generally defined as inventory in excess of projected usage, and
is determined using the Companys best estimate of future
demand at the time, based upon information then available. See
Note 3.

Cost of goods sold for the years ended
December 31, 2003 and 2002 included reversals of
$10.0 million and $15.3 million, respectively, of
special charges originally recorded in 2001 and 2000 for vendor
cancellation charges and inventory considered to be excess and
obsolete. The Company was able to reverse the provisions in 2003
and 2002, as it was able to sell inventory originally considered
to be excess and obsolete. In addition, the Company was able to
negotiate downward certain vendor cancellation claims to terms
more favorable to the Company. Cost of goods sold for the year
ended December 31, 2001 included $33.5 million of
special charges for vendor cancellation and inventory considered
to be excess and obsolete.

Additionally, during 2003 and 2002, the Company
recorded inventory charges of $4.1 million and
$6.1 million, respectively, to reduce some of its inventory
due to excess and obsolescence and to reduce the inventory to
the lower of cost or market value in 2002 as ASPs fell below the
cost of these products and to record charges for excess and
obsolete inventory. No changes to reduce inventories to the
lower of cost or market were recorded in 2003.

63



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##### Table of Contents



TERAYON COMMUNICATION
SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |                          
| | -------------------------
| | Other Current Receivables

As of December 31, 2003 and 2002, other
current receivables are primarily composed of interest, taxes,
and non-trade receivables, and included approximately
$1.8 million and $1.4 million, respectively, due from
contract manufacturers for raw materials purchased from the
Company.



| |                       
| | ----------------------
| | Property and Equipment

Property and equipment are carried at cost less
accumulated depreciation and amortization. Property and
equipment are depreciated for financial reporting purposes using
the straight-line method over the estimated useful lives,
generally three to seven years. Leasehold improvements are
amortized using the straight-line method over the shorter of the
useful lives of the assets or the terms of the leases. The
recoverability of the carrying amount of property and equipment
is assessed based on estimated future undiscounted cash flows,
and if an impairment exists, the charge to operations is
measured as the excess of the carrying amount over the fair
value of the assets. Based upon this method of assessing
recoverability, for the years ended December 31, 2003 and
2002, the Company recorded $0.5 million and
$1.3 million, respectively in asset impairments primarily
related to restructuring activities.

Property and equipment are as follows (In
thousands):

|                                          |  |              |         |      |  |   |         |  
|----------------------------------------- |  | ------------ | ------- | ---- |  | - | ------- | -
|                                          |  |             
|                                          |  | December 31,
|                                          |  |             
|                                          |  | 2003         |         | 2002
|                                          |  |              |         |     
|Software and computers                    |  | $            | 23,273  |      |  | $ | 25,531  |  
|Furniture and equipment                   |  |              | 23,816  |      |  |   | 31,092  |  
|Leasehold improvements                    |  |              | 4,935   |      |  |   | 5,018   |  
|Automobiles                               |  |              | 16      |      |  |   | 16      |  
|                                          |  |              |         |      |  |   |         |  
|Property and equipment                    |  |              | 52,040  |      |  |   | 61,657  |  
|Accumulated depreciation and amortization |  |              | (40,169 | )    |  |   | (43,751 | )
|                                          |  |              |         |      |  |   |         |  
|Property and equipment, net               |  | $            | 11,871  |      |  | $ | 17,906  |  
|                                          |  |              |         |      |  |   |         |  



| |                                         
| | ----------------------------------------
| | Goodwill and Other Intangible
    Assets

Goodwill is the excess of the purchase price over
the fair value of identifiable net assets acquired in business
combinations accounted for as purchases. During 2002 and 2001,
the Company recorded impairment charges for goodwill, assembled
workforce, and other intangible assets (see Note 5). At
December 31, 2003, all goodwill had either been amortized
or written-off the Companys books. Consequently, no
goodwill was included in the Companys condensed
consolidated Balance Sheets at December 31, 2003.

Goodwill and other long-lived assets were
reviewed for impairment whenever events such as product
discontinuance, plant closures, product dispositions or other
changes in circumstances indicated that the carrying amount may
not have be recoverable. When such events occurred, the Company
compared the carrying amount of the assets to undiscounted
expected future cash flows. If this comparison indicated that
there was an impairment, the amount of the impairment was
typically calculated using discounted expected future cash
flows. The discount rate applied to these cash flows was based
on the Companys weighted average cost of capital, which
represented the blended costs of debt and equity.



| |                  
| | -----------------
| | Warranty Reserves

The Company provides a standard warranty for most
of its products, generally lasting one to five years from the
date of purchase. The Company provides for the estimated cost of
product warranties at the time revenue is recognized. The
Companys warranty obligation is affected by product
failure rates, material usage

64



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##### Table of Contents



TERAYON COMMUNICATION
SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

and service delivery costs incurred in correcting
a product failure. Reserve estimates are based on historical
experience and expectation of future conditions. See
Note 14.



| |                         
| | ------------------------
| | Stock-Based Compensation

The Company accounts for its employee stock plans
in accordance with Accounting Principles Board Opinion
No. 25, Accounting for Stock Issued to
Employees (APB Opinion No. 25), and includes the
disclosure-only provisions as required under
SFAS No. 123, Accounting for Stock-Based
Compensation (SFAS No. 123). The Company
provides additional pro forma disclosures as required under
SFAS No. 123 and SFAS No. 148,
Accounting for Stock-Based Compensation, Transition and
Disclosure in Note 9.

For purposes of pro forma disclosures, the
estimated fair value of the options granted and ESPP shares to
be issued is amortized to expense over their respective vesting
periods. Had compensation cost for the Companys
stock-based compensation plans been determined based on the fair
value at the grant dates for awards under those plans consistent
with the method of SFAS No. 123, the Companys
net loss applicable to common stockholders and net loss per
share applicable to common stockholders would have been
increased to the pro forma amounts indicated below (see
Note 9)(in thousands, except per share data):

|                                               |  |                          |         |      |  |      |         |   |  |   |          |  
|---------------------------------------------- |  | ------------------------ | ------- | ---- |  | ---- | ------- | - |  | - | -------- | -
|                                               |  |                         
|                                               |  | Years Ended December 31,
|                                               |  |                         
|                                               |  | 2003                     |         | 2002 |  | 2001
|                                               |  |                          |         |      |  |     
|Net loss                                       |  | $                        | (50,353 | )    |  | $    | (44,213 | ) |  | $ | (563,846 | )
|Stock option plans                             |  |                          | (22,210 | )    |  |      | (33,718 | ) |  |   | (126,721 | )
|Employee stock purchase plan                   |  |                          | (1,712  | )    |  |      | (1,990  | ) |  |   | (2,212   | )
|                                               |  |                          |         |      |  |      |         |   |  |   |          |  
|Pro forma net loss                             |  | $                        | (74,275 | )    |  | $    | (79,921 | ) |  | $ | (692,779 | )
|                                               |  |                          |         |      |  |      |         |   |  |   |          |  
|Pro forma basic and diluted net loss per share |  | $                        | (1.00   | )    |  | $    | (1.10   | ) |  | $ | (10.14   | )
|                                               |  |                          |         |      |  |      |         |   |  |   |          |  

The pro forma impact of options granted and
shares from the employee stock purchase plan to be issued for
the years ended December 31, 2003, 2002 and 2001 is not
representative of the effects on net income (loss) for future
years, as future years will include the continued effects of
options vesting as well as the impact of multiple years of stock
option grants.

Equity instruments granted to non-employees are
accounted for under the fair value method, in accordance with
SFAS No. 123 and EITF No. 96-18, Accounting
for Equity Instruments That Are Issued to Other Than Employees
for Acquiring, or in Conjunction with Selling, Goods or
Services, using the Black-Scholes option pricing model and
are recorded in the equity section of the Companys
consolidated balance sheet as deferred compensation. These
instruments are subject to periodic revaluations over their
vesting terms. The expense is recognized as the instruments vest.

Accumulated Other Comprehensive Loss

Accumulated other comprehensive loss presented in
the accompanying consolidated balance sheets and consolidated
statements of stockholders equity consists of net
unrealized gain on short-term investments and accumulated net
foreign currency translation losses.

65



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##### Table of Contents



TERAYON COMMUNICATION
SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The following are the components of accumulated
other comprehensive loss (in thousands):

|                                                             |  |              |        |      |  |   |        |  
|------------------------------------------------------------ |  | ------------ | ------ | ---- |  | - | ------ | -
|                                                             |  |             
|                                                             |  | Years Ended 
|                                                             |  | December 31,
|                                                             |  |             
|                                                             |  | 2003         |        | 2002
|                                                             |  |              |        |     
|Cumulative translation adjustments                           |  | $            | (2,400 | )    |  | $ | (3,572 | )
|Unrealized gain/(loss) on available-for-sale
    investments |  |              | 32     |      |  |   | 502    |  
|                                                             |  |              |        |      |  |   |        |  
|Total accumulated other comprehensive loss                   |  | $            | (2,368 | )    |  | $ | (3,070 | )
|                                                             |  |              |        |      |  |   |        |  



| |                 
| | ----------------
| | Reclassification

Certain amounts reported in previous years have
been reclassified to conform to 2003 presentation. Such
reclassifications had no effect on previously reported results
of operations, total assets or accumulated deficit.



| |                                                   
| | --------------------------------------------------
| | Impact of Recently Issued Accounting
    Standards

In May 2003, the Financial Accounting Standards
Board (FASB) issued Statement of Financial Accounting
Standards (SFAS) No. 150, Accounting For Certain
Financial Instruments with Characteristics of Both Liabilities
and Equity which establishes standards for how an issuer
of financial instruments classifies and measures certain
financial instruments with characteristics of both liabilities
and equity. It requires that an issuer classify a financial
instrument that is within its scope as a liability (or an asset
in some circumstances) if, at inception, the monetary value of
the obligation is based solely or predominantly on a fixed
monetary amount known at inception, variations in something
other than the fair value of the issuers equity shares or
variations inversely related to changes in the fair value of the
issuers equity shares. SFAS No. 150 is effective
for financial instruments entered into or modified after
May 31, 2003, and otherwise is effective at the beginning
of the first interim period beginning after June 15, 2003.
The adoption of SFAS No. 150 did not have a material
impact on the Companys financial position or results of
operations.

In April 2003, the FASB issued
SFAS No. 149, Amendment of Statement 133 on
Derivative Instruments and Hedging Activities.
SFAS No. 149 amends and clarifies financial accounting
and reporting for derivative instruments, including certain
derivative instruments embedded in other contracts (collectively
referred to as derivatives) and for hedging activities under
SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities. This statement is
effective for contracts entered into or modified after
June 30, 2003, and did not have a material impact on the
Companys financial position or results of operations.

In January 2003, the FASB issued Interpretation
No. 46, Consolidation of Variable Interest
Entities, which was revised in December 2003.
Interpretation No. 46, as revised, clarifies the
application of Accounting Research Bulletin No. 51 and
applies immediately to any variable interest entities created
after January 31, 2003 and to variable interest entities in
which an interest is obtained after that date. This
Interpretation is applicable in the quarter ending
March 31, 2004, for interests acquired in variable interest
entities prior to February 1, 2003. This Interpretation
requires variable interest entities to be consolidated if the
equity investment at risk is not sufficient to permit an entity
to finance its activities without support from other parties or
the equity investors lack specified characteristics. The
adoption of Interpretation No. 46, as revised, is not
expected to have a material impact on the Companys
financial position or results of operations.

In November 2002, the EITF reached a consensus on
Issue No. 00-21, Revenue Arrangements with Multiple
Deliverables. EITF Issue No. 00-21 provides guidance
on how to account for certain arrangements that involve the
delivery or performance of multiple products, services and/or
rights to use assets. The provisions of EITF Issue
No. 00-21 will apply to revenue arrangements entered into
in fiscal periods beginning after June 15, 2003. The
adoption of EITF Issue No. 00-21 did not have any
significant impact on the Companys financial position or
results of operations.

66



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##### Table of Contents



TERAYON COMMUNICATION
SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

In July 2002, the Financial Accounting Standards
Board issued Statement of Financial Accounting Standard
No. 146, Accounting for Costs Associated with Exit or
Disposal Activities (FAS 146). FAS 146 addresses the financial
accounting and reporting for costs associated with exit or
disposal activities, and supersedes Emerging Issues Task Force
Issue No. 94-3, Liability Recognition for Certain Employee
Termination Benefits and Other Costs to Exit an Activity,
including Certain Costs Incurred in a Restructuring (EITF 94-3).
FAS 146 requires companies to recognize costs associated with
exit or disposal activities when they are incurred rather than
at the date of a commitment to an exit or disposal plan. In
addition, FAS No. 146 establishes that fair value is the
objective for initial measurement of the liability. FAS 146 is
effective for exit or disposal activities initiated after
December 31, 2002. The adoption of FAS 146 did not have any
significant impact on the Companys financial position or
results of operations.

In June 2001, the FASB issued SFAS No. 142,
Goodwill and Other Intangible Assets (SFAS
No. 142). SFAS No. 142 prohibits the amortization of
goodwill and intangible assets with indefinite useful lives.
SFAS No. 142 requires that these assets be reviewed for
impairment at least annually. Intangible assets with definite
lives will continue to be amortized over their estimated useful
lives. Additionally, SFAS No. 142 requires that goodwill
included in the carrying value of equity method investments no
longer be amortized.

The Company adopted SFAS No. 142 on
January 1, 2002. Identifiable intangible assets with
indefinite lives were reclassified, as defined by SFAS
No. 142, to goodwill at the date of adoption. The Company
tested goodwill for impairment using the two-step process
prescribed in SFAS No. 142. The first step is a screen for
potential impairment, while the second step measures the amount
of the impairment, if any. See Note 5.

The following pro forma information reflects the
impact on net loss and basic and diluted net loss per share
assuming the adoption of SFAS No. 142 had occurred on
January 1, 2001 (in thousands):

|                                               |                                                                                                |                          |         |       |   |             |         |       |   |   |          |        |  
|---------------------------------------------- | ---------------------------------------------------------------------------------------------- | ------------------------ | ------- | ----- | - | ----------- | ------- | ----- | - | - | -------- | ------ | -
|                                               |                                                                                                |                         
|                                               |                                                                                                | Years ended December 31,
|                                               |                                                                                                |                         
|                                               |                                                                                                | 2003                     |         | 2002  |   | 2001       
|                                               |                                                                                                |                          |         |       |   |            
|                                               |                                                                                                |                          |         |       |   | (Pro forma)
|Reported net loss                              |                                                                                                | $                        | (50,353 | )     |   | $           | (44,213 | )     |   | $ | (563,846 | )     
|                                               | Amortization of goodwill and intangible assets
    with indefinite lives                       |                          |         |      |   |             |         |      |   |   |          | 53,846 |  
|Pro forma net loss                             |                                                                                                | $                        | (50,353 | )     |   | $           | (44,213 | )     |   | $ | (510,000 | )     
|Basic and diluted net loss per share:          |                                                                                                |                          |         |       |   |             |         |       |   |   |          |       
|                                               | Reported net loss                                                                              |                          | $       | (0.68 | ) |             | $       | (0.61 | ) |   | $        | (8.25  | )
|                                               | Adjustment related to amortization of goodwill
    and intangible assets with indefinite lives |                          |         |      |   |             |         |      |   |   |          | 0.79   |  
|Pro forma basic and diluted net loss per share |                                                                                                | $                        | (0.68   | )     |   | $           | (0.61   | )     |   | $ | (7.46    | )     

In July 2002, the Financial Accounting Standards
Board issued Statement of Financial Accounting Standard
No. 146, Accounting for Costs Associated with Exit or
Disposal Activities (FAS 146). FAS 146 addresses the financial
accounting and reporting for costs associated with exit or
disposal activities, and supersedes Emerging Issues Task Force
Issue No. 94-3, Liability Recognition for Certain Employee
Termination Benefits and Other Costs to Exit an Activity,
including Certain Costs Incurred in a Restructuring (EITF 94-3).
FAS 146 requires companies to recognize costs associated with
exit or disposal activities when they are incurred rather than
at the date of a commitment to an exit or disposal plan. In
addition, FAS No. 146 establishes that fair value is the
objective for initial measurement of the liability. FAS 146 is
effective for exit or disposal activities initiated after
December 31, 2002. The adoption of FAS 146 did not have any
significant impact on the Companys financial position or
results of operations.

67



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##### Table of Contents



TERAYON COMMUNICATION
SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|   |                                    
|-- | -----------------------------------
|2. | Fair Value of Financial Instruments

The amounts reported as cash and cash
equivalents, accounts receivable, accounts payable and accrued
liabilities approximate fair value due to their short-term
maturities. The fair value for the Companys investments in
marketable debt and equity securities is estimated based on
quoted market prices.

The fair value of short-term and long-term
capital lease and debt obligations is estimated based on current
interest rates available to us for debt instruments with similar
terms, degrees of risk and remaining maturities. The carrying
values of these obligations, as of each period presented
approximate their respective fair values.

The following estimated fair value amounts have
been determined using available market information. However,
considerable judgment is required in interpreting market data to
develop the estimates of fair value.

68



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##### Table of Contents



TERAYON COMMUNICATION
SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Accordingly, the estimates presented herein are
not necessarily indicative of the amounts that the Company could
realize in a current market exchange.

|                                              |       |                   |        |            |         |            |    |            |    |   |     |     |     |   |        |        |         | 
|--------------------------------------------- | ----- | ----------------- | ------ | ---------- | ------- | ---------- | -- | ---------- | -- | - | --- | --- | --- | - | ------ | ------ | ------- | 
|                                              |       |                  
|                                              |       | December 31, 2003
|                                              |       |                  
|                                              |       |                   |        | Gross      |         | Gross      |    |           
|                                              |       | Amortized         |        | Unrealized |         | Unrealized |    | Estimated 
|Short-term investments                        |       | Cost              |        | Gains      |         | Losses     |    | Fair Value
|                                              |       |                   |        |            |         |            |    |           
|                                              |       |                  
|                                              |       | (In thousands)   
|Investments maturing in less than
    1 year: |       |                   |        |            |         |            |    |            |    |   |     |     |     |   |        |       
|Commercial paper                              |       | $                 | 38,939 |            |         | $          |   |            |    | $ | (11 | )   |     | $ | 38,928 |       
|Fixed income corporate securities             |       |                   | 2,223  |            |         |            | 1  |            |    |   |    |     |     |   | 2,224  |       
|Government agency obligations                 |       |                   | 7,918  |            |         |            | 1  |            |    |   |    |     |     |   | 7,919  |       
|                                              |       |                   |        |            |         |            |    |            |    |   |     |     |     |   |        |       
|                                              | Total |                   |        | 49,080     |         |            |    | 2          |    |   |     | (11 | )   |   |        | 49,071 |        
|Investments maturing in
    1-2 years:        |       |                   |        |            |         |            |    |            |    |   |     |     |     |   |        |       
|Fixed income corporate securities             |       |                   | 1,333  |            |         |            |   |            |    |   |    |     |     |   | 1,333  |       
|Government agency obligations                 |       |                   | 58,006 |            |         |            | 68 |            |    |   | (26 | )   |     |   | 58,048 |       
|                                              |       |                   |        |            |         |            |    |            |    |   |     |     |     |   |        |       
|                                              | Total |                   |        | 59,339     |         |            |    | 68         |    |   |     | (26 | )   |   |        | 59,381 |        
|                                              |       |                   |        |            |         |            |    |            |    |   |     |     |     |   |        |       
|                                              |       | Total             |        | $          | 108,419 |            |    | $          | 70 |   |     | $   | (37 | ) |        | $      | 108,452 | 
|                                              |       |                   |        |            |         |            |    |            |    |   |     |     |     |   |        |       

|                                              |       |                   |        |            |        |            |     |           |       |   |     |     |     |   |        |        |        | 
|--------------------------------------------- | ----- | ----------------- | ------ | ---------- | ------ | ---------- | --- | --------- | ----- | - | --- | --- | --- | - | ------ | ------ | ------ | 
|                                              |       |                  
|                                              |       | December 31, 2002
|                                              |       |                  
|                                              |       |                   |        | Gross      |        | Gross      |     | Estimated
|                                              |       | Amortized         |        | Unrealized |        | Unrealized |     | Fair     
|Short-term investments                        |       | Cost              |        | Gains      |        | Losses     |     | Value    
|                                              |       |                   |        |            |        |            |     |          
|                                              |       |                  
|                                              |       | (In thousands)   
|Investments maturing in less than
    1 year: |       |                   |        |            |        |            |     |           |       |   |     |     |     |   |        |       
|Commercial paper                              |       | $                 | 16,000 |            |        | $          |    |           |       | $ | (26 | )   |     | $ | 15,974 |       
|Fixed income corporate securities             |       |                   | 12,920 |            |        |            | 196 |           |       |   |    |     |     |   | 13,116 |       
|Government agency obligations                 |       |                   | 18,300 |            |        |            | 260 |           |       |   |    |     |     |   | 18,560 |       
|Corporate equity securities                   |       |                   | 202    |            |        |            | 151 |           |       |   |    |     |     |   | 353    |       
|                                              |       |                   |        |            |        |            |     |           |       |   |     |     |     |   |        |       
|                                              | Total |                   |        | 47,422     |        |            |     | 607       |       |   |     | (26 | )   |   |        | 48,003 |       
|Investments maturing in
    1-2 years:        |       |                   |        |            |        |            |     |           |       |   |     |     |     |   |        |       
|Fixed income corporate securities             |       |                   | 2,000  |            |        |            | 145 |           |       |   |    |     |     |   | 2,145  |       
|Government agency obligations                 |       |                   | 39,000 |            |        |            | 276 |           |       |   |    |     |     |   | 39,276 |       
|                                              |       |                   |        |            |        |            |     |           |       |   |     |     |     |   |        |       
|                                              | Total |                   |        | 41,000     |        |            |     | 421       |       |   |     |    |     |   |        | 41,421 |       
|                                              |       |                   |        |            |        |            |     |           |       |   |     |     |     |   |        |       
|                                              |       | Total             |        | $          | 88,422 |            |     | $         | 1,028 |   |     | $   | (26 | ) |        | $      | 89,424 | 
|                                              |       |                   |        |            |        |            |     |           |       |   |     |     |     |   |        |       

Realized gains and losses were insignificant for
each of the years in the period ended December 31, 2003.



|   |            
|-- | -----------
|3. | Commitments



| |       
| | ------
| | Leases

The Company leases its facilities and certain
equipment under operating leases. The operating lease for the
Companys corporate headquarters expires in 2009. The
operating lease for the Companys Israel headquarters
expires in 2005. The Companys other operating leases
expire at various times through 2006. Rent expense was
approximately $7.1 million, $7.9 million, and
$7.2 million, for the years ended December 31, 2003,
2002, and 2001, respectively. The Company subleases a portion of
its facilities to third parties. In

69



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##### Table of Contents



TERAYON COMMUNICATION
SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

connection with the restructuring plans announced
January 27, 2004, the Company is seeking to sublease
approximately 56,400 square feet of its Santa Clara,
California facility. See Note 16. The Companys
sublease rental income was approximately $1.1 million,
$0.4 million, and $0.1 million for the years ended
December 31, 2003, 2002, and 2001, respectively.

The Company leases certain equipment under
noncancellable lease agreements that are accounted for as
capital leases. Equipment under capital lease arrangements
included in property and equipment aggregated $0.3 million
and $0.7 million at December 31, 2003 and 2002,
respectively. Related accumulated amortization was $0.3 million
and $0.6 million at December 31, 2003 and 2002,
respectively. Amortization expense related to assets under
capital leases is included in depreciation expense. The capital
leases are secured by the related equipment and the Company is
required to maintain liability and property damage insurance.

In 2002, the Company entered into an operating
lease arrangement to lease a corporate aircraft. This lease
arrangement was secured by a $9.0 million letter of credit
at December 31, 2002. The letter of credit was reduced to
$7.5 million in February 2003. The lease commitment for the
aircraft is included in the table below.

Future minimum lease payments under noncancelable
operating leases and capital leases as of December 31, 2003
are as follows (in thousands):

|                                  |  |           |        |         |  |   |     | 
|--------------------------------- |  | --------- | ------ | ------- |  | - | --- | 
|                                  |  | Operating |        | Capital
|                                  |  | Leases    |        | Leases 
|                                  |  |           |        |        
|2004                              |  | $         | 8,258  |         |  | $ | 126 | 
|2005                              |  |           | 7,188  |         |  |   |    | 
|2006                              |  |           | 4,660  |         |  |   |    | 
|2007                              |  |           | 3,165  |         |  |   |    | 
|2008                              |  |           | 3,045  |         |  |   |    | 
|Thereafter                        |  |           | 2,537  |         |  |   |    | 
|                                  |  |           |        |         |  |   |     | 
|Total minimum payments            |  | $         | 28,853 |         |  |   | 126 | 
|                                  |  |           |        |         |  |   |     | 
|Less amount representing interest |  |           |        |         |  |   | 2   | 
|                                  |  |           |        |         |  |   |     | 
|Total current portion             |  |           |        |         |  | $ | 124 | 
|                                  |  |           |        |         |  |   |     | 

There are no future minimum sublease payments to
be received under noncancelable subleases.



| |                                             
| | --------------------------------------------
| | Purchase Obligations and Special
    Charges

The Company has purchase obligations to certain
of its suppliers that support the Companys ability to
manufacture its products. The obligations consist of purchase
orders placed with vendors for goods and services and require
the Company to purchase minimum quantities of the
suppliers products at a specified price. As of
December 31, 2003, $54.4 million of purchase
obligations were outstanding. As a result of declines in
forecast, the Company has canceled certain purchase orders with
its contract manufacturers that had existing inventory on hand
or on order in anticipation of the Companys earlier
forecasts. Consequently, the Company accrued for vendor
cancellation charges in amounts, which represented
managements estimate of the Companys exposure to
vendors for its inventory commitments. At December 31,
2003, accrued vendor cancellation charges were $2.9 million
and the remaining $51.5 million attributable to open
purchase orders. The remaining obligations are expected to
become payable at various times throughout 2004.

On February 26, 2003, the Company entered
into an agreement with Solectron Corporation (Solectron) to
settle all outstanding obligations under three manufacturing
agreements between the Company and Solectron. Under the terms of
the settlement agreement, the Company paid Solectron
approximately

70



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TERAYON COMMUNICATION
SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

$3.9 million, and each party released any
and all claims that it may have had against the other party.
Additionally, the Company received selected inventory from
Solectron. The Company previously accrued $6.0 million
toward the settlement of the Solectron matter as a vendor
cancellation charge in the fourth quarter of 2000 and the second
quarter of 2001. In 2003, in connection with the Solectron
settlement, the Company reversed $2.1 million of the
accrued vendor cancellation charges included in cost of goods
sold.

On September 29, 2003, the Company entered
into an agreement with Flextronics (Israel) Ltd., an Israeli
company (Flextronics), to purchase inventory from Flextronics
and settle all outstanding claims between the Company and
Flextronics. Under the terms of the settlement agreement, the
Company paid Flextronics approximately $1.5 million to be
applied toward the purchase of future inventory from
Flextronics, if any. Additionally, each party released any and
all claims that it may have had against the other party. The
Company previously accrued $2.0 million toward the
settlement of the Flextronics matter as a vendor cancellation
charge in the second quarter of 2001. In 2003, in connection
with the Flextronics settlement, the Company reversed
$0.5 million of the accrued vendor cancellation charges
included in cost of goods sold.



| |                  
| | -----------------
| | Letters of Credit

As of December 31, 2003, the Company had
$9.2 million in unused outstanding letters of credit
primarily required to support operating leases, which expire at
various dates through 2009.



| |          
| | ---------
| | Royalties

The Companys total accrued obligation for
royalties, at December 31, 2003 and 2002, was
$1.3 million and $0.9 million, respectively.

The Company has purchased, through its
acquisition of Radwiz Ltd. (Radwiz), certain technology that
utilized funding provided by the Israeli Chief Scientist of the
Ministry of Industry and Trade. The Company has committed to pay
royalties to the Government of Israel on proceeds from sales of
products based on this technology at rates of
3%5% per sale. Sales of products using this
technology are immaterial.

Additionally, the Company has various royalty
arrangements, which require it to pay nominal amounts to various
suppliers for usage of licensed property.



| |           
| | ----------
| | Guarantees

The Company from time to time enters into certain
types of contracts that contingently require the Company to
indemnify parties against third party claims. These obligations
primarily relate to certain agreements with the Companys
officers, directors and employees, under which the Company may
be required to indemnify such persons for liabilities arising
out of their employment relationship.

The terms of such obligations vary. Generally, a
maximum obligation is not explicitly stated. Because the
obligated amounts of these types of agreements often are not
explicitly stated, the overall maximum amount of the obligations
cannot be reasonably estimated. Historically, the Company has
not been obligated to make any payments for these obligations,
and no liabilities have been recorded for these obligations on
its consolidated balance sheets as of December 31, 2003.



|   |                      
|-- | ---------------------
|4. | Accrued Severance Pay

Several of the Companys subsidiaries are
subject to Israeli law and labor agreements, under which they
are required to make severance payments to dismissed employees
and employees leaving its employment in certain other
circumstances. The subsidiaries severance pay liability to
its employees, which is calculated on the basis of the salary of
each employee for the last month of the reported year multiplied
by the years of such employees employment is included in
the Companys consolidated balance sheets on the accrual
basis, and is

71



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##### Table of Contents



TERAYON COMMUNICATION
SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

partially funded by a purchase of insurance
policies in the subsidiaries name. At December 31,
2003, $1.9 million for accrued severance pay was included
in long-term obligations. In accordance with EITF No. 88-1,
Determination of Vested Benefit Obligation for a Defined
Benefit Pension Plan, the Company included
$1.3 million relating to the amounts funded by the purchase
of insurance policies for the Israeli severance liability in its
consolidated balance sheets as other assets at December 31,
2003.



|   |                                               
|-- | ----------------------------------------------
|5. | Restructuring Charges and Asset
    Write-offs



| |              
| | -------------
| | Restructuring



| |                   
| | ------------------
| | 2003 Restructuring

During the first quarter of 2003, the
Companys Board of Directors approved a restructuring plan
to conform the Companys expenses to its revenue levels and
to better position the Company for future growth and eventual
profitability. The Company incurred restructuring charges in the
amount of $2.7 million related to employee termination
costs as part of the 2003 restructuring. As of December 31,
2003, 81 employees were terminated throughout the Company, and
the Company paid $2.7 million in termination costs. In the
second quarter of 2003, the Company reversed $86,000 of
previously accrued termination costs due to a change in
estimate. At December 31, 2003, no restructuring charges
remained accrued.

A summary of the 2003 accrued restructuring
charges is as follows (in thousands):

|                             |  |              |        |  
|---------------------------- |  | ------------ | ------ | -
|                             |  | Involuntary 
|                             |  | Terminations
|                             |  |             
|Total charge                 |  | $            | 2,745  |  
|Recovery of charge           |  |              | (86    | )
|Cash payments                |  |              | (2,659 | )
|                             |  |              |        |  
|Balance at December 31, 2003 |  | $            |       |  
|                             |  |              |        |  



| |                   
| | ------------------
| | 2002 Restructuring

During the third quarter of 2002, the
Companys Board of Directors approved a restructuring plan
to conform the Companys expenses to its revenue levels and
to better position the Company for future growth and eventual
profitability. The Company incurred restructuring charges in the
amount of $3.6 million of which $2.3 million related
to employee termination costs and the remaining
$1.3 million related to costs for excess leased facilities.
At December 31, 2003, restructuring charges of
$1.2 million remained accrued. As of December 31,
2003, 153 employees were terminated throughout the Company as
part of the 2002 restructuring, and the Company paid
$2.2 million in termination costs and $0.2 million in
excess facility costs. During 2002, the Company reclassified
$0.1 million of excess termination costs to leased
facilities due to a change in estimate. The Company anticipates
the remaining restructuring accrual, primarily relating to
excess leased facilities, will be utilized for servicing
operating lease payments or negotiated buyout of operating lease
commitments, through 2005.

72



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##### Table of Contents



TERAYON COMMUNICATION
SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The following table summarizes the costs and
activities related to the 2002 restructuring (in thousands):

|                             |  |              |        |                |  |       |       |   |  |   |        |  
|---------------------------- |  | ------------ | ------ | -------------- |  | ----- | ----- | - |  | - | ------ | -
|                             |  |              |        | Excess Leased  |  |      
|                             |  |              |        | Facilities and |  |      
|                             |  | Involuntary  |        | Cancelled      |  |      
|                             |  | Terminations |        | Contracts      |  | Total
|                             |  |              |        |                |  |      
|Total charge in 2002         |  | $            | 2,319  |                |  | $     | 1,322 |   |  | $ | 3,641  |  
|Cash Payments                |  |              | (2,131 | )              |  |       |      |   |  |   | (2,131 | )
|Reclassification             |  |              | (100   | )              |  |       | 100   |   |  |   |       |  
|Balance at December 31, 2002 |  |              | 88     |                |  |       | 1,422 |   |  |   | 1,510  |  
|Cash Payments                |  |              | (88    | )              |  |       | (219  | ) |  |   | (307   | )
|                             |  |              |        |                |  |       |       |   |  |   |        |  
|Balance at December 31, 2003 |  | $            |       |                |  | $     | 1,203 |   |  | $ | 1,203  |  
|                             |  |              |        |                |  |       |       |   |  |   |        |  



| |                   
| | ------------------
| | 2001 Restructuring

During 2001, the Companys Board of
Directors approved a restructuring plan to streamline the
Companys organizational structure worldwide. The Company
incurred restructuring charges in the amount of
$12.7 million in fiscal year 2001 of which
$3.3 million remained accrued at December 31, 2003. Of
the total restructuring charges recorded during fiscal year
2001, $3.2 million related to employee termination costs
throughout the Company, and the remaining $9.5 million
related primarily to costs for excess leased facilities. During
2003, the Company reversed $0.3 million of previously
accrued termination costs due to a change in estimate. The
Company anticipates utilizing the remaining restructuring
accrual, which relates to servicing operating lease payments or
negotiated buyout of operating lease commitments, through 2005.

The following table summarizes the costs and
activities related to the 2001 restructuring (in thousands):

|                             |  |              |        |                |  |       |        |   |  |   |        |  
|---------------------------- |  | ------------ | ------ | -------------- |  | ----- | ------ | - |  | - | ------ | -
|                             |  |              |        | Excess Leased  |  |      
|                             |  |              |        | Facilities and |  |      
|                             |  | Involuntary  |        | Cancelled      |  |      
|                             |  | Terminations |        | Contracts      |  | Total
|                             |  |              |        |                |  |      
|Total charges in 2001        |  | $            | 3,168  |                |  | $     | 9,501  |   |  | $ | 12,669 |  
|Cash payments                |  |              | (1,891 | )              |  |       | (2,580 | ) |  |   | (4,471 | )
|Balance at December 31, 2001 |  |              | 1,277  |                |  |       | 6,921  |   |  |   | 8,198  |  
|Cash payments                |  |              | (100   | )              |  |       | (2,855 | ) |  |   | (2,955 | )
|Reclassification             |  |              | (1,177 | )              |  |       | 1,177  |   |  |   |       |  
|                             |  |              |        |                |  |       |        |   |  |   |        |  
|Balance at December 31, 2002 |  |              |       |                |  |       | 5,243  |   |  |   | 5,243  |  
|Recovery of charge           |  |              |       |                |  |       | (261   | ) |  |   | (261   | )
|Cash payments                |  |              |       |                |  |       | (1,685 | ) |  |   | (1,685 | )
|                             |  |              |        |                |  |       |        |   |  |   |        |  
|Balance at December 31, 2003 |  | $            |       |                |  | $     | 3,297  |   |  | $ | 3,297  |  
|                             |  |              |        |                |  |       |        |   |  |   |        |  



| |                 
| | ----------------
| | Asset Write-offs

Primarily as a result of restructuring activities
in 2003, the Company wrote off $0.4 million of fixed assets
in 2003, which were determined to have no remaining useful life.
As a result of restructuring activities in 2002 and 2001, and a
rapid decline in demand for Access Network Electronics (ANE)
products, certain property and equipment were determined to have
no remaining useful life. During 2002, $1.3 million of
fixed assets were written-off. During 2001, $1.6 million
related to fixed assets acquired from ANE were determined to
have no remaining useful life and were written-off. The impaired
fixed assets in each period represent the net book value of idle
manufacturing equipment, leasehold, and office equipment.

73



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##### Table of Contents



TERAYON COMMUNICATION
SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

From September 1999 through December 2000, the
Company acquired ten companies. In March 2001, the Company
evaluated the carrying value of certain long-lived assets and
acquired intangibles, consisting primarily of goodwill recorded
on its consolidated balance sheet. Pursuant to accounting rules
applicable at that time, during the first quarter of 2001,
intangible assets totaling $163.1 million, related to
certain acquisitions were deemed to be impaired with no future
value and were written-off. Further, the aforementioned
downturns in the principal markets in which the Company
continues to operate, resulted in a write-down of these
intangible assets related to both the Cable and Telecom segments
of $409.7 million in the first nine months of 2001. These
amounts were included in asset write-offs in the Companys
consolidated statements of operations in 2001.

The Company adopted SFAS No. 142 on
January 1, 2002. The Company reclassified $1.3 million
of assembled workforce, net of accumulated amortization, with an
indefinite life, to goodwill at the date of adoption. The
Company tests goodwill for impairment using the two-step process
prescribed in SFAS No. 142. The first step is a screen
for potential impairment, while the second step measures the
amount of the impairment, if any. The impairment tests were
completed during the second quarter of 2002 and indicated no
impairment. Due to a difficult economic environment and
heightened price competition in the modem and telecom businesses
during the three months ended June 30, 2002, the Company
experienced a significant drop in its market capitalization, and
therefore proceeded to perform an interim test to measure
goodwill and intangible assets for impairment at June 30,
2002. Based on the forecast, the estimated undiscounted future
cash flows from the use of the goodwill would have been less
than its carrying amount. The Company determined that the
outcome of this test reflected that the fair value of the
goodwill was zero. This resulted in a non-cash charge of
$4.0 million to write off the remaining goodwill of which
$3.0 million in 2002 was related to the Cable segment and
$1.0 million was related to the Telecom segment. Subsequent
to this write-off, the Company had no intangible assets, which
were deemed to have indefinite useful lives.

During 2001, the Company recorded a deferred tax
asset of approximately $4.0 million and corresponding
reduction of goodwill, for the tax benefit of foreign net
operating loss carryforwards related to a previous acquisition.
Due to the impairment write-off, the deferred tax asset, and
remaining net deferred tax liability were also written-off.

74



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##### Table of Contents



TERAYON COMMUNICATION
SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The following table describes the intangible
assets written off during 2001:

|                        |  |                |       |            |  |           |       |           |  |          |     |           |  |       |      |  |  |   |     |  |  |   |     |  |  |   |       | 
|----------------------- |  | -------------- | ----- | ---------- |  | --------- | ----- | --------- |  | -------- | --- | --------- |  | ----- | ---- |  |  | - | --- |  |  | - | --- |  |  | - | ----- | 
|                        |  |                |       | Developed  |  |           |       | Customer  |  | Customer |     | Assembled |  |      
|                        |  | Goodwill       |       | Technology |  | Trademark |       | Relations |  | Base     |     | Workforce |  | Total
|                        |  |                |       |            |  |           |       |           |  |          |     |           |  |      
|                        |  |               
|                        |  | (In thousands)
|Cable Segment:          |  |                |       |            |  |           |       |           |  |          |     |           |  |       |      |  |  |   |     |  |  |   |     |  |  |   |       | 
|Ultracom                |  | $              | 46.2  |            |  | $         | 0.9   |           |  | $        |    |           |  | $     |     |  |  | $ |    |  |  | $ | 0.3 |  |  | $ | 47.4  | 
|ComBox                  |  |                | 65.3  |            |  |           | 10.0  |           |  |          |    |           |  |       |     |  |  |   |    |  |  |   | 0.2 |  |  |   | 75.5  | 
|Imedia                  |  |                | 47.2  |            |  |           | 20.0  |           |  |          | 2.9 |           |  |       |     |  |  |   |    |  |  |   | 0.3 |  |  |   | 70.4  | 
|Digitrans               |  |                | 8.2   |            |  |           | 0.5   |           |  |          |    |           |  |       |     |  |  |   |    |  |  |   | 0.3 |  |  |   | 9.0   | 
|Telegate                |  |                | 52.8  |            |  |           | 17.0  |           |  |          |    |           |  |       | 20.2 |  |  |   |    |  |  |   | 0.8 |  |  |   | 90.8  | 
|Internet Telecom        |  |                | 39.1  |            |  |           | 5.0   |           |  |          |    |           |  |       |     |  |  |   |    |  |  |   | 0.1 |  |  |   | 44.2  | 
|TrueChat                |  |                |      |            |  |           |      |           |  |          |    |           |  |       |     |  |  |   |    |  |  |   |    |  |  |   |      | 
|                        |  |                |       |            |  |           |       |           |  |          |     |           |  |       |      |  |  |   |     |  |  |   |     |  |  |   |       | 
|Total Cable Segment     |  | $              | 258.8 |            |  | $         | 53.4  |           |  | $        | 2.9 |           |  | $     | 20.2 |  |  | $ | 0.0 |  |  | $ | 2.0 |  |  | $ | 337.3 | 
|                        |  |                |       |            |  |           |       |           |  |          |     |           |  |       |      |  |  |   |     |  |  |   |     |  |  |   |       | 
|Telecom Segment:        |  |                |       |            |  |           |       |           |  |          |     |           |  |       |      |  |  |   |     |  |  |   |     |  |  |   |       | 
|MainSail                |  |                | 97.0  |            |  |           | 44.1  |           |  |          |    |           |  |       |     |  |  |   |    |  |  |   | 0.6 |  |  |   | 141.7 | 
|ANE                     |  |                | 33.5  |            |  |           | 10.3  |           |  |          | 0.5 |           |  |       |     |  |  |   | 2.0 |  |  |   | 4.5 |  |  |   | 50.8  | 
|Radwiz                  |  |                | 18.7  |            |  |           | 23.1  |           |  |          | 0.9 |           |  |       |     |  |  |   |    |  |  |   | 0.3 |  |  |   | 43.0  | 
|                        |  |                |       |            |  |           |       |           |  |          |     |           |  |       |      |  |  |   |     |  |  |   |     |  |  |   |       | 
|Total Telecom Segment   |  | $              | 149.2 |            |  | $         | 77.5  |           |  | $        | 1.4 |           |  | $     | 0.0  |  |  | $ | 2.0 |  |  | $ | 5.4 |  |  | $ | 235.5 | 
|                        |  |                |       |            |  |           |       |           |  |          |     |           |  |       |      |  |  |   |     |  |  |   |     |  |  |   |       | 
|Total Cable and Telecom |  | $              | 408.0 |            |  | $         | 130.9 |           |  | $        | 4.3 |           |  | $     | 20.2 |  |  | $ | 2.0 |  |  | $ | 7.4 |  |  | $ | 572.8 | 
|                        |  |                |       |            |  |           |       |           |  |          |     |           |  |       |      |  |  |   |     |  |  |   |     |  |  |   |       | 

The following table describes the intangible
assets written off during 2002:

|                        |  |                |     |           |  |       |     |  |  |   |     | 
|----------------------- |  | -------------- | --- | --------- |  | ----- | --- |  |  | - | --- | 
|                        |  |                |     | Assembled |  |      
|                        |  | Goodwill       |     | Workforce |  | Total
|                        |  |                |     |           |  |      
|                        |  |               
|                        |  | (In thousands)
|Cable Segment:          |  |                |     |           |  |       |     |  |  |   |     | 
|Ultracom                |  | $              |    |           |  | $     | 0.1 |  |  | $ | 0.1 | 
|ComBox                  |  |                |    |           |  |       | 0.1 |  |  |   | 0.1 | 
|Digitrans               |  |                | 0.2 |           |  |       |    |  |  |   | 0.2 | 
|Internet Telecom        |  |                |    |           |  |       | 0.1 |  |  |   | 0.1 | 
|TrueChat                |  |                | 2.5 |           |  |       |    |  |  |   | 2.5 | 
|                        |  |                |     |           |  |       |     |  |  |   |     | 
|Total Cable Segment     |  | $              | 2.7 |           |  | $     | 0.3 |  |  | $ | 3.0 | 
|Telecom Segment:        |  |                |     |           |  |       |     |  |  |   |     | 
|MainSail                |  |                |    |           |  |       | 0.5 |  |  |   | 0.5 | 
|ANE                     |  |                |    |           |  |       | 0.5 |  |  |   | 0.5 | 
|                        |  |                |     |           |  |       |     |  |  |   |     | 
|Total Telecom Segment   |  | $              |    |           |  | $     | 1.0 |  |  | $ | 1.0 | 
|                        |  |                |     |           |  |       |     |  |  |   |     | 
|Total Cable and Telecom |  | $              | 2.7 |           |  | $     | 1.3 |  |  | $ | 4.0 | 
|                        |  |                |     |           |  |       |     |  |  |   |     | 



|   |                                   
|-- | ----------------------------------
|6. | Impairment of Long-Term Investment

The Companys long-lived assets include
long-term equity investments. During 2002, the Company
determined that one such equity investment in a privately-held
company was impaired. The investees forecasts were not met
and market conditions significantly deteriorated and
accordingly, the Company recorded an impairment charge of
$4.5 million.

75



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##### Table of Contents



TERAYON COMMUNICATION
SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|   |                               
|-- | ------------------------------
|7. | Convertible Subordinated Notes

In July 2000, the Company issued
$500 million of 5% Convertible Subordinated Notes
(Notes) due in August 2007 resulting in net proceeds to the
Company of approximately $484.4 million. The Notes are the
Companys general unsecured obligation and are subordinated
in right of payment to all existing and future senior
indebtedness and to all of the liabilities of the Companys
subsidiaries. The Notes are convertible into shares of the
Companys common stock at a conversion price of
$84.01 per share at any time on or after October 24,
2000 through maturity, unless previously redeemed or
repurchased. The Company could have redeemed some or all of the
Notes at any time on or after October 24, 2000 and before
August 7, 2003 at a redemption price of $1,000 per
$1,000 principal amount of the Notes, plus accrued and unpaid
interest, if any, if the closing price of the Companys
stock exceeded 150% of the conversion price, or $126.01 for at
least 20 trading days within a period of 30 consecutive trading
days ending on the trading day prior to the date of mailing of
the redemption notice. The Company would also make an additional
payment of $193.55 per $1,000 principal amount of the
Notes, less the amount of any interest actually paid on the
Notes before the date of redemption. The Company may redeem the
Notes at any time on or after August 7, 2003 at specified
prices plus accrued and unpaid interest. Interest is payable
semi-annually. Debt issuance costs related to the Notes were
approximately $15.6 million and are amortized over seven
years. At December 31, 2003, amortization of debt issuance
costs totaled $14.5 million.

In 2002, the Company repurchased approximately
$109.1 million of the Notes for $57.6 million in cash,
resulting in a gain of approximately $49.1 million, net of
related unamortized issuance costs of $2.4 million. In
2001, the Company repurchased approximately $325.9 million
of the Notes for $113.4 million in cash and
$17.9 million in stock, resulting in a gain of
approximately $185.3 million, net of related unamortized
issuance costs of $9.3 million. The Company did not
repurchase any Notes during 2003.

In April 2002, the Company adopted
SFAS No. 145 and determined that the extinguishment of
its debt did not meet the criteria of an extraordinary item as
set forth in SFAS No. 145. Accordingly, in 2002, the
Company began reporting the gain from retirement of the Notes in
operating results. As a result of adopting
SFAS No. 145, the Company reclassified the
$185.3 million previously recorded in 2001 as extraordinary
gain as a component of operating results.

Approximately $65.1 million of the Notes
were outstanding at December 31, 2003.



|   |              
|-- | -------------
|8. | Contingencies



| |           
| | ----------
| | Litigation

Beginning in April 2000, several plaintiffs filed
class action lawsuits in federal court against the Company and
certain of its officers and directors. Later that year, the
cases were consolidated in the United States District Court,
Northern District of California as In re Terayon
Communication Systems, Inc. Securities Litigation. The
Court then appointed lead plaintiffs who filed an amended
complaint. In 2001, the Court granted in part and denied in part
defendants motion to dismiss, and plaintiffs filed a new
complaint. In 2002, the Court denied defendants motion to
dismiss that complaint, which, like the earlier complaints,
alleges that the defendants violated the federal securities laws
by issuing materially false and misleading statements and
failing to disclose material information regarding our
technology. On February 24, 2003, the Court certified a
plaintiff class consisting of those who purchased or otherwise
acquired our securities between November 15, 1999 and
April 11, 2000.

On September 8, 2003, the Court heard
defendants motion to disqualify two of the lead plaintiffs
and to modify the definition of the plaintiff class. On
September 10, 2003, the Court issued an order vacating the
hearing date for the parties summary judgment motions,
and, on September 22, 2003, the Court issued another order
staying all discovery until further notice and vacating the
trial date, which had been November 4, 2003. See
Note 16 for subsequent activities related to this matter.

76



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TERAYON COMMUNICATION
SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

On October 16, 2000, a lawsuit was filed
against the Company and the individual defendants (Zaki Rakib,
Selim Rakib and Raymond Fritz) in the California Superior Court,
San Luis Obispo County. This lawsuit is titled
Bertram v. Terayon Communications Systems, Inc.
The factual allegations in the Bertramcomplaint were
similar to those in the federal class action, but the Bertramcomplaint sought remedies under state law. Defendants
removed the Bertramcase to the United States District
Court, Central District of California, which dismissed the
complaint and transferred the case to the United States District
Court, Northern District of California. That Court eventually
issued an order dismissing the case. Plaintiffs have appealed
this order, and their appeal has been set for oral argument on
April 16, 2004.

The Company believes that the allegations in both
the class action and the Bertramcase are without merit,
and it intends to contest these matters vigorously. These
matters, however, could prove costly and time consuming to
defend, and there can be no assurances about the eventual
outcome.

On January 19, 2003, Omniband Group Limited,
a Russian company, or Omniband, filed a request for arbitration
with the Zurich Chamber of Commerce, claiming damages in an
amount of $2,094,970 allegedly caused by the Companys
breach of an agreement to sell to Omniband certain equipment
pursuant to an agreement between Omniband and Radwiz, Ltd., one
of the Companys wholly-owned subsidiaries. On
December 18, 2003, the panel of arbiters with the Zurich
Chamber of Commerce allowed the arbitration proceeding to
continue against Radwiz. The Company believes that the
allegations are without merit and intends to present a vigorous
defense in the arbitration proceedings.

The Company, as well as its customers, has
received letters from third parties claiming that the
Companys technology and products infringe on the third
parties patents. The Company has consulted with its patent
counsel and is in the process of reviewing the allegations made
by such third parties. The Company does not know whether the
third parties will pursue their claims of patent infringement in
court, and if they do, whether the Company would be found to
infringe the third parties patents. If the Company is
found to have infringed such third party patents, the Company
could be subject to substantial damages and/or an injunction
preventing it from selling its products and conducting our
business. Additionally, such third parties and additional third
parties could assert infringement claims against the Company in
the future. Any such claim of patent infringement, whether
meritorious or not, could be time-consuming, result in costly
litigation, cause product shipment delays or require the Company
to enter into royalty or licensing agreements. Such royalty or
licensing agreements may not be available on terms acceptable to
the Company or at all.

The Company is currently a party to various other
legal proceedings, in addition to those noted above, and may
become involved from time to time in other legal proceedings in
the future. While the Company currently believes that the
ultimate outcome of these other proceedings, individually and in
the aggregate, will not have a material adverse effect on the
Companys financial position or overall results of
operations, litigation is subject to inherent uncertainties.
Were an unfavorable ruling to occur in any of the Companys
legal proceedings, there exists the possibility of a material
adverse impact on the Companys results of operations for
the period in which the ruling occurs. The estimate of the
potential impact on the Companys financial position or
overall results of operations for any of the above legal
proceedings could change in the future.



|   |                     
|-- | --------------------
|9. | Stockholders Equity



| |                      
| | ---------------------
| | Common Stock Warrants

In conjunction with a 1998 preferred stock
financing, the Company issued Shaw a warrant (Anti-Dilution
Warrant) to purchase an indeterminate number of shares of common
stock. The Anti-Dilution Warrant was exercisable at the option
of Shaw during the period that Shaw owned equity in the Company
and in the event the Company issued new equity securities at
below the current market price defined in the Anti-Dilution
Warrant. The aggregate exercise price was $0.50. The Company
issued certain equity securities that, as of December 31,
2003, 2002, and 2001, required the Company to issue an
additional 37,283, 17,293, and 35,982

77



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##### Table of Contents



TERAYON COMMUNICATION
SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

warrants, respectively, to purchase shares of
common stock pursuant to the Anti-Dilution Warrant. The Company
recorded expenses of approximately $45,000, $26,000 and
$0.2 million relating to the issuance of warrants pursuant
to the Anti-Dilution Warrant, in 2003, 2002 and 2001,
respectively. The expense was calculated by multiplying the
annualized fair market value of the Companys stock by the
share dilution attributable to the Anti-Dilution Warrant. In
February 2003, Shaw transferred its ownership to a third party
and the Anti-Dilution Warrant expired unexercised. As of
December 31, 2003, the Anti-Dilution Warrant had expired
and was not exercised.

In October 1999, a customer of the Company
entered into an agreement with Telegate Ltd., an Israeli company
(Telegate), which was negotiating with the Company to be
acquired by the Company, whereby the customer committed to an
investment in Telegate in connection with the acquisition of all
the outstanding shares of Telegate by the Company. The customer
committed to provide this investment in the event that the
acquisition of Telegate by the Company did not close. In January
2000, the Company issued the customer a warrant to purchase
2,000,000 shares of the Companys common stock at a
price of $30.75 per share; the closing price of the
Companys common stock on the date the warrant was issued.
The warrant was fully vested, non-forfeitable, and immediately
exercisable and has a term of three years. The fair value of the
warrant, determined as approximately $34.6 million using
the Black Scholes model, was included in the Telegate purchase
price and was associated with the value of the customer
relationship. The value of the warrant resulted in a non-cash
charge to cost of goods sold to be amortized over the three-
year term of the warrant. In the first quarter of 2001, the
Company wrote-off the intangible assets relating to the purchase
of Telegate (see Note 5). For the year ended December 2003
and 2002, the Company incurred no amortization expense related
to the warrant. For the year ended December 31, 2001, the
Company incurred approximately $2.9 million in amortization
expense related to the warrant. The Telegate warrant expired in
January 2003 unexercised.

In February 2001, the Company issued a warrant to
purchase 200,000 shares of the Companys common stock
at a price of $5.4375 per share, the closing price of the
Companys common stock on the date the warrant was issued,
in connection with the December 2000 acquisition of
TrueChat, Inc. (TrueChat). Under terms of the warrant
100,000 shares are vested and exercisable immediately and
the remaining 100,000 shares vest and become exercisable at
the rate of 1/24th per month, beginning January 31,
2001. The fair value of the warrant of approximately
$0.7 million was calculated using the Black-Scholes method
and was recorded as additional consideration relating to the
purchase of TrueChat. As of December 31, 2003, the TrueChat
warrant was exercisable for an aggregate of 200,000 shares
of the Companys common stock. The TrueChat warrant expired
unexercised in February 2004.



| |                        
| | -----------------------
| | Stockholder Rights Plan

In February 2001, the Companys Board of
Directors approved the adoption of a Stockholder Rights Plan
under which all stockholders of record as of February 20,
2001 received rights to purchase shares of a new series of
preferred stock. The rights were distributed as a non-taxable
dividend and will expire in ten years from the record date. The
rights will be exercisable only if a person or group acquires
15% or more of the Companys common stock or announces a
tender offer for 15% or more of the Companys common stock.
If a person or group acquires 15% or more of the Companys
common stock, all rights holders except the buyer will be
entitled to acquire the Companys common stock at a
discount. The Board may terminate the Rights Plan at any time or
redeem the rights prior to the time a person or group acquires
more than 15% of the Companys common stock.

78



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##### Table of Contents



TERAYON COMMUNICATION
SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |                      
| | ---------------------
| | Common Stock Reserved

Common stock reserved for issuance is as follows:

|                             |  |              |            | 
|---------------------------- |  | ------------ | ---------- | 
|                             |  | December 31,
|                             |  | 2003        
|                             |  |             
|Common stock options         |  |              | 25,945,559 | 
|Common stock warrants        |  |              | 200,000    | 
|Employee stock purchase plan |  |              | 2,400,152  | 
|                             |  |              |            | 
|                             |  |              | 28,545,711 | 
|                             |  |              |            | 



| |                                          
| | -----------------------------------------
| | Stock Option and Stock Purchase
    Plans



| |          
| | ---------
| | 1995 Plan

In March 1995, the Companys Board of
Directors approved a stock option plan (1995 Plan) that
authorized shares for future issuance to be granted as options
to purchase shares of the Companys common stock. As of
December 31, 2003 a total of 4,229,494 shares have
been authorized for issuance related to the 1995 Plan.



| |          
| | ---------
| | 1997 Plan

In March 1997, the Companys Board of
Directors approved an equity incentive plan (1997 Plan) that
authorized 1,600,000 shares for future issuance to be
granted as options to purchase shares of the Companys
common stock. In 1998, 2000 and 2003, the Companys Board
of Directors amended the 1997 Plan, increasing the aggregate
number of shares authorized for issuance under the 1997 Plan to
a total of 15,516,702 shares as of December 31, 2003.



| |          
| | ---------
| | 1998 Plan

In June 1998, the Companys Board of
Directors authorized the adoption of the 1998 Non-Employee
Directors Stock Option Plan (1998 Plan), pursuant to which
400,000 shares of the Companys common stock have been
reserved for future issuance to non-employee directors of the
Company. In 2002, the Companys Board of Directors amended
the 1998 Plan to increase the shares authorized for issuance by
400,000 additional shares. As of December 31, 2003, a total
of 800,000 shares have been authorized for issuance related
to the 1998 Plan.

The 1998 Plan provides for non-discretionary
nonqualified stock options to be issued to non-employee
directors of the Company automatically as of the effective date
of their election to the Board of Directors and annually
following each annual stockholder meeting. Prices for
nonqualified options may not be less than 100% of the fair
market value of the common stock at the date of grant. Options
generally vest and become exercisable over a period not to
exceed three years from the date of grant. Unexercised options
expire ten years after the date of grant.



| |          
| | ---------
| | 1999 Plan

In September 1999, the Companys Board of
Directors authorized the adoption of the 1999 Non-Officers
Equity Incentive Plan (1999 Plan), pursuant to which
6,000,000 shares of the Companys common stock have
been reserved for future issuance to non-officer employees of
the Company. The plan has been amended by the Board of Directors
to increase the amount of authorized shares available to a total
of 14,737,826 shares as of December 31, 2003.

79



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##### Table of Contents



TERAYON COMMUNICATION
SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The 1995 and 1997 Plans provide for incentive
stock options or nonqualified stock options to be issued to
employees, directors, and consultants of the Company. Prices for
incentive stock options may not be less than the fair market
value of the common stock at the date of grant. Prices for
nonqualified stock options may not be less than 85% of the fair
market value of the common stock at the date of grant. Options
are immediately exercisable and vest over a period not to exceed
five years from the date of grant. Any unvested stock issued is
subject to repurchase by the Company at the original issuance
price upon termination of the option holders employment.
Unexercised options expire ten years after the date of grant.

The 1999 Plan provides for nonqualified stock
options to be issued to non-officer employees and consultants of
the Company. Prices for nonqualified stock options may not be
less than 85% of the fair market value of the common stock at
the date of the grant. Options generally vest and become
exercisable over a period not to exceed five years from the date
of grant. Unexercised options expire ten years after date of
grant.

During the years ended December 31, 2002 and
2001, the Company recorded aggregate deferred compensation of
approximately $38,000 and $35,000, respectively, representing
the difference between the grant price and the deemed fair value
of the Companys common stock options granted during the
period. During the year ended December 31, 2003, the
Company did not record any additional deferred compensation. The
amortization of deferred compensation is being charged to
operations and is being amortized over the vesting period of the
options, which is typically five years. In each subsequent
reporting period (through the vesting period) the remaining
deferred compensation will be remeasured. For the years ended
December 31, 2003, 2002, and 2001, the amortization expense
was approximately $53,000, $0.5 million, and
$0.5 million, respectively.

During 2002, the Company issued
20,000 nonqualified stock options of common stock to a
member of its Board of Advisors who is also a director and Chief
Executive Officer of one of its customers, and recorded $38,000
in related compensation expense. The compensation expense was
calculated using the closing price of the Companys common
stock on the date the stock was issued of $1.95 per share.

During 2002, the Company issued
200,000 shares of common stock to a consultant and recorded
$290,000 in related compensation expense. The compensation
expense was calculated using the closing price of the
Companys common stock on the date the stock was issued of
$1.45 per share.

In June 2001, the Company issued
160,000 shares of the Companys common stock to
members of its Board of Advisors and recorded $0.6 million
in related compensation expense. The compensation expense was
calculated using the closing price of the Companys common
stock on the date the stock was issued at $3.72 per share.

During 2001, the Company issued
115,250 shares of common stock to its employees, and
recorded $0.6 million in related compensation expense. The
compensation expense was calculated using the closing price of
the Companys common stock on the date the stock was issued
at $5.57 per share.

80



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##### Table of Contents



TERAYON COMMUNICATION
SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The following is a summary of additional
information with respect to the 1995 Plan, the 1997 Plan, the
1998 Plan, the 1999 Plan, outstanding options assumed by the
Company in conjunction with its business acquisitions and option
grants made outside the plans (if any):

|                             |                    |               |            |                     |   |                  |            |             |   |   |       |       | 
|---------------------------- | ------------------ | ------------- | ---------- | ------------------- | - | ---------------- | ---------- | ----------- | - | - | ----- | ----- | 
|                             |                    |               |            |                    
|                             |                    |               |            | Options Outstanding
|                             |                    | Options       |            |                    
|                             |                    | Available for |            | Number of           |   | Weighted-Average
|                             |                    | Grant         |            | Shares              |   | Exercise Price  
|                             |                    |               |            |                     |   |                 
|Balance at December 31, 2000 |                    |               | 8,840,090  |                     |   |                  | 21,489,536 |             |   | $ | 39.27 |      
|                             | Options authorized |               |            | 13,000,000          |   |                  |            |            |   |   |       |      | 
|                             | Options granted    |               |            | (22,925,565         | ) |                  |            | 22,925,565  |   |   | $     | 6.25  | 
|                             | Options exercised  |               |            |                    |   |                  |            | (2,924,274  | ) |   | $     | 4.59  | 
|                             | Options canceled   |               |            | 21,483,141          |   |                  |            | (21,483,141 | ) |   | $     | 35.99 | 
|                             |                    |               |            |                     |   |                  |            |             |   |   |       |      
|Balance at December 31, 2001 |                    |               | 20,397,666 |                     |   |                  | 20,007,686 |             |   | $ | 9.75  |      
|                             | Options authorized |               |            | 3,400,000           |   |                  |            |            |   |   |       |       | 
|                             | Options granted    |               |            | (1,734,400          | ) |                  |            | 1,734,400   |   |   | $     | 5.40  | 
|                             | Options exercised  |               |            |                    |   |                  |            | (257,521    | ) |   | $     | 3.95  | 
|                             | Options canceled   |               |            | 6,849,540           |   |                  |            | (6,849,540  | ) |   | $     | 12.66 | 
|                             |                    |               |            |                     |   |                  |            |             |   |   |       |      
|Balance at December 31, 2002 |                    |               | 28,912,806 |                     |   |                  | 14,635,025 |             |   | $ | 8.05  |      
|                             |                    |               |            |                     |   |                  |            |             |   |   |       |      
|                             | Options authorized |               |            | 3,000,000           |   |                  |            |            |   |   |       |       | 
|                             | Options reduced    |               |            | (20,000,000         | ) |                  |            |            |   |   |       |       | 
|                             | Options granted    |               |            | (7,153,320          | ) |                  |            | 7,153,320   |   |   | $     | 3.05  | 
|                             | Options exercised  |               |            |                    |   |                  |            | (602,272    | ) |   | $     | 4.20  | 
|                             | Options canceled   |               |            | 3,722,114           |   |                  |            | (3,722,114  | ) |   | $     | 7.58  | 
|                             |                    |               |            |                     |   |                  |            |             |   |   |       |      
|Balance at December 31, 2003 |                    |               | 8,481,600  |                     |   |                  | 17,463,959 |             |   | $ | 6.20  |      
|                             |                    |               |            |                     |   |                  |            |             |   |   |       |      

In addition, the following table summarizes
information about stock options that were outstanding and
exercisable at December 31, 2003:

|                         |       |                     |           |                     |  |                  |      |             |  |                  |       |      |  |  |           |           |  |   |       |      | 
|------------------------ | ----- | ------------------- | --------- | ------------------- |  | ---------------- | ---- | ----------- |  | ---------------- | ----- | ---- |  |  | --------- | --------- |  | - | ----- | ---- | 
|                         |       |                     |           |                     |  |                  |      |            
|                         |       | Options Outstanding |           |                    
|                         |       |                     |           | Options Exercisable
|                         |       |                     |           | Number of Average   |  |                 
|                         |       | Weighted Number     |           | Remaining           |  | Weighted Average |      | Exercisable |  | Weighted Average
|Range of Exercise Prices |       | Outstanding         |           | Contractual Life    |  | Exercise Price   |      | Options     |  | Exercise Price  
|                         |       |                     |           |                     |  |                  |      |             |  |                 
|$0.01 - $  2.45          |       |                     | 5,480,406 |                     |  |                  | 9.23 |             |  | $                | 2.34  |      |  |  | 201,017   |           |  | $ | 1.22  |     
|$2.46 - $  4.26          |       |                     | 1,599,731 |                     |  |                  | 8.05 |             |  | $                | 3.77  |      |  |  | 532,214   |           |  | $ | 3.51  |     
|$4.38 - $  6.50          |       |                     | 2,819,153 |                     |  |                  | 7.86 |             |  | $                | 5.70  |      |  |  | 1,197,386 |           |  | $ | 5.66  |     
|$6.52 - $  8.39          |       |                     | 6,483,914 |                     |  |                  | 7.23 |             |  | $                | 6.85  |      |  |  | 5,152,720 |           |  | $ | 6.82  |     
|$8.51 - $123.50          |       |                     | 1,080,755 |                     |  |                  | 6.42 |             |  | $                | 26.86 |      |  |  | 884,176   |           |  | $ | 27.56 |     
|                         |       |                     |           |                     |  |                  |      |             |  |                  |       |      |  |  |           |           |  |   |       |     
|                         | Total |                     |           | 17,463,959          |  |                  |      | 7.98        |  |                  | $     | 6.20 |  |  |           | 7,967,513 |  |   | $     | 8.58 | 
|                         |       |                     |           |                     |  |                  |      |             |  |                  |       |      |  |  |           |           |  |   |       |     

At December 31, 2003, there were no shares
of the Companys common stock subject to repurchase by the
Company.

Employee Stock Purchase Plan

In June 1998, the Board of Directors approved,
and the Company adopted, the 1998 Employee Stock Purchase Plan
(ESPP), which is designed to allow eligible employees of the
Company to purchase shares of common stock at semi-annual
intervals through periodic payroll deductions. In 2002, the ESPP
was amended

81



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##### Table of Contents



TERAYON COMMUNICATION
SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

to add an additional 3,000,000 shares to the
ESPP. An aggregate of 4,400,000 shares of common stock are
reserved for the ESPP, and 1,999,848 shares have been
issued through December 31, 2003. The ESPP is implemented
in a series of successive offering periods, each with a maximum
duration of 24 months. Eligible employees can have up to
15% of their base salary deducted that can be used to purchase
shares of the common stock on specific dates determined by the
Board of Directors (up to a maximum of $25,000 per year
based upon the fair market value of the shares at the beginning
date of the offering). The price of common stock purchased under
the ESPP will be equal to 85% of the lower of the fair market
value of the common stock on the commencement date of each
offering period or the specified purchase date. In November 2002
the Companys Board of Directors suspended the ESPP after
the current offering period expires (no later than July 31,
2004).

The Company has elected to follow APB Opinion
No. 25 and related interpretations in accounting for its
employee stock plans because, as discussed below, the
alternative fair value accounting provided for under
SFAS No. 123 requires the use of valuation models that
were not developed for use in valuing employee stock
instruments. Under APB Opinion No. 25, when the exercise
price of the Companys employee stock options equals the
market price of the underlying stock on the date of grant, no
compensation expense is recognized.

Pro forma information regarding net loss is
required under SFAS No. 123 and is calculated as if
the Company had accounted for its employee stock options granted
during the years ended December 31, 2003, 2002, and 2001
and for its ESPP shares to be issued under the fair value method
of SFAS No. 123. The fair value for employee stock
options granted and ESPP shares was estimated at the date of
grant based on the Black-Scholes model using the following
weighted average assumptions:

|                             |  |               |      |               |  |               |      |   |  |  |      |  
|---------------------------- |  | ------------- | ---- | ------------- |  | ------------- | ---- | - |  |  | ---- | -
|                             |  | Risk Free     |      | Risk Free     |  | Risk Free    
|                             |  | Interest Rate |      | Interest Rate |  | Interest Rate
|                             |  | 2003          |      | 2002          |  | 2001         
|                             |  |               |      |               |  |              
|Stock option plans           |  |               | 2.67 | %             |  |               | 4.22 | % |  |  | 4.50 | %
|Employee stock purchase plan |  |               | 2.88 | %             |  |               | 4.36 | % |  |  | 4.14 | %

|                             |  |                |     |                   |  |                   |      |                   |  |  |      |  |  |  |      | 
|---------------------------- |  | -------------- | --- | ----------------- |  | ----------------- | ---- | ----------------- |  |  | ---- |  |  |  | ---- | 
|                             |  | Dividend Yield |     | Volatility Factor |  | Volatility Factor |      | Volatility Factor
|                             |  | All Years      |     | 2003              |  | 2002              |      | 2001             
|                             |  |                |     |                   |  |                   |      |                  
|Stock option plans           |  |                | 0.0 |                   |  |                   | 0.87 |                   |  |  | 1.50 |  |  |  | 1.50 | 
|Employee stock purchase plan |  |                | 0.0 |                   |  |                   | 1.54 |                   |  |  | 1.50 |  |  |  | 1.50 | 

|                             |  |                  |     |                  |  |                  |     |  |  |  |     | 
|---------------------------- |  | ---------------- | --- | ---------------- |  | ---------------- | --- |  |  |  | --- | 
|                             |  | Weighted Average |     | Weighted Average |  | Weighted Average
|                             |  | Expected Life    |     | Expected Life    |  | Expected Life   
|                             |  | 2003             |     | 2002             |  | 2001            
|                             |  |                  |     |                  |  |                 
|Stock option plans           |  |                  | 5.0 |                  |  |                  | 5.0 |  |  |  | 5.0 | 
|Employee stock purchase plan |  |                  | 0.5 |                  |  |                  | 0.5 |  |  |  | 0.5 | 

As discussed above, the valuation models used
under SFAS No. 123 were developed for use in
estimating the fair value of traded options that have no vesting
restrictions and are fully transferable. In addition, valuation
models require the input of highly subjective assumptions,
including the expected life of the option. Because the
Companys employee stock options have characteristics
significantly different from those of traded options and because
changes in the subjective input assumptions can materially
affect the fair value estimate, in managements opinion,
the existing models do not necessarily provide a reliable single
measure of the fair value of its employee stock instruments.

The options weighted average grant date
fair value, which is the value assigned to the options under
SFAS No. 123, was $2.14, $4.98, and $5.83, for options
granted during 2003, 2002, and 2001,respectively. The weighted
average grant date fair value of ESPP shares to be issued was
$1.00, $2.25, and $3.99 for the years ended December 31,
2003, 2002 and 2001, respectively.

82



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##### Table of Contents



TERAYON COMMUNICATION
SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|    |             
|--- | ------------
|10. | Income Taxes

For the years ended December 31, 2003, 2002
and 2001, the Company had an income tax expense of
$0.3 million, $0.2 million, and an income tax benefit
of $13.9 million, respectively.

|          |         |                          |     |      |     |      |     |     |     |   |         |         |         |  
|--------- | ------- | ------------------------ | --- | ---- | --- | ---- | --- | --- | --- | - | ------- | ------- | ------- | -
|          |         |                         
|          |         | Years Ended December 31,
|          |         |                         
|          |         | 2003                     |     | 2002 |     | 2001
|          |         |                          |     |      |     |     
|          |         |                         
|          |         | (In thousands)          
|Current:  |         |                          |     |      |     |      |     |     |     |   |         |        
|          | Federal |                          | $   |     |     |      | $   |    |     |   | $       |        |        
|          | State   |                          |     |     |     |      |     | 20  |     |   |         |        |        
|          | Foreign |                          |     | 316  |     |      |     | 218 |     |   |         | 831     |        
|          |         |                          |     |      |     |      |     |     |     |   |         |        
|          |         | Total current            |     |      | 316 |      |     |     | 238 |   |         |         | 831     |  
|Deferred: |         |                          |    |      |     |      |    |     |     |   |        |        
|          | Federal |                          |     |     |     |      |     |    |     |   |         |        |        
|          | State   |                          |     |     |     |      |     |    |     |   |         |        |        
|          | Foreign |                          |     |     |     |      |     |    |     |   |         | (14,746 | )      
|          |         |                          |     |      |     |      |     |     |     |   |         |        
|          |         | Total deferred           |     |      |    |      |     |     |    |   |         |         | (14,746 | )
|          |         |                          |     |      |     |      |     |     |     |   |         |        
|Total     |         | $                        | 316 |      |     | $    | 238 |     |     | $ | (13,915 | )      
|          |         |                          |     |      |     |      |     |     |     |   |         |        

The reconciliation of income tax benefit
attributable to net loss applicable to common stockholders
computed at the U.S. federal statutory rates to income tax
benefit (in thousands):

|                                                            |  |                          |         |      |  |      |         |   |  |   |          |  
|----------------------------------------------------------- |  | ------------------------ | ------- | ---- |  | ---- | ------- | - |  | - | -------- | -
|                                                            |  |                         
|                                                            |  | Years Ended December 31,
|                                                            |  |                         
|                                                            |  | 2003                     |         | 2002 |  | 2001
|                                                            |  |                          |         |      |  |     
|Tax benefit at U.S. statutory rate                          |  | $                        | (17,624 | )    |  | $    | (15,391 | ) |  | $ | (197,346 | )
|Goodwill amortization                                       |  |                          |        |      |  |      |        |   |  |   | 2,849    |  
|Loss for which no tax benefit is currently
    recognizable |  |                          | 17,536  |      |  |      | 15,391  |   |  |   | 179,338  |  
|Other, net                                                  |  |                          | 404     |      |  |      | 238     |   |  |   | 1,244    |  
|                                                            |  |                          |         |      |  |      |         |   |  |   |          |  
|                                                            |  | $                        | 316     |      |  | $    | 238     |   |  | $ | (13,915  | )
|                                                            |  |                          |         |      |  |      |         |   |  |   |          |  

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TERAYON COMMUNICATION
SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Deferred income taxes reflect the net tax effects
of temporary differences between the carrying amounts of assets
and liabilities for financial reporting purposes and the amounts
used for income tax purposes. Significant components of the
Companys deferred tax assets and liabilities as of
December 31, 2003 and 2002 are as follows (in thousands):

|                     |                                  |                                      |                           |         |        |          |   |         |        |          |  
|-------------------- | -------------------------------- | ------------------------------------ | ------------------------- | ------- | ------ | -------- | - | ------- | ------ | -------- | -
|                     |                                  |                                     
|                     |                                  | December 31,                        
|                     |                                  |                                     
|                     |                                  | 2003                                 |                           | 2002   
|                     |                                  |                                      |                           |        
|Deferred tax assets: |                                  |                                      |                           |         |        |          |   |        
|                     | Net operating loss carryforwards |                                      | $                         | 149,862 |        |          | $ | 118,021 |       
|                     | Tax credit carryforwards         |                                      |                           | 19,505  |        |          |   | 14,936  |       
|                     |                                  | Reserves and accruals                |                           |         | 9,949  |          |   |         | 96,428 |         
|                     |                                  | Capitalized research and development |                           |         | 8,761  |          |   |         | 4,372  |         
|                     |                                  | Intangibles amortization             |                           |         | 38,864 |          |   |         | 2,616  |         
|                     |                                  | Other, net                           |                           |         | 12,130 |          |   |         | 8,430  |         
|                     |                                  |                                      |                           |         |        |          |   |        
|                     |                                  |                                      | Gross deferred tax assets |         |        | 239,071  |   |         |        | 244,803  |  
|                     |                                  |                                      | Valuation allowance       |         |        | (239,071 | ) |         |        | (244,803 | )
|                     |                                  |                                      |                           |         |        |          |   |        
|                     |                                  |                                      | Total deferred tax assets |         | $      |         |   |         | $      |         |  
|                     |                                  |                                      |                           |         |        |          |   |        

Realization of deferred tax assets is dependent
on future earnings, if any, the timing and the amount of which
are uncertain. Accordingly, a valuation allowance has been
established to reflect these uncertainties as of
December 31, 2003 and 2002. The change in the valuation
allowance was a net decrease of $5.7 million and a net
increase of approximately $26.4 million and
$86.7 million for the years ended December 31, 2003,
2002, and 2001, respectively. Approximately $44.2 million
of the valuation allowance will be credited to equity when
realized.

As of December 31, 2003, the Company had
federal, California and foreign net operating loss carryforwards
of approximately $340.0 million, $129.0 million and
$107.0 million, respectively. The Company also had federal
and California tax credit carryforwards of approximately
$9.0 million and $16.0 million, respectively. The
federal and California net operating loss and credit
carryforwards will expire at various dates beginning in the
years 2004 through 2023, if not utilized. The foreign net
operating losses have an unlimited carryover period.

Utilization of net operating loss and tax credit
carryforwards may be subject to a substantial annual limitation
due to the ownership change limitations provided by the Internal
Revenue Code of 1986, as amended, and similar state provisions.
The annual limitation may result in the expiration of net
operating loss and tax credit carryforwards before full
utilization.



|    |                          
|--- | -------------------------
|11. | Defined Contribution Plan

During 1995, the Company adopted a
401(k) Profit Sharing Plan and Trust that allows eligible
employees to make contributions subject to certain limitations.
The Company may make discretionary contributions based on
profitability as determined by the Board of Directors. No amount
was contributed by the Company to the plan during the years
ended December 31, 2003, 2002, and 2001.



|    |                                                      
|--- | -----------------------------------------------------
|12. | Segments of an Enterprise and Related
    Information

Since late 2000, the worldwide telecom and
satellite industries have experienced severe downturns that have
resulted in significantly reduced purchases of new broadband
equipment. Because of this overall drop in demand, the Company
has refocused its efforts on the cable industry, and has
significantly reduced its investment in the telecom and
satellite businesses. Consequently, beginning in 2003, the
Companys previously

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TERAYON COMMUNICATION
SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

reported Telecom segment no longer meets the
quantitative threshold for disclosure and the Company now
operates as one business segment. Therefore, operating segment
disclosure for the year ended December 31, 2003 is not
provided.

Prior to December 31, 2002, the Company
operated primarily in two principal operating segments: Cable
Broadband Access Systems (Cable) and Telecom Carrier Access
Systems (Telecom). The Cable segment consisted primarily of
TeraComm System, TJ line of DOCSIS cable modems, Bluewave line
of DOCSIS CMTS, and the CherryPicker family of Digital Video
Management Systems that are sold primarily to cable operators
for the deployment of data, video and voice services over the
existing cable infrastructure. The Telecom segment consisted
primarily of MiniPlex DSL Systems, IPTL Converged Voice and
Data Service System and Mainsail products, which are sold to
providers of broadband services for the deployment of voice and
data services over the existing copper wire infrastructure. The
Company determined these reportable operating segments based
upon how the businesses were managed and operated.

Information on reportable segments is as follows
(in thousands):

|                                  |                                          |                          |          |         |        |         |         |          |         |          |  
|--------------------------------- | ---------------------------------------- | ------------------------ | -------- | ------- | ------ | ------- | ------- | -------- | ------- | -------- | -
|                                  |                                          |                         
|                                  |                                          | Years Ended December 31,
|                                  |                                          |                         
|                                  |                                          | 2002                     |          | 2001   
|                                  |                                          |                          |          |        
|Cable Broadband Access Segment:   |                                          |                          |          |         |        |         |         |         
|                                  | Revenues:                                |                          |          |         |        |         |         |          |        
|                                  |                                          | TeraComm System          |          | $       | 68,753 |         |         | $        | 192,757 |         
|                                  |                                          | TJ DOCSIS cable modems   |          |         | 23,059 |         |         |          | 25,069  |         
|                                  |                                          | Video products           |          |         | 20,833 |         |         |          | 16,363  |         
|                                  |                                          | Other                    |          |         | 6,284  |         |         |          | 11,639  |         
|                                  |                                          |                          |          |         |        |         |         |         
|                                  | Total Cable revenues                     |                          | $        | 118,929 |        |         | $       | 245,828  |        
|                                  | Depreciation expense                     |                          | $        | 10,347  |        |         | $       | 12,028   |        
|                                  | Operating loss                           |                          | $        | (78,731 | )      |         | $       | (465,435 | )      
|Telecom Broadband Access Segment: |                                          |                          |          |         |        |         |         |         
|                                  | Revenues:                                |                          |          |         |        |         |         |          |        
|                                  |                                          | MiniPlex DSL Systems     |          | $       | 8,366  |         |         | $        | 23,417  |         
|                                  |                                          | Other                    |          |         | 2,108  |         |         |          | 10,236  |         
|                                  |                                          |                          |          |         |        |         |         |         
|                                  | Total Telecom revenues                   |                          | $        | 10,474  |        |         | $       | 33,653   |        
|                                  | Depreciation expense                     |                          | $        | 1,225   |        |         | $       | 3,700    |        
|                                  | Operating loss                           |                          | $        | (10,852 | )      |         | $       | (297,697 | )      
|Total revenues                    |                                          | $                        | 129,403  |         |        | $       | 279,481 |         
|Total depreciation expense        |                                          | $                        | 11,572   |         |        | $       | 15,728  |         
|Operating loss:                   |                                          |                          |          |         |        |         |         |         
|                                  | Operating loss by reportable segments    |                          | $        | (89,583 | )      |         | $       | (763,132 | )      
|                                  | Unallocated amounts:                     |                          |          |         |        |         |         |          |        
|                                  | Interest and other income (expense), net |                          |          | (3,481  | )      |         |         | 44       |        
|                                  | Gain on early retirement of debt         |                          |          | 49,089  |        |         |         | 185,327  |        
|                                  | Income tax (expense) benefit             |                          |          | (238    | )      |         |         | 13,915   |        
|                                  |                                          |                          |          |         |        |         |         |         
|                                  |                                          |                          | Net loss |         | $      | (44,213 | )       |          | $       | (563,846 | )
|                                  |                                          |                          |          |         |        |         |         |         

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TERAYON COMMUNICATION
SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

|                  |           |                          |       |      |        |         |  |   |        |         |  |   |         |         | 
|----------------- | --------- | ------------------------ | ----- | ---- | ------ | ------- |  | - | ------ | ------- |  | - | ------- | ------- | 
|                  |           |                         
|                  |           | Years Ended December 31,
|                  |           |                         
|                  |           | 2003                     |       | 2002 |        | 2001   
|                  |           |                          |       |      |        |        
|Geographic areas: |           |                          |       |      |        |         |  |   |        |         |  |  
|                  | Revenues: |                          |       |      |        |         |  |   |        |         |  |   |        
|                  |           | United States            |       | $    | 74,341 |         |  | $ | 41,150 |         |  | $ | 50,291  |        
|                  |           | Canada                   |       |      | 3,145  |         |  |   | 17,247 |         |  |   | 113,300 |        
|                  |           | Europe                   |       |      | 17,635 |         |  |   | 11,381 |         |  |   | 34,952  |        
|                  |           | Israel                   |       |      | 7,038  |         |  |   | 8,283  |         |  |   | 16,528  |        
|                  |           | Japan                    |       |      | 21,183 |         |  |   | 36,214 |         |  |   | 37,721  |        
|                  |           | Asia, excluding Japan    |       |      | 9,575  |         |  |   | 11,845 |         |  |   | 24,094  |        
|                  |           | South America            |       |      | 568    |         |  |   | 3,283  |         |  |   | 2,595   |        
|                  |           |                          |       |      |        |         |  |   |        |         |  |  
|                  |           |                          | Total |      | $      | 133,485 |  |   | $      | 129,403 |  |   | $       | 279,481 | 
|                  |           |                          |       |      |        |         |  |   |        |         |  |  

|        |                                  |              |   |         |         | 
|------- | -------------------------------- | ------------ | - | ------- | ------- | 
|        |                                  | December 31,
|        |                                  | 2002        
|        |                                  |             
|Assets: |                                  |              |   |        
|        | Cable Broadband Access Segment   |              | $ | 217,531 |        
|        | Telecom Broadband Access Segment |              |   | 58,179  |        
|        |                                  |              |   |        
|        |                                  | Total assets |   | $       | 275,710 | 
|        |                                  |              |   |        

|                   |                         |                      |              |              |         |         |   |        |         |         | 
|------------------ | ----------------------- | -------------------- | ------------ | ------------ | ------- | ------- | - | ------ | ------- | ------- | 
|                   |                         | December 31,         |              | December 31,
|                   |                         | 2003                 |              | 2002        
|                   |                         |                      |              |             
|Long-lived assets: |                         |                      |              |              |         |         |   |       
|                   | United States           |                      | $            | 19,630       |         |         | $ | 28,169 |        
|                   | Canada                  |                      |              | 810          |         |         |   | 787    |        
|                   | Europe                  |                      |              | 175          |         |         |   | 170    |        
|                   | Israel                  |                      |              | 3,104        |         |         |   | 3,442  |        
|                   | Asia                    |                      |              | 173          |         |         |   | 207    |        
|                   | South America           |                      |              |             |         |         |   | 118    |        
|                   |                         |                      |              |              |         |         |   |       
|                   | Total long-lived assets |                      |              | 23,892       |         |         |   | 32,893 |        
|                   |                         | Total current assets |              |              | 191,348 |         |   |        | 242,817 |        
|                   |                         |                      |              |              |         |         |   |       
|                   |                         |                      | Total assets |              | $       | 215,240 |   |        | $       | 275,710 | 
|                   |                         |                      |              |              |         |         |   |       

Three customers, Adelphia, Cross Beam Networks, a
subsidiary of Sumitomo, and Comcast accounted for more than 10%
of total revenues for the year ended December 31, 2003
(22%, 16%, and 13%). One customer, related to the Cable segment,
Cross Beam Networks, accounted for more than 10% of total
revenues for the year ended December 31, 2002 (28%). Two
customers, Shaw and Cross Beam Networks, both related to the
Cable segment, accounted for 10% or more of total revenues (33%
and 13%) for the year ended December 31, 2001. Two
customers accounted for 10% or more of total accounts receivable
for the year ended December 31, 2003 (24% and 20%). One
customer, related to the Cable segment, accounted for 10% or
more of total accounts receivable for the year ended
December 31, 2002 (24%).

86



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TERAYON COMMUNICATION
SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|    |                           
|--- | --------------------------
|13. | Related Party Transactions

During the years ended December 31, 2003,
2002 and 2001, the Company recognized revenue of
$4.7 million, $9.1 million, and $52.4 million,
respectively in connection with product shipments made to
related parties. Prior to the third quarter of 2001, both Shaw
and Rogers, each of which had one representative on the
Companys Board of Directors were significant stockholders
and were related parties. Beginning in the third quarter of
2001, Shaw was no longer a significant stockholder because Shaw
no longer exercised voting rights over its shares in the
Company, and the board member from Shaw resigned. Accordingly,
Shaw was no longer considered a related party. Revenues from
Shaw have not been included as revenues from related parties
after the second quarter of 2001, when Shaw ceased to be a
related party. In 2001, the Company recognized
$31.4 million of related party revenues in connection with
product shipments to Shaw, net of amortization of co-marketing
expense.

Alek Krstajic, a member of the Companys
Board of Directors, was the Senior Vice President of Interactive
Services, Sales and Product Development for Rogers until January
2003. Beginning April 1, 2003, the Company no longer
recognized revenues related to Rogers as related party revenues
as Rogers was no longer considered to be a related party. For
the year ended 2003, 2002 and 2001, the Company recognized
$1.5 million, $8.0 million, and $21.0 million,
respectively of related party revenues in connection with
product shipments to Rogers, net of amortization of co-marketing
expense.

Lewis Solomon, a member of the Companys
Board of Directors and Chairman of the Companys Audit
Committee is also a member of the Board of Directors of
Harmonic, Inc. (Harmonic) a manufacturer and seller of
broadband products. In April 2002, the Company entered into a
reseller agreement with Harmonic to sell certain of the
Companys products. The agreement appoints Harmonic as an
authorized, non-exclusive reseller of certain of the
Companys video products. For the years ended
December 31, 2003 and 2002, revenues from Harmonic of
$3.2 million and $1.1 million, respectively were
included as revenues from related parties.

Cost of related party product revenues in the
Companys consolidated statements of operations consists of
direct and indirect product costs. Accounts receivable from
Rogers and Harmonic totaled approximately $0.6 million and
$0.8 million at December 31, 2003 and 2002,
respectively. None of the related parties is a supplier to the
Company.

In December 2001, the Company entered into
co-marketing arrangements with Shaw and Rogers. The Company paid
$7.5 million to Shaw and $0.9 million to Rogers, and
recorded these amounts as other current assets. The Company
entered into these arrangements with Shaw and Rogers to promote
the Companys brand and identify its products In July 2002,
the Company began amortizing these prepaid assets and charging
them against Cable revenues in accordance with EITF 01-09,
Accounting for Consideration given by a Vendor to a
Customer or Reseller in Connection with the Purchase or
Promotion of the Vendors Products. The Company
charged $1.4 million of amortization of these assets
against revenues in each quarter beginning in the third quarter
of 2002 through the fourth quarter of 2003. Amounts charged
against revenues in 2003 and 2002 totaled approximately
$5.6 million and $2.8 million, respectively. Of the
co-marketing amortization charged to total revenue,
approximately $0.15 million and $0.3 million were
charged to related party revenues in the year ended 2003 and
2002, respectively.

In October 2002, the Company incurred a marketing
expense of $150,000 for Team Honor, an organization that
supports a professional sailing team. One of the Companys
Board members, Aleksander Krstajic is the founder and President
of Team Honor.



|    |                   
|--- | ------------------
|14. | Product Warranties

The Company provides for estimated product
warranty expenses when it sells the related products. Because
warranty estimates are forecasts that are based on the best
available information  mostly historical

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TERAYON COMMUNICATION
SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

claims experience  claims costs may
differ from amounts provided. An analysis of changes in the
liability for product warranties is as follows (in thousands):

|                             |                  |            |   |            |  |            |  |                |  |  |  |        |   |  |   |       | 
|---------------------------- | ---------------- | ---------- | - | ---------- |  | ---------- |  | -------------- |  |  |  | ------ | - |  | - | ----- | 
|                             |                  |            |   | Additions  |  |            |  |               
|                             |                  | Balance at |   | Charged to |  |            |  |               
|                             |                  | Beginning  |   | Costs and  |  |            |  | Balance at End
|                             |                  | of Period  |   | Expenses   |  | Write-Offs |  | of Period     
|                             |                  |            |   |            |  |            |  |               
|Year ended December 31, 2001 |                  |            |   |            |  |            |  |                |  |  |  |        |   |  |   |      
|                             | Warranty reserve |            | $ | 5,925      |  |            |  | 7,956          |  |  |  | (5,513 | ) |  | $ | 8,368 | 
|Year ended December 31, 2002 |                  |            |   |            |  |            |  |                |  |  |  |        |   |  |   |      
|                             | Warranty reserve |            | $ | 8,368      |  |            |  | 2,730          |  |  |  | (2,491 | ) |  | $ | 8,607 | 
|Year ended December 31, 2003 |                  |            |   |            |  |            |  |                |  |  |  |        |   |  |   |      
|                             | Warranty reserve |            | $ | 8,607      |  |            |  | 2,287          |  |  |  | (5,385 | ) |  | $ | 5,509 | 

Guarantees, Including Indirect Guarantees of
Indebtedness of Others

In addition to product warranties, the Company,
from time to time, in the normal course of business, indemnifies
other parties with whom it enters into contractual
relationships, including customers, lessors, and parties to
other transactions with the Company, with respect to certain
matters. The Company has agreed to hold the other party harmless
against specified losses, such as those arising from a breach of
representations or covenants, third party claims that the
Terayons products when used for their intended purpose(s)
infringe the intellectual property rights of such third party or
other claims made against certain parties. It is not possible to
determine the maximum potential amount of liability under these
indemnification obligations due to the limited history of prior
indemnification claims and the unique facts and circumstances
that are likely to be involved in each particular claim.
Historically, payments made by the Company under these
obligations were not material and no liabilities have been
recorded for these obligations on the balance sheets as of
December 31, 2003 or 2002.



|    |                       
|--- | ----------------------
|15. | Sale of Certain Assets

In July 2003, the Company entered into an
agreement with Verilink Corporation (Verilink) to sell certain
assets to Verilink for up to a maximum of $0.9 million. The
Company received $0.45 million in July 2003 and will
receive additional payments totaling up to $0.45 million
through December 31, 2004. The assets were originally
acquired through the Companys acquisition of Access
Network Electronics (ANE) in February 2000. Additionally,
Verilink agreed to purchase at least $2.1 million of
related inventory from the Company on or before
December 31, 2004. As of December 31, 2003, Verilink
had purchased $0.7 million of this inventory.

As part of this agreement, Verilink agreed to
assume all warranty obligations related to ANE products sold
prior to, on, or after July 2003. The Company agreed to
reimburse Verilink for up to $2.4 million of certain
warranty obligations for ANE products sold prior to July 2003.
Further, Verilink assumed the obligation for one of the
Companys operating leases, previously accrued as
restructuring, resulting in a recovery of restructuring charges
of $0.3 million in 2003.



|    |                              
|--- | -----------------------------
|16. | Subsequent Events (Unaudited)

In the first quarter of 2004, the Company
initiated a worldwide reduction in force of approximately 70
employees, or 17% of the workforce, consolidation of certain
facilities, and reduction or elimination of certain
discretionary costs and programs. In connection with this
restructuring, the Company will seek to sublease approximately
56,400 square feet of its Santa Clara, California
facility. The Company expects to record total charges in the
range of approximately $5.0 million to $7.0 million
associated with this realignment in the quarter ending
March 31, 2004.

88



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TERAYON COMMUNICATION
SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

On February 23, 2004, the United States
District Court, Northern District of California, issued an order
disqualifying two of the lead plaintiffs in the class action
lawsuits against the Company. The order also states that
plaintiffs counsel must provide certain information to the
Court about counsels relationship with the disqualified
lead plaintiffs, and it provides that defendants may serve
certain additional discovery.



|    |                                   
|--- | ----------------------------------
|17. | Unaudited Quarterly Financial Data

Summarized quarterly financial data for 2003 and
2002 is as follows (in thousands, except per share data):

|                                                           |  |         |         |        |  |       |         |        |  |   |        |   |  |   |        |  
|---------------------------------------------------------- |  | ------- | ------- | ------ |  | ----- | ------- | ------ |  | - | ------ | - |  | - | ------ | -
|                                                           |  |        
|                                                           |  | Quarter
|                                                           |  |        
|2003                                                       |  | First   |         | Second |  | Third |         | Fourth
|                                                           |  |         |         |        |  |       |         |       
|Total revenues                                             |  | $       | 22,268  |        |  | $     | 30,599  |        |  | $ | 37,628 |   |  | $ | 42,990 |  
|Gross profit (loss)                                        |  |         | 2,675   |        |  |       | 6,863   |        |  |   | 10,194 |   |  |   | 12,719 |  
|Restructuring costs (recovery) and asset
    write-offs(1) |  |         | (3,162  | )      |  |       | 115     |        |  |   | 244    |   |  |   |       |  
|Net loss                                                   |  |         | (23,989 | )      |  |       | (13,139 | )      |  |   | (7,210 | ) |  |   | (6,015 | )
|Basic and diluted net loss per share                       |  | $       | (0.33   | )      |  | $     | (0.18   | )      |  | $ | (0.10  | ) |  | $ | (0.08  | )

|                                            |  |         |        |        |  |       |        |        |  |   |         |   |  |   |         |  
|------------------------------------------- |  | ------- | ------ | ------ |  | ----- | ------ | ------ |  | - | ------- | - |  | - | ------- | -
|                                            |  |        
|                                            |  | Quarter
|                                            |  |        
|2002                                        |  | First   |        | Second |  | Third |        | Fourth
|                                            |  |         |        |        |  |       |        |       
|Total revenues                              |  | $       | 57,218 |        |  | $     | 22,407 |        |  | $ | 24,475  |   |  | $ | 25,303  |  
|Gross profit (loss)                         |  |         | 25,491 |        |  |       | (27    | )      |  |   | 296     |   |  |   | 2,694   |  
|Restructuring costs and asset write-offs(1) |  |         |       |        |  |       | (3,972 | )      |  |   | (4,950  | ) |  |   |        |  
|Net loss(2)                                 |  |         | (4,090 | )      |  |       | (3,685 | )      |  |   | (15,972 | ) |  |   | (20,466 | )
|Basic and diluted net loss per share        |  | $       | (0.06  | )      |  | $     | (0.05  | )      |  | $ | (0.22   | ) |  | $ | (0.28   | )

Earnings per share are computed independently for
each of the quarters presented. The sum of the quarterly
earnings per share in 2003 and 2002 does not necessarily equal
the total computed for the year due to changes in shares
outstanding and rounding.



---



|    |                                                                                                                                                                
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | See Note 5 for an explanation for
    restructuring and asset write-offs.                                                                                      
|   
|(2) | See Note 7 for an explanation of the gains
    on repurchase of subordinated Convertible Notes in the second
    quarter ($33,276) and third quarter ($15,813).

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|        |                                                                                              
|------- | ---------------------------------------------------------------------------------------------
|Item 9. | Changes in and Disagreements with
    Accountants on Accounting and Financial
    Disclosures

Not applicable.






|         |                        
|-------- | -----------------------
|Item 9A. | Controls and Procedures

As of the end of the period covered by this
Annual Report on Form 10-K, the Company carried out an
evaluation, under the supervision and with the participation of
the Companys Disclosure Committee and the Companys
management, including the Chief Executive Officer and the Chief
Financial Officer, of the effectiveness of the design and
operation of the Companys disclosure controls and
procedures pursuant to Exchange Act Rules 13a-15(b) and
15d-15(b); and whether any change has occurred in the
Companys internal control over financial reporting
pursuant to Exchange Act Rules 13a-15(d) and 15d-15(d).
Based upon that evaluation, the Chief Executive Officer and the
Chief Financial Officer concluded that the Companys
disclosure controls and procedures are effective in timely
alerting them to material information relating to the Company
(including its consolidated subsidiaries) required to be
included in the Companys periodic Securities and Exchange
Commission filings; and that no change in the Companys
internal control over financial reporting occurred during the
Companys most recent fiscal quarter that materially
affected, or is reasonably likely to materially affect, the
Companys internal control over financial reporting.




PART III






|         |                                             
|-------- | --------------------------------------------
|Item 10. | Directors and Officers of the
    Registrant

Certain information regarding our executive
officers as of March 15, 2004, is set forth below.

|                       |  |     |    |          |  |                                                                           
|---------------------- |  | --- | -- | -------- |  | --------------------------------------------------------------------------
|Name                   |  | Age |    | Position
|                       |  |     |    |         
|Zaki Rakib(4)          |  |     | 45 |          |  | Chief Executive Officer, Secretary and Director                           
|Shlomo Rakib           |  |     | 47 |          |  | Chairman of the Board, President, Chief Technical
    Officer and Director
|Arthur T. Taylor       |  |     | 47 |          |  | Chief Financial Officer                                                   
|Douglas Sabella        |  |     | 46 |          |  | Chief Operating Officer                                                   
|Edward Lopez           |  |     | 44 |          |  | Senior Vice President, General Counsel and Human
    Resources            
|Alek Krstajic(2)       |  |     | 40 |          |  | Director                                                                  
|Mark Slaven(1)(2)(3)   |  |     | 47 |          |  | Director                                                                  
|Lewis Solomon(1)(3)    |  |     | 70 |          |  | Director                                                                  
|David Woodrow(1)(2)(3) |  |     | 57 |          |  | Director                                                                  



---



|    |                                           
|--- | ------------------------------------------
|(1) | Member of Audit Committee                 
|   
|(2) | Member of Compensation Committee          
|   
|(3) | Member of the Nominating Committee        
|   
|(4) | Member of the Non-Officer Option Committee

The Board of Directors (Board) is divided into
three classes, each having a three-year term. Mr. Slaven
and Dr. Zaki Rakib are Class III directors, whose
terms expire in 2004. Mr. Krstajic and Mr. Solomon are
Class I directors, whose terms expire in 2005.
Mr. Woodrow and Mr. Shlomo Rakib are Class II
directors, whose terms expire in 2006.

Zaki Rakibco-founded Terayon Communication
Systems, Inc. (Company) and has served as Chief Executive
Officer, Secretary and as a director of the Board since January
1993. From January 1993 to July 1998, Dr. Rakib also served
as our Chief Financial Officer. Prior to co-founding the
Company, Dr. Rakib served as Director of Engineering for
Cadence Design Systems, an electronic design automation software
company, from 1990 to 1994. Prior to joining Cadence,
Dr. Rakib was Vice President of Engineering at Helios

90



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Software, which was acquired by Cadence in 1990.
Dr. Rakib is a director of a privately held company.
Dr. Rakib holds B.S., M.S. and Ph.D. degrees in engineering
from Ben-Gurion University in Israel. Dr. Rakib is the
brother of Shlomo Rakib, the Companys Chairman of the
Board, President and Chief Technical Officer and a director on
the Board.


Shlomo Rakibco-founded the Company in 1993 and has
served as Chairman of the Board and President since January 1993
and as Chief Technical Officer since February 1995. Prior to
co-founding the Company, Mr. Rakib served as Chief Engineer
at PhaseCom, Inc. a communications products company, from
1981 to 1993, where he pioneered the development of data and
telephony applications over cable. Mr. Rakib is the
inventor of several patented technologies in the area of data
and telephony applications over cable. Mr. Rakib is a
director of a privately held company. Mr. Rakib holds a
B.S.E.E. degree from Technion University in Israel.
Mr. Rakib is the brother of Zaki Rakib, the Companys
Chief Executive Officer, Secretary and a director on the Board.

Arthur T. Taylorjoined the Company in February 2003 as
Senior Vice President and Chief Financial Officer. Prior to
joining the Company, Mr. Taylor served as Vice President,
Chief Financial Officer and Secretary of Evolve
Software, Inc., an enterprise software company, from July
2002 until February 2003. From March 2001 to July 2002,
Mr. Taylor was Vice President and Chief Financial Officer
for Docent, Inc., an eLearning enterprise software company.
From August 1998 to March 2001, Mr. Taylor was Vice
President and Corporate Treasurer for 3Com Corporation, a high
technology networking company. From June 1997 to July 1998,
Mr. Taylor was Chief Financial Officer, Treasurer, and Vice
President, Finance for ReSound Corporation, a hearing health
care company. Prior to that Mr. Taylor held several senior
financial management positions at Allergan, Inc., an eye
and skin care pharmaceutical and medical device company.
Mr. Taylor received a Bachelor of Science in Business
Administration from San Diego State University and an MBA
from the University of Southern California. Mr. Taylor is
also a Certified Management Accountant.

Douglas Sabella,
joined the Company in July 2003 as the Chief Operating Officer.
Prior to joining the Company, Mr. Sabella was the President
and Chief Operating Officer of Tumbleweed Communications
Corporation, a provider of secure internet communications
software products, from March 2001 to May 2003. From February
2000 to March 2001, Mr. Sabella was the President and Chief
Executive Officer of Bidcom (now Citadon, Inc.), an
application service provider for the construction industry. From
1997 to February 2000, Mr. Sabella was the President of the
Communications Application group at Lucent Technologies, an
equipment provider. From February 1984 to March 2000,
Mr. Sabella spent more than fifteen years in executive
management at Lucent Technologies, with the last position being
the President of the communications application group.
Mr. Sabella holds a B.A. in Accounting and Economics from
Hofstra University.

Edward Lopez, joined
the Company in October 1999 as the Companys Vice President
General Counsel and Human Resources. Prior to joining the
Company, Mr. Lopez was Vice President, Business
Development, General Counsel and Secretary of ReSound
Corporation, a technology leader in the hearing device industry.
From 1993 to 1998, Mr. Lopez served as Senior Corporate
Counsel and Assistant Secretary of Nellcor Puritan Bennett, a
medical device company, and prior to that was associated with
Morrison & Foerster, an international law firm
headquartered in San Francisco, California. Mr. Lopez
earned his law degree from the Harvard Law School and holds a
B.A. in economics from Columbia University.

Alek Krstajichas
served as a director of the Company since July 1999. Since July
2003, Mr. Krstajic has been the Chief Marketing Officer at
Bell Canada, a telecommunications company. Mr. Krstajic
held a variety of senior management positions at Rogers
Communications, Inc., most recently as Senior Vice
President, Sales and Marketing, from 1994 through January of
2003. Mr. Krstajic is a director of Ontario Energy Savings
Corporation and several privately held companies.
Mr. Krstajic holds a B.A. degree in economics from the
University of Toronto in Canada and attended the executive
educational program at Wharton School of Business at the
University of Pennsylvania.

Mark Slavenhas
served as a director of the Company since July 2003. Since March
2003, Mr. Slaven has been the Executive Vice President,
Finance, and Chief Financial Officer of 3Com Corporation
(3Com), a provider of networking products, services
and solutions for enterprises. Mr. Slaven was 3Coms
Senior Vice President, Finance, and Chief Financial Officer from
June 2002 to March 2003 and prior to that the Vice

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President of Treasury, Tax, Trade and Investor
Relations and Vice President and Treasurer from August 2000 to
June 2002. Prior to that, Mr. Slaven was Vice President of
Finance for Supply Chain Operations since joining the company
through 3Coms acquisition of U.S. Robotics in June
1997, where he was Vice President of Finance for
U.S. Robotics manufacturing division. Before joining
U.S. Robotics, Mr. Slaven was Chief Financial Officer
of the personal printer division at Lexmark International Inc.
Mr. Slaven holds a B.S. degree from Tufts University and
holds an M.B.A. from The University of Chicago.


Lewis Solomonhas
served as a director of the Company since March 1995.
Mr. Solomon has been a principal of G&L Investments, a
consulting firm, since 1989 and currently serves as Chief
Executive Officer of Broadband Services, Inc. From 1983 to
1988, he served as Executive Vice President at Alan Patricof
Associates, a venture capital firm focused on high technology,
biotechnology and communications industries. Prior to that,
Mr. Solomon served in various capacities with General
Instrument Corporation, most recently as Senior Vice President.
From April 1986 to January 1997, he served as Chairman of the
Board of Cybernetic Services, Inc., a LED systems
manufacturer, which commenced a Chapter 7 bankruptcy
proceeding in April 1997. Mr. Solomon serves on the boards
of Anadigics, Inc., a manufacturer of integrated circuits,
Harmonic, Inc., a company that designs, manufacturers and
markets digital and fiberoptic systems, and Artesyn
Technologies, Inc., a power supply and power converter
supply company. Mr. Solomon also serves on the boards of
several privately held companies. Mr. Solomon holds a B.S.
degree in Physics from St. Josephs College.

David Woodrowhas
served as a director of the Company since June 2002. From
September 2000 until March 2002, Mr. Woodrow served as the
Chief Executive Officer and President of Qwest Digital Media
LLC, a production and digital media management company. From
1982 until his retirement in September 2000, Mr. Woodrow
held a number of senior management positions, most recently the
Executive Vice President, Broadband Services, with Cox
Communications, Inc., a major cable operator in the United
States. Mr. Woodrow is a director of several privately held
companies. Mr. Woodrow holds a B.S. and M.S. degree in
mechanical engineering from Purdue University and a M.B.A. from
the University of Connecticut.

Audit Committee and Financial Expert

The Audit Committee is responsible for reviewing
the financial information, which will be provided to
stockholders and others, the systems of internal controls, which
management and the Board of Directors have established, the
performance and selection of independent auditors, and the
Companys audit and financial reporting processes. The
Audit Committee consists of Mark Slaven, Lewis Solomon and David
Woodrow. The Board of Directors has determined that
Mr. Slaven is an audit committee financial
expert as defined in Item 401(h) of
Regulation S-K. Mr. Slaven and each of the other
members of the Audit Committee is an independent
director as defined in Rule 4200 of the Marketplace
Rules of the National Association of Securities
Dealers, Inc. and section 10A of the Exchange Act and is
financially literate and have the requisite financial
sophistication as required by the Nasdaq rules applicable to
issuers listed on the Nasdaq National Market.

Section 16(a) Beneficial Ownership
Reporting Compliance

Section 16(a) of the Exchange Act requires
the Companys directors and executive officers, as well as
persons who own more than ten percent of a registered class of
the Companys equity securities, to file with the SEC
initial reports of ownership and report of changes in ownership
of common stock and other equity securities of the Company.
Officers, directors and greater than ten percent stockholders
are required by SEC regulation to furnish the Company with
copies of all Section 16(a) forms they file.

To the Companys knowledge, based solely on
review of the copies of such reports furnished to us and written
representations that no other reports were required, during the
year ended December 31, 2003, all Section 16(a) filing
requirements applicable to our directors, officers and greater
than ten percent beneficial owners were complied with and filed
on a timely basis.

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Code of Ethics

The Company has a Code of Business
Conduct, which is applicable to all employees, including the
controller, executive officers, including the chief executive
officer, and the chief financial officer, and members of the
Board of Directors. The Code of Business Conductis
available on the Companys Investor Relations website
(www.terayon.com/investor). The Code of Business Conduct
satisfies the requirements under the Sarbanes-Oxley Act of 2002,
as well as Nasdaq rules applicable to issuers listed on the
Nasdaq National Market. The Code of Business Conduct,
among other things, addresses issues relating to conflicts of
interests, including internal reporting of violations and
disclosures, and compliance with applicable laws, rules and
regulations. The purpose of the code is to deter wrongdoing and
to promote, among other things, honest and ethical conduct and
to ensure to the greatest possible extent that our business is
conducted in a legal and ethical manner. The Company intends to
post amendments to or waivers from the Code of Business
Conduct(to the extent applicable to the Companys
executive officers and members of the Board of Directors) at
this location on its website. The audit committee has also
established procedures for (a) the receipt, retention and
treatment of complaints received by us regarding accounting,
internal accounting controls or auditing matters, and
(b) the confidential, anonymous submission by our employees
of concerns regarding questionable accounting or auditing
matters.






|         |                       
|-------- | ----------------------
|Item 11. | Executive Compensation

Summary of Compensation

The following table shows for the fiscal years
ended December 31, 2003, 2002 and 2001, compensation
awarded or paid to, or earned by, the Companys Chief
Executive Officer and its other four most highly compensated
executive officers at December 31, 2003 (Named Executive
Officers). There were no other Named Executive Officers of the
Company during 2003.

Summary Compensation Table

|                            |                                                   |                     |      |              |  |            |         |              |  |                        |   |           |  |         |   |              |  |  |   |         |  |  |         |         |  |  |   |   |  |  |        |         |          
|--------------------------- | ------------------------------------------------- | ------------------- | ---- | ------------ |  | ---------- | ------- | ------------ |  | ---------------------- | - | --------- |  | ------- | - | ------------ |  |  | - | ------- |  |  | ------- | ------- |  |  | - | - |  |  | ------ | ------- | ---------
|                            |                                                   |                     |      |              |  |            |         |              |  |                       
|                            |                                                   |                     |      |              |  |            |         |              |  | Long-Term Compensation
|                            |                                                   |                     |      |              |  |            |         |              |  |                       
|                            |                                                   |                     |      |              |  |            |         |              |  |                        |   |          
|                            |                                                   |                     |      |              |  |            |         |              |  | Awards                 |   |          
|                            |                                                   |                     |      |              |  |           
|                            |                                                   | Annual Compensation |      |              |  | Securities |         |             
|                            |                                                   |                     |      | Restricted   |  | Underlying |         | Payouts      |  |                       
|                            |                                                   |                     |      | Other Annual |  | Stock      |         | Options/     |  | LTIP                   |   | All Other
|                            |                                                   |                     |      | Salary       |  | Bonus      |         | Compensation |  | Awards                 |   | SARs      |  | Payouts |   | Compensation
|Name and Principal Position |                                                   | Year                |      | ($)          |  | ($)(9)     |         | ($)          |  | ($)                    |   | (#)(10)   |  | ($)     |   | ($)         
|                            |                                                   |                     |      |              |  |            |         |              |  |                        |   |           |  |         |   |             
|Dr. Zaki Rakib              |                                                   |                     | 2003 |              |  |            | 450,000 |              |  |                        |  |           |  |         |  |              |  |  |  |         |  |  | 500,000 |         |  |  |  |   |  |  | 99,484 | (1)(3) 
|                            | Chief Executive                                   |                     |      | 2002         |  |            |         | 450,000      |  |                        |   |          |  |         |   |             |  |  |   |        |  |  |         |        |  |  |   |  |  |  |        | 25,500  | (1)(4)   
|                            | Officer and Secretary                             |                     |      | 2001         |  |            |         | 450,000      |  |                        |   |          |  |         |   |             |  |  |   | 44,374  |  |  |         | 800,000 |  |  |   |  |  |  |        | 136,630 | (1)(2)(5)
|Mr. Shlomo Rakib            |                                                   |                     | 2003 |              |  |            | 450,000 |              |  |                        |  |           |  |         |  |              |  |  |  |         |  |  | 500,000 |         |  |  |  |   |  |  | 450    | (3)    
|                            | Chairman of the                                   |                     |      | 2002         |  |            |         | 450,000      |  |                        |   |          |  |         |   |             |  |  |   |        |  |  |         |        |  |  |   |  |  |  |        | 450     | (4)      
|                            | Board and President                               |                     |      | 2001         |  |            |         | 450,000      |  |                        |   |          |  |         |   |             |  |  |   | 44,374  |  |  |         | 800,000 |  |  |   |  |  |  |        | 95,324  | (2)(5)   
|Mr. Arthur Taylor(6)        |                                                   |                     | 2003 |              |  |            | 213,542 |              |  |                        |  |           |  |         |  |              |  |  |  |         |  |  | 450,000 |         |  |  |  |   |  |  | 394    | (3)    
|                            | Senior Vice President and Chief Financial Officer |                     |      |              |  |            |         |              |  |                        |   |           |  |         |   |              |  |  |   |         |  |  |         |         |  |  |   |   |  |  |        |         |          
|Mr. Douglas Sabella(7)      |                                                   |                     | 2003 |              |  |            | 139,808 |              |  |                        |  |           |  |         |  |              |  |  |  |         |  |  | 500,000 |         |  |  |  |   |  |  | 223    | (3)    
|                            | Chief Operating Officer                           |                     |      |              |  |            |         |              |  |                        |   |           |  |         |   |              |  |  |   |         |  |  |         |         |  |  |   |   |  |  |        |         |          
|Mr. Edward Lopez(8)         |                                                   |                     | 2003 |              |  |            | 230,000 |              |  |                        |  |           |  |         |  |              |  |  |  |         |  |  | 250,000 |         |  |  |  |   |  |  | 300    | (3)    
|                            | Vice President,                                   |                     |      | 2002         |  |            |         | 230,000      |  |                        |   |          |  |         |   |             |  |  |   |        |  |  |         |        |  |  |   |  |  |  |        | 300     | (4)      
|                            | General Counsel and                               |                     |      | 2001         |  |            |         | 230,000      |  |                        |   |          |  |         |   |             |  |  |   | 233,459 |  |  |         | 315,000 |  |  |   |  |  |  |        | 313     | (5)      
|                            | Human Resources                                   |                     |      |              |  |            |         |              |  |                        |   |           |  |         |   |              |  |  |   |         |  |  |         |         |  |  |   |   |  |  |        |         |          



---



| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | --- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (1) | Includes $30,000, $25,200 and $24,700 of
    compensation paid by the Company on behalf of Dr. Rakib for
    an apartment in Israel in 2003, 2002 and 2001, respectively. In
    2003, Dr. Rakib incurred $69,034 of incremental cost of
    personal usage of a corporate aircraft calculated in accordance
    with Internal Revenue Service guidelines. The amount of $69,034
    was attributed to Dr. Rakib as compensation and included in
    All Other Compensation in 2003. In 2002,
    Dr. Rakib paid $35,000 to reimburse the Company for his
    cost related to personal usage of a corporate aircraft
    calculated in accordance with

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| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |     | Internal Revenue Service guidelines. The amount
    of $35,000 was not included in All Other
    Compensation in 2002, and may not be sufficient to cover
    all of the costs associated with his personal usage of the
    corporate aircraft in 2002.                                                                                                                                                                                                                                                                                                                          
|
| | (2) | Includes $111,630 of accrued and unused vacation
    paid to Dr. Rakib in 2001 and $95,024 for accrued and
    unused vacation paid out to Mr. Rakib in 2001.                                                                                                                                                                                                                                                                                                                                                                                                                       
|
| | (3) | Includes $450, $450, $394, $223 and $300
    contributed by the Company for premiums under a group term life
    insurance policy on behalf of Dr. Rakib, Mr. Rakib,
    Mr. Taylor, Dr. Sabella, and Mr. Lopez,
    respectively, in 2003.                                                                                                                                                                                                                                                                                                                                         
|
| | (4) | Includes $300, $450, and $300 contributed by the
    Company for premiums under a group term life insurance policy on
    behalf of Dr. Rakib, Mr. Rakib, and Mr. Lopez,
    respectively, in 2002.                                                                                                                                                                                                                                                                                                                                                                                 
|
| | (5) | Includes $300, $300, and $313 contributed by the
    Company for premiums under a group term life insurance policy on
    behalf of Dr. Rakib, Mr. Rakib, and Mr. Lopez,
    respectively, in 2001.                                                                                                                                                                                                                                                                                                                                                                                 
|
| | (6) | Mr. Taylor joined the Company as Chief
    Financial Officer on February 24, 2003. On an annualized
    basis, Mr. Taylors salary is $250,000.                                                                                                                                                                                                                                                                                                                                                                                                                                     
|
| | (7) | Mr. Sabella joined the Company as Chief
    Operating Officer on July 14, 2003. On an annualized basis,
    Mr. Sabellas salary is $300,000.                                                                                                                                                                                                                                                                                                                                                                                                                                       
|
| | (8) | Mr. Lopez became a Named Executive Officer
    of the Company on July 15, 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|
| | (9) | In 2003, Dr. Rakib and Mr. Rakib each
    accrued $216,563 of bonus related the Companys Executive
    Compensation Plan, which would have been paid in 2004.
    Dr. Rakib and Mr. Rakib voluntarily waived their right
    to receive their bonuses and consequently did not receive any
    payout under the Companys Executive Compensation Plan. In
    2003, Mr. Taylor, Mr. Sabella, and Mr. Lopez
    accrued $111,429, $67,282, $110,688, respectively, of bonuses
    related the Companys Executive Compensation Plan, which
    were earned in 2003 but paid in 2004.



|     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|---- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(10) | On February 14, 2001, Dr. Rakib,
    Mr. Rakib, and Mr. Lopez each received a stock option
    grant for 800,000, 800,000 and 340,000 shares,
    respectively, of common stock at a price per share of $6.81. In
    November 2001, the Companys Board of Directors approved a
    stock option exchange offer, which permitted employees and
    members of the Board of Directors to exchange all stock options
    with an exercise price per share equal to or greater than $9.00
    for a common stock award. Dr. Rakib, Mr. Rakib and
    Mr. Lopez participated in the Companys stock option
    exchange offer. On December 5, 2001, Dr. Rakib and
    Mr. Rakib each cancelled stock option grants for
    800,000 shares of common stock at a price per share of
    $81.38. On December 5, 2001, Mr. Lopez cancelled stock
    option grants for 296,160, 20,000, and 23,840 shares of
    common stock at a price per share of $20.97, $31.41, $20.97,
    respectively. On December 6, 2001, Dr. Rakib,
    Mr. Rakib and Mr. Lopez received 3,136, 3,136, and
    12,937 shares, respectively, of common stock in connection
    with the stock option exchange offer and those shares of common
    stock had a value of $44,374, $44,374, and $183,059,
    respectively, on that date.

The Company grants options to its executive
officers under its 1997 Equity Incentive Plan, as amended, (1997
Plan) and options to its non-officer and non-director employees
and consultants of the Company and Company officers under its
1999 Non-Officer Equity Incentive Plan (1999 Plan). As of
December 31, 2003, options to purchase a total
7,794,701 shares and 9,099,202 shares were outstanding
under the 1997 Plan and the 1999 Plan, respectively, and
4,513,436 shares and 3,112,391 shares remained
available for grant under the 1997 Plan and the 1999 Plan,
respectively.

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The following tables show for the fiscal year
ended December 31, 2003, certain information regarding
options granted to, exercised by, and held at year-end by, the
Named Executive Officers:

Option/ SAR Grants in Last Fiscal
Year

|            |  |                   |         |              |  |          |      |            |  |                               |      |             |  |          |            |  |  |   |           |  |  |   |           |  |  |   |           | 
|----------- |  | ----------------- | ------- | ------------ |  | -------- | ---- | ---------- |  | ----------------------------- | ---- | ----------- |  | -------- | ---------- |  |  | - | --------- |  |  | - | --------- |  |  | - | --------- | 
|            |  |                   |         |              |  |          |      |            |  |                               |      |            
|            |  | Individual Grants |         |              |  |          |      |            |  |                               |      |            
|            |  |                   |         |              |  |          |      |            |  |                               |      | Alternative
|            |  |                   |         |              |  |          |      |            |  |                               |      | to Grant   
|            |  |                   |         |              |  |          |      |            |  | Date Value                   
|            |  | Number of         |         | % of Total   |  |          |      |            |  | Potential Realizable Value at |      |            
|            |  | Securities        |         | Options/     |  |          |      |            |  | Assumed Annual Rates of       |      |            
|            |  | Under-lying       |         | SARs         |  | Exercise |      |            |  | Stock Price Appreciation for  |      |            
|            |  | Options/          |         | Granted to   |  | or Base  |      |            |  | Option Term                   |      | Grant Date 
|            |  | SARs              |         | Employees in |  | Price    |      | Expiration |  |                               |      | Present    
|Name        |  | Granted(#)        |         | Fiscal Year  |  | ($/Sh)   |      | Date       |  | 5%($)                         |      | 10%($)      |  | Value($)
|            |  |                   |         |              |  |          |      |            |  |                               |      |             |  |         
|Dr. Rakib   |  |                   | 500,000 |              |  |          | 7.21 | %          |  | $                             | 2.45 |             |  |          | 05/28/2013 |  |  | $ | 770,396   |  |  | $ | 1,952,335 |  |  | $ | 844,750   | 
|Mr. Rakib   |  |                   | 500,000 |              |  |          | 7.21 | %          |  | $                             | 2.45 |             |  |          | 05/28/2013 |  |  | $ | 770,396   |  |  | $ | 1,952,335 |  |  | $ | 844,750   | 
|Mr. Taylor  |  |                   | 325,000 |              |  |          | 4.69 | %          |  | $                             | 2.04 |             |  |          | 02/24/2013 |  |  | $ | 416,957   |  |  | $ | 1,056,651 |  |  | $ | 398,385   | 
|Mr. Taylor  |  |                   | 125,000 |              |  |          | 1.80 | %          |  | $                             | 2.45 |             |  |          | 05/28/2013 |  |  | $ | 192,599   |  |  | $ | 488,084   |  |  | $ | 211,188   | 
|Mr. Sabella |  |                   | 500,000 |              |  |          | 7.21 | %          |  | $                             | 4.26 |             |  |          | 07/15/2013 |  |  | $ | 1,339,546 |  |  | $ | 3,394,671 |  |  | $ | 1,652,350 | 
|Mr. Lopez   |  |                   | 250,000 |              |  |          | 3.61 | %          |  | $                             | 2.45 |             |  |          | 05/28/2013 |  |  | $ | 385,198   |  |  | $ | 976,167   |  |  | $ | 422,375   | 

Aggregated Option/ SAR Exercises in Last
Fiscal Year, and FY-End Option/ SAR Values

|            |  |                 |   |             |  |                 |   |                      |  |  |                 |  |  |  |         | 
|----------- |  | --------------- | - | ----------- |  | --------------- | - | -------------------- |  |  | --------------- |  |  |  | ------- | 
|            |  |                 |   |             |  | Number of       |   |                     
|            |  |                 |   |             |  | Securities      |   |                     
|            |  |                 |   |             |  | Underlying      |   | Value of Unexercised
|            |  |                 |   |             |  | Unexercised     |   | In-the-Money        
|            |  |                 |   |             |  | Options/SARs at |   | Options/SARs at     
|            |  |                 |   |             |  | FY-End(#)       |   | FY-End($)           
|            |  | Shares Acquired |   | Value       |  | Exercisable/    |   | Exercisable/        
|Name        |  | on Exercise(#)  |   | Realized($) |  | Unexercisable   |   | Unexercisable       
|            |  |                 |   |             |  |                 |   |                     
|Dr. Rakib   |  |                 |  |             |  |                 |  |                      |  |  | 733,333/566,667 |  |  |  | /     | 
|Mr. Rakib   |  |                 |  |             |  |                 |  |                      |  |  | 733,333/566,667 |  |  |  | /     | 
|Mr. Taylor  |  |                 |  |             |  |                 |  |                      |  |  | /450,000       |  |  |  | /3,250 | 
|Mr. Sabella |  |                 |  |             |  |                 |  |                      |  |  | /500,000       |  |  |  | /     | 
|Mr. Lopez   |  |                 |  |             |  |                 |  |                      |  |  | 261,249/303,751 |  |  |  | /     | 

COMPENSATION OF DIRECTORS

In October 2002, the Company adopted a
compensation plan for non-employee board members whereby each
non-employee director receives a monthly retainer of $2,000 and
$1,000 per board or committee meeting attended. Committee
chairs receive an additional $500 per committee meeting
attended. In fiscal 2003, Mr. Krstajic received a total of
$38,000, Mr. Slaven a total of $15,000, Mr. Solomon a
total of $46,500 and Mr. Woodrow a total of $46,000 for
their Board service. One of the Companys former Board
members, Christopher Schaepe who resigned from the
Companys board September 26, 2003, received $38,000
for his board service in 2003. The members of the board are
eligible for reimbursement for their expenses incurred in
connection with attendance at board and committee meetings in
accordance with Company policy. Mr. Krstajic also received
compensation of $30,000 in March of 2004 for consulting services
that he provided to the Company in 2003.

Each non-employee director of the Company also
receives stock option grants under the 1998 Non-Employee
Directors Stock Option Plan (Directors Plan). Only
non-employee directors, which are currently
Messrs. Krstajic, Slaven, Solomon and Woodrow, are eligible
to receive non-qualified stock options under the Directors
Plan. The Directors Plan is administered by the board,
unless the board delegates the administration of the
Directors Plan to a committee comprised of Board members.

The aggregate number of shares of common stock of
the Company that may be issued pursuant to options granted under
the Directors Plan is 800,000 shares. Option grants
under the Directors Plan are non-discretionary. Pursuant
to the Directors Plan, non-employee directors
automatically receive (i) an option to

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purchase 60,000 shares of common stock on
the date of his or her initial election or appointment to be a
non-employee director and (ii) an option to purchase
25,000 shares of common stock on the date of each annual
meeting of stockholders, which amount shall be prorated for the
12-month period prior to the annual meeting of stockholders if
the non-employee director has not continuously served as an
non-employee director during such period. In addition, each
non-employee director who is then serving as a member of a
committee automatically receives an option to purchase
6,000 shares of common stock for each such committee on the
date of each annual meeting of stockholders, which amount shall
be prorated for the 12 month period prior to the annual
meeting of stockholders if the non-employee director has not
continuously served as an committee member during such 12-month
period. No other options may be granted at any time under the
Directors Plan. The exercise price of the options granted
under the Directors Plan will be equal to the fair market
value of the common stock on the date of grant. Options granted
under the Directors Plan vest and become exercisable as to
33% of the shares on the first anniversary of the date of grant
and 1/36th of the shares monthly thereafter. An optionee whose
service relationship with the Company or any affiliate (whether
as a non-employee director or subsequently as an employee,
director or consultant of either the Company or an affiliate)
ceases for any reason may exercise vested options for the term
provided in the option agreement (three months generally,
12 months in the event of disability and 18 months in
the event of death). Options granted under the Directors
Plan generally are non-transferable, however, an optionee may
designate a beneficiary who may exercise the option following
the optionees death. In the event of certain changes in
control of the Company, all outstanding awards under the
Directors Plan either will be assumed or substituted for
by the surviving entity. If the surviving entity determines not
to assume or substitute for such awards, the vesting and time
during which such options may be exercised shall be accelerated
prior to such event and the options will terminate if not
exercised after such acceleration and at or prior to such event.
The term of options granted under the Directors Plan is
10 years. Unless terminated sooner by the board, the
Directors Plan will terminate in June 2008.


During fiscal 2003, the Company granted 211,527
stock options from the Directors Plan to non-employee
directors of the Company. These options were granted at an
average exercise price of $2.95 per share to
Messrs. Krstajic, Slaven, Solomon, Woodrow, and Schaepe.
The exercise price was the respective fair market value of the
common stock on the date of grant. As of February 29, 2004,
24,591 options had been exercised under the Directors
Plan. Directors who are employees of the Company do not receive
separate compensation for their services as directors.

EMPLOYMENT CONTRACTS, TERMINATION OF
EMPLOYMENT

AND CHANGE OF CONTROL AGREEMENTS


Dr. Rakib has an employment agreement with
the Company, which establishes him as the Chief Executive
Officer of the Company. Dr. Rakibs employment
agreement does not provide for any specified compensation
arrangement. In October 1999, the Company entered into an
employment agreement with Mr. Lopez, which established
Mr. Lopez as the Companys General Counsel beginning
in October 1999 with his original salary set at $195,000 per
year, and granted him an option to purchase 160,000 shares of
the Companys common stock. In January 2003, the Company
entered into an employment agreement with Arthur Taylor, which
established Mr. Taylor as the Companys Chief
Financial Officer beginning in February 2003 with a base salary
of $250,000, and granted Mr. Taylor a stock option to
purchase 325,000 shares of the Companys common stock.
In July 2003, the Company entered into an employment agreement
with Douglas Sabella, which established Mr. Sabella as the
Companys Chief Operating Officer beginning in July 2003
with a base salary of $300,000, and granted Mr. Sabella a
stock option agreement for 500,000 shares of the
Companys common stock. The employment agreement between
the Company and Mr. Sabella also provides for the payment
of twelve months of base salary and continuation of benefits if
Mr. Sabella is terminated by the Company without
cause, which is defined to include the commission of
a crime against the Company, the conviction of a crime involving
moral turpitude, willful failure to perform job duties as
determined by the Board of Directors and misconduct that is
materially injurious to the Company. There are no employment
agreements with any of the Companys other executive
officers, and other than Mr. Sabellas there are no

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employment agreements that contain severance or
change of control provisions for any of the Companys
executive officers.


In January 2004, the Company entered into change
of control agreements entitled Severance Agreement with each of
its executive officers, Dr. Rakib and Messrs. Lopez,
Rakib, Sabella and Taylor. The change of control agreements
provide for the payment of severance and acceleration of stock
option upon the termination of employment other than for
cause or with good reason within twelve
months of a change of control, which is defined as
an acquisition of more than 50% of the Companys
outstanding voting securities, a stockholder approved merger,
consolidation or reorganization of more than 51% of the
Companys outstanding voting securities, a stockholder
approved liquidation or dissolution of the Company or the
agreement for the sale or dissolution of all or substantially
all of the assets of the Company to a third party. Upon such
termination, Dr. Rakib and Mr. Rakib will each receive
a payment equal to 150% of his base and target incentive
compensation and 100% vesting of unvested stock options and
Messrs. Lopez, Sabella and Taylor will each receive a
payment equal to 100% of his base and target incentive
compensation and 100% vesting of unvested stock options.
Cause is defined as fraud, misappropriation,
embezzlement or willful engagement in misconduct that is
demonstrably and materially injurious to the Company and its
subsidiaries taken as a whole. Good reason is
defined as a change in job duties, status, position,
responsibilities or salary, a failure to pay compensation,
material change in a benefit plan, breach of the Severance
Agreement, insolvency, relocation that is more than
60 miles from Santa Clara, California or
Companys termination attempts that do not comply with the
Severance Agreement.

COMPENSATION COMMITTEE INTERLOCKS AND INSIDER
PARTICIPATION

In the fiscal year ended December 31, 2003,
the Compensation Committee consisted of Messrs. Krstajic,
Slaven and Woodrow and met three times. In February 2003, the
Board of Directors reconstituted the Compensation Committee,
which prior to that time had consisted of Dr. Rakib, the
Companys Chief Executive Officer and Secretary, and
Messrs. Krstajic and Schaepe. The Board of Directors
reconstituted the Compensation Committee to consist of
Messrs. Krstajic, Schaepe and Woodrow with Mr. Woodrow
as Chairman of the Committee. Mr. Slaven joined the
Compensation Committee in August 2003 and Mr. Schaepe
resigned from the Board of Directors, including Board of
Director committees, in September 2004. The Board members,
Messrs. Krstajic, Schaepe, Slaven and Woodrow, are not and
were not officers or employees of the Company in 2003. Each of
the Companys directors holds securities of the Company. In
January 1999, the Compensation Committee created a Non-Officer
Stock Option Committee of the Board, which consists of
Dr. Zaki Rakib. The function of the Non-Officer Stock
Option Committee is to grant options to purchase shares of
common stock to eligible persons who are not officers of the
Company. No executive officer of the Company served on the board
of directors or compensation committee of any entity, which has
one or more executive officers serving as a member of the
Companys Board or Compensation Committee.

REPORT OF THE COMPENSATION COMMITTEE

ON EXECUTIVE COMPENSATION


The material in this report is not
soliciting material, is not deemed filed
with the Securities and Exchange Commission, and is not to be
incorporated by reference into any filing of the Company under
the Securities Act or Exchange Act, whether made before or after
the date hereof and irrespective of any general incorporation
language contained in such.

The Compensation Committee of the Board
(Compensation Committee) has furnished the following report on
executive compensation for fiscal year 2003.

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Role of the Compensation Committee

The Compensation Committee Charter gives the
Compensation Committee the direct responsibility to:



| |   |                                                                                                                                                                                                                                              
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | review and approve corporate goals and objectives
    relevant to the compensation of the Companys Chief
    Executive Officer;                                                                                                             
|
| |  | evaluate the performance of the Chief Executive
    Officer and, either as a committee or together with the other
    independent members of the Board, determine and approve the
    compensation level for the Chief Executive Officer; and
|
| |  | make recommendations to the Board regarding the
    compensation of the Companys officers and certain
    compensation plans.                                                                                                               

The Committees specific responsibilities
include:



| |   |                                                                                                                                                                                                                                    
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | periodic review of the Companys general
    compensation policies and strategies, including executive
    compensation;                                                                                                           
|
| |  | review and approve corporate goals and objectives
    relevant to executive officers and evaluation of their
    performance in light of those goals and objectives;                                                               
|
| |  | approval of salaries, bonuses and all
    equity-based compensation of the Companys officers;                                                                                                                                     
|
| |  | review the Companys benefit programs and
    review and approval of all incentive performance-based and
    equity based plans, plus review and approve other plans
    submitted to the Compensation Committee by management; and
|
| |  | review and approval of the terms of employment
    contracts of the Companys officers.                                                                                                                                            

Compensation Philosophy

The goals of the Company, the Board and the
Compensation Committee are to align compensation with business
objectives and performance and to enable the Company to attract,
retain and reward officers and other key employees who
contribute to the long-term success of the Company and to
motivate them to enhance long-term stockholder value. Key
elements of this philosophy are:



| |   |                                                                                                                                                                                                                                                                                                      
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | The Company pays competitively compared to
    leading technology companies with which the Company competes for
    talent. To ensure that pay is competitive, the Company regularly
    compares its pay practices with these companies and establishes
    its pay parameters based on this review.
|
| |  | The Company considers individual and corporate
    performance and an individuals levels of responsibility,
    prior experience, breadth of knowledge and skill set in
    establishing an individuals level of compensation.                                                                     
|
| |  | The Company maintains annual incentive
    opportunities sufficient to provide motivation to achieve
    specific operating goals and to generate rewards that bring
    total compensation to competitive levels.                                                                                   
|
| |  | The Company provides significant equity-based
    incentives for executives and other key employees to ensure that
    they are motivated over the long term to respond to the
    Companys business challenges and opportunities as owners
    and not just as employees.                          

Philosophy Regarding Section 162(m) of
the Code.Section 162(m) of
the Code limits the Company to a deduction for federal income
tax purposes of no more than $1 million of compensation
paid to certain named executive officers in a taxable year.
Compensation above $1 million may be deducted if it is
performance-based compensation within the meaning of
the Code. While the Compensation Committee considers and
attempts to preserve deductibility in executive compensation, it
believes that stockholder interests are best preserved in not
restricting the Compensation Committees discretion and
flexibility in crafting and adopting compensation programs, even
if such programs may result in certain non-deductible
compensation expenses. Accordingly, the Compensation Committee
may in the future approve compensation arrangements for certain

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officers that are not fully deductible. Further,
because of ambiguities and uncertainties as to the application
and interpretation of Section 162(m) and the regulations
issued thereunder, no assurance can be given, notwithstanding
any of the Companys efforts, that compensation intended by
the Company to satisfy the requirements for deductibility under
Section 162(m) does in fact do so.


The Compensation Committee has determined that
stock options granted under the Companys 1997 Equity
Incentive Plan (1997 Plan) and 1999 Non-Officer Equity Incentive
Plan (1999 Plan) with an exercise price at least equal to the
fair market value of the Companys common stock on the date
of grant shall be treated as performance-based
compensation.

Long-Term Incentives.The Company believes in providing
its employees, including its executive officers, with equity
incentive through the form of stock option to provide employees
with a personal incentive in the Company and as a retention
mechanism. The Company believes that providing employees with
such equity incentives builds long-term stockholder value and
aligns the interests of the employees and the stockholders. The
Companys long-term equity incentive program consists of
the 1997 Plan and the 1999 Plan. The equity incentive programs
utilize vesting periods (generally four or five years for new
hire stock option grants and shorter periods for stock option
refresh grants) to encourage key employees to continue in the
employ of the Company. Grants are made at 100% of the fair
market value on the date of grant. Executives receive value from
these grants only if the value of the Companys common
stock appreciates over the long-term. The size of option grants
is determined based on competitive practices of comparable and
leading companies in the technology industry and the
Companys philosophy of significantly linking executive
compensation with stockholder interests.

Chief Executive Officer Compensation

Dr. Rakibs base salary in 2003 was
$450,000, and Dr. Rakib was eligible to receive a bonus of
up to $216,563 under the Companys 2003 Executive Incentive
Compensation Plan (Compensation Plan), which would have been
paid in 2004. Dr. Rakib voluntarily waived his right to
receive his bonus and consequently did not receive any payout
under the Compensation Plan, which is described below. The
Compensation Committee, and the in the past  the
Board, reviews Dr. Rakibs compensation annually and
sets Dr. Rakibs compensation. The Compensation
Committee took into account (i) its belief that
Dr. Rakib is the Chief Executive Officer of a technology
company that designs, develops and sells broadband equipment,
(ii) the scope of Dr. Rakibs responsibility and
(iii) Dr. Rakibs ability to lead the
Companys continued development.

In 2003, the Board, upon the recommendation of
the Compensation Committee, implemented the Compensation Plan
for certain of the Companys officers, including the Chief
Executive Officer and each of the executive officers. The
Compensation Plan was a bonus plan in which the Companys
officers would be eligible to receive a bonus based on
(i) the Companys performance and (ii) qualitative
performance by the officer. The Chief Executive Officer would
make a recommendation to the Compensation Committee on the
qualitative performance of each of the officers and the
Compensation Committee would evaluate the Chief Executive
Officers performance. Any payment from the Compensation
Plan would be based on a percentage of the officers base
pay.

In 2003, the Board, upon the recommendation of
the Compensation Committee, implemented a stock option refresh
program for all employees, including the Chief Executive Officer
and the other executive officers. In determining the size of the
stock option grant to the Chief Executive Officer (and other
employees, including the executive officers), the Compensation
Committee and the Board considered the Companys policy of
providing officers with significant equity incentives to retain
such executives (and employees), stock option grants being
provided by other companies that design, develop and sell
broadband equipment and the size and value of outstanding stock
option grants. The Board, upon the recommendation of the
Compensation Committee, provided Dr. Rakib with a stock option
grant of 500,000 that would vest fifty percent (50%) on each of
the first and second year anniversary (the vesting schedule was
the same for all other employees, including executive officers).

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Other Executive Officers
Compensation

In 2003, the Company hired two of its executive
officers, Messrs. Sabella and Taylor. In reviewing and
approving the compensation, including base salary and incentive
compensation (in both the form of equity in stock options and
target compensation in the form of the Compensation Plan) of
Messrs. Sabella and Taylor, as well as Messrs. Lopez
and Rakib (the Companys two other executive officers), the
Compensation Committee and the Board considered the
recommendation of the Chief Executive Officer, to the extent
available, the salary norms for persons in comparable positions
at comparable companies and the persons experience. The
fiscal 2003 salaries of Messrs. Lopez, Rakib, Sabella and
Taylor are shown in the Executive Compensation Summary Table.

The Compensation Committee of the Board of
Directors  Fiscal 2003

Aleksander Krstajic

Mark Slaven


David Woodrow  Chairman of the
Compensation Committee







|         |                                                                   
|-------- | ------------------------------------------------------------------
|Item 12. | Security Ownership of Certain Beneficial
    Owners and Management

The following table sets forth certain
information regarding the ownership of the Companys common
stock as of February 29, 2004 by: (i) each director
and nominee for director; (ii) each of the Named Executive
Officers; (iii) all executive officers and directors of the
Company as a group; and (iv) all those known by the Company
to be beneficial owners of more than five percent of its common
stock. All shares of the Companys common stock subject to
options currently exercisable or exercisable within 60 days
of February 29, 2004, are deemed to be outstanding for the
purpose of computing the percentage of ownership of the person
holding such options, but are not deemed to be outstanding for
computing the percentage of ownership of any other person. This
table is based upon information supplied by officers, directors
and principal stockholders and Schedules 13D and 13G filed with
the SEC. Unless otherwise indicated in the footnotes to this
table and subject to community property laws where applicable,
the Company believes that each of the stockholders named in this
table has sole voting and investment power with respect to the
shares indicated as beneficially owned. Applicable percentages
are based on 75,536,192 shares outstanding on
February 29, 2004, adjusted as required by rules
promulgated by the SEC. Unless otherwise indicated in the table,
the address of each party listed in the table is 4988 Great
America Parkway, Santa Clara, California 95054.

|                                                                    |                                |                      |           |            |  |  |       |   | 
|------------------------------------------------------------------- | ------------------------------ | -------------------- | --------- | ---------- |  |  | ----- | - | 
|                                                                    |                                |                     
|                                                                    |                                | Beneficial Ownership
|                                                                    |                                |                     
|                                                                    |                                | Number of            |           | Percentage
|Beneficial Owner                                                    |                                | Shares               |           | Ownership 
|                                                                    |                                |                      |           |           
|FMR Corporation                                                     |                                |                      | 9,750,403 |            |  |  | 12.91 | %
|                                                                    | 82 Devonshire Street           |                      |           |            |  |  |       |   | 
|                                                                    | Boston, Massachusetts 02109(1) |                      |           |            |  |  |       |   | 
|Zaki Rakib(2)                                                       |                                |                      | 3,952,040 |            |  |  | 5.18  | %
|Shlomo Rakib(3)                                                     |                                |                      | 3,952,040 |            |  |  | 5.18  | %
|Edward Lopez(4)                                                     |                                |                      | 283,646   |            |  |  | *     |  
|Arthur T. Taylor(5)                                                 |                                |                      | 75,833    |            |  |  | *     |  
|Douglas Sabella(6)                                                  |                                |                      |          |            |  |  | *     |  
|Lewis Solomon(7)                                                    |                                |                      | 278,749   |            |  |  | *     |  
|Aleksander Krstajic(8)                                              |                                |                      | 207,394   |            |  |  | *     |  
|David M. Woodrow(9)                                                 |                                |                      | 36,550    |            |  |  | *     |  
|Mark Slaven(10)                                                     |                                |                      |          |            |  |  | *     |  
|All executive officers and directors as a group
    (8 persons)(11) |                                |                      | 8,786,252 |            |  |  | 11.63 | %



---



| |   |                       
| | - | ----------------------
| | * | Less than one percent.

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| |     |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | --- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (1) | FMR Corporation filed an amendment to
    Schedule 13G, dated as of February 17, 2004, with the
    Securities and Exchange Commission. FMR Corporation reported
    beneficial ownership of 9,750,403 shares.                                                                                                                                                                                                                                                                                                
|
| | (2) | Shares beneficially owned by Dr. Zaki Rakib
    include 240,000 shares of common stock held by the Shlomo
    Rakib Childrens Trust of which Dr. and
    Mrs. Rakib are trustees and 800,000 shares of common
    stock underlying stock options, which are exercisable within
    60 days of February 29, 2004. In addition,
    Mr. Rakibs family members hold 31,298 shares of
    common stock underlying stock options. Dr. Rakib disclaims
    beneficial ownership of these shares and stock options.
|
| | (3) | Shares beneficially owned by Shlomo Rakib include
    240,000 shares of common stock held by the Zaki Rakib
    Childrens Trust of which Mr. And Mrs. Rakib are
    trustees and 800,000 shares of common stock underlying
    stock options which are exercisable within 60 days of
    February 29, 2004. In addition, Mr. Rakibs
    family members hold 31,298 shares of common stock
    underlying stock options. Mr. Rakib disclaims beneficial
    ownership of these shares and stock options.     
|
| | (4) | Shares beneficially owned include
    282,999 shares of common stock underlying stock options,
    which are exercisable within 60 days of February 29,
    2004.                                                                                                                                                                                                                                                                                                                                             
|
| | (5) | Shares beneficially owned include
    75,833 shares of common stock underlying stock options,
    which are exercisable within 60 days of February 29,
    2004. Mr. Taylor began employment with the Company as Chief
    Financial Officer on February 24, 2003.                                                                                                                                                                                                                                            
|
| | (6) | Mr. Sabella began employment with the
    Company as Chief Operating Officer on July 14, 2003.                                                                                                                                                                                                                                                                                                                                                                                                                
|
| | (7) | Shares beneficially owned include
    218,749 shares of common stock underlying stock options
    that are exercisable within 60 days of February 29,
    2004.                                                                                                                                                                                                                                                                                                                                               
|
| | (8) | Shares beneficially owned include
    207,394 shares of common stock underlying stock options
    that are exercisable within 60 days of February 29,
    2004.                                                                                                                                                                                                                                                                                                                                               
|
| | (9) | Shares beneficially owned include
    36,550 shares of common stock underlying stock options that
    are exercisable within 60 days of February 29, 2004.                                                                                                                                                                                                                                                                                                                                                    



|     |                                                                                                                                                                                                                                 
|---- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(10) | Mr. Slaven joined the Company as a director
    in July 2003.                                                                                                                                                                   
|    
|(11) | Shares beneficially owned by the Companys
    current directors and officers as a group include
    8,791,586 shares of common stock underlying stock options
    that are exercisable within 60 days of February 29,
    2004.

101



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##### Table of Contents



PERFORMANCE MEASUREMENT COMPARISON

The following graph compares the cumulative total
stockholder return of an investment of $100 in cash from
August 18, 1998 through December 31, 2003 for
(i) the Companys common stock, (ii) the
Standards & Poors 500 Index (S&P 500)
and (iii) the Nasdaq Telecommunications Stock Index (Nasdaq
Telecom). All values assume reinvestment of the full amount of
all dividends and are calculated as of the last trading day of
each month listed. The information contained in the performance
graph shall not be deemed to be soliciting material,
is not deemed filed with the SEC and is not to be
incorporated by reference in any filing of the Company under the
Securities Act or the Exchange Act whether made before or after
the date hereof and irrespective of any general incorporation
language in any such filing.

(PERFORMANCE GRAPH)

|               |  |      |          |      |  |      |          |      |  |      |          |      |  |      |          |  |  |   |        |  |  |   |          |  |  |   |          | 
|-------------- |  | ---- | -------- | ---- |  | ---- | -------- | ---- |  | ---- | -------- | ---- |  | ---- | -------- |  |  | - | ------ |  |  | - | -------- |  |  | - | -------- | 
|              
|              
|Data Points(1) |  | 1998 |          | 1999 |  | 2000 |          | 2001 |  | 2002 |          | 2003 |  | 2004
|              
|              
|Terayon        |  | $    | 37.00    |      |  | $    | 62.81    |      |  | $    | 4.06     |      |  | $    | 8.27     |  |  | $ | 2.05   |  |  | $ | 4.50     |  |  | $ | 4.42     | 
|S&P 500        |  | $    | 1,229.23 |      |  | $    | 1,469.25 |      |  | $    | 1,320.28 |      |  | $    | 1,148.08 |  |  | $ | 879.82 |  |  | $ | 1,111.92 |  |  | $ | 1,144.94 | 
|NASDAQ Telecom |  | $    | 500.91   |      |  | $    | 1,015.40 |      |  | $    | 463.44   |      |  | $    | 236.63   |  |  | $ | 108.79 |  |  | $ | 183.57   |  |  | $ | 191.57   | 



|                              |  |      |     |      |  |      |     |      |  |      |     |      |  |      |     |  |  |  |    |  |  |  |     |  |  |  |     | 
|----------------------------- |  | ---- | --- | ---- |  | ---- | --- | ---- |  | ---- | --- | ---- |  | ---- | --- |  |  |  | -- |  |  |  | --- |  |  |  | --- | 
|                             
|                             
|Conversion to Index Point(2)) |  | 1998 |     | 1999 |  | 2000 |     | 2001 |  | 2002 |     | 2003 |  | 2004
|                             
|                             
|Terayon                       |  |      | 256 |      |  |      | 435 |      |  |      | 28  |      |  |      | 57  |  |  |  | 14 |  |  |  | 31  |  |  |  | 31  | 
|S&P 500                       |  |      | 112 |      |  |      | 133 |      |  |      | 120 |      |  |      | 104 |  |  |  | 80 |  |  |  | 101 |  |  |  | 104 | 
|NASDAQ Telecom                |  |      | 121 |      |  |      | 245 |      |  |      | 112 |      |  |      | 57  |  |  |  | 26 |  |  |  | 44  |  |  |  | 46  | 





---



|    |                                         
|--- | ----------------------------------------
|(1) | Stock closing price                     
|   
|(2) | Index Point = Data Point/ Baseline X 100





|         |                                                  
|-------- | -------------------------------------------------
|Item 13. | Certain Relationship and Related
    Transactions

The Company has entered into indemnity agreements
with certain officers and directors which provide, among other
things, that the Company will indemnify such officer or
director, under the circumstances and to the extent provided for
therein, for expenses, damages, judgments, fines and settlements
he or she may be required to pay in actions or proceedings which
he or she is or may be made a party by reason of his or her
position as a director, officer or other agent of the Company,
and otherwise to the fullest extent permitted under Delawarelaw and the Companys Bylaws.

Mr. Krstajic, a director of the Company, was
the Senior Vice President Interactive Services, Sales and
Product Development for Rogers Cable, Inc., a wholly-owned
subsidiary of Rogers Communications, Inc. until January
2003. Effective in April 2003, Rogers was no longer a related
party to the Company. Consequently, revenues attributed to
Rogers were classified as related party revenues in the first
quarter of 2003. During the fiscal year ended December 31,
2003, Rogers Communications, Inc. purchased equipment and
services from the Company, which accounted for approximately
$1.5 million worth of the Companys related party
revenues.

During the fiscal year ended December 31,
2003, Harmonic, Inc. purchased equipment and services from
the Company, which accounted for approximately $3.2 million
worth of the Companys revenues. Mr. Solomon, a
director of the Company and chairman of the Companys audit
committee is also a member of the Board of Directors of
Harmonic, Inc.

During fiscal 2003, the Company employed Suzan
Fishel, a sister of Dr. Rakib and Mr. Rakib. She was
paid an aggregate salary of $97,363 for her services during the
year.

102



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##### Table of Contents



The Company believes that the terms of the
transactions described above were no less favorable to the
Company than would have been obtained from an unaffiliated third
party. Any future transactions between the Company and any of
its officers, directors or principal stockholders will be on
terms no less favorable to the Company than could be obtained
from unaffiliated third parties and will be approved by a
majority of the independent and disinterested members of the
Board.






|         |                                           
|-------- | ------------------------------------------
|Item 14. | Principal Accounting Fees and
    Services

Audit Fees

Ernst & Young LLP performed services for
us in fiscal 2002 and 2003 related to financial statement audit
work, quarterly reviews, tax services, special projects and
other ongoing consulting projects. Fees paid to Ernst &
Young in fiscal 2002 and 2003 were as follows:

|                  |  |      |         |      |  |   |         | 
|----------------- |  | ---- | ------- | ---- |  | - | ------- | 
|                  |  | 2003 |         | 2002
|                  |  |      |         |     
|Audit Fees(1)     |  | $    | 566,422 |      |  | $ | 585,889 | 
|Tax Fees(2)       |  | $    | 54,991  |      |  | $ | 162,874 | 
|All Other Fees(3) |  | $    | 43,670  |      |  | $ | 15,187  | 



---



|    |                                                                                                                                                                                                                                                          
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Audit fees represent aggregate fees billed for
    the audit of consolidated financial statements for the fiscal
    year ended December 31, 2003 and 2002 and the review of
    financial statements included in our quarterly reports on
    Form 10-Q.
|   
|(2) | Tax fees represent fees for professional services
    provided in connection with the preparation of our federal and
    state tax returns and advisory services for other tax compliance
    matters.                                                   
|   
|(3) | All other fees represent fees for international
    tax consulting.                                                                                                                                                                                      

Under the Sarbanes-Oxley Act of 2002, all audit
and non-audit services performed by Ernst & Young must
be approved in advance by our audit committee to assure that
such services do not impair the auditors independence from
the company. Our audit committee specifically approved all audit
and non-audit services prior to them being performed by
Ernst & Young in fiscal 2003.






|         |                                                                     
|-------- | --------------------------------------------------------------------
|Item 15. | Exhibits, Financial Statement Schedules,
    and Reports on Form 8-K

(a) The following documents are filed as
part of this report on Form 10-K:



| |                                                                                                                                                                                                                                     
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 1. Consolidated Financial Statements. The
    following consolidated financial statements of Terayon
    Communication Systems, Inc. and related Independent
    Auditors Report are filed as part of this report of
    Form 10-K:



| |                                                                                                                                                                                                                                                      
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  Independent Auditors Report.                                                                                                                                                                                                                      
|
| |  Consolidated Balance Sheets, as of
    December 31, 2003 and 2002.                                                                                                                                                                                 
|
| |  Consolidated Statements of
    Operations, Consolidated Statements of Stockholders
    Equity, Consolidated Statements of Cash Flows and Notes to
    Consolidated Financial Statements for the years ended
    December 31, 2003, 2002, and 2001.



| |                                                                                                                                                                                                                                                                                                                                     
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 2. Consolidated Financial Statement
    Schedules. The following consolidated financial statement
    schedules of Terayon Communication Systems, Inc. are filed
    as part of this report on Form 10-K and should be read in
    conjunction with the consolidated financial statements of
    Terayon Communication Systems, Inc:



| |                                                                                                                 
| | ----------------------------------------------------------------------------------------------------------------
| |  Schedule II of Valuation and
    Qualifying Accounts for the years ended December 31, 2003,
    2002 and 2001.



| |                                                                                                                                                                                                            
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Schedules not listed above are omitted because
    they are not required, they are not applicable or the
    information is already included in the consolidated financial
    statements or notes thereto.

103



---



##### Table of Contents





| |                                                                                                                                                           
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------
| | 3. Exhibits. The exhibits listed on the
    accompanying Index to Exhibits are filed or incorporated by
    reference as part of this report on Form 10-K.

(b) Reports on Form 8-K in the fourth
quarter of 2003:



| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 1. On October 7, 2003, the Company
    filed a report on Form 8-K announcing that Comcast would
    use the Companys DOCSIS 2.0-qualified Cable Modem
    Termination System (CMTS) equipment in the development of
    Comcasts headend platforms as a way to expedite the
    ubiquitous adoption of DOCSIS 2.0 in Comcasts networks.
    The Company also announced the appointment of two new
    executives, Jeffrey Barco as Vice President and General Manager
    of Terayons Digital Video Solutions Group, and William
    Rohrbach as Vice President of North America Sales. Additionally,
    the Company announced a better than expected third quarter
    financial performance.
|
| | 2. On October 9, 2003, the Company
    filed a report on Form 8-K announcing the filing of a
    Form S-3 shelf registration statement with the Securities
    and Exchange Commission that would allow the Company to offer,
    from time to time, common stock, preferred stock, debt
    securities and/or warrants, with an aggregate public offering
    price up to $125 million.                                                                                                                                                                                                                                                                                                           
|
| | 3. On October 24, 2003, the Company
    filed a report on Form 8-K announcing the issuance of a
    press release on October 14, 2003 which stated that the
    Company will release financial results for its third quarter
    ended September 30, 2003 and announce the financial results
    for its third quarter ended September 30, 2003 via a press
    release on October 22, 2003.                                                                                                                                                                                                                                                                                                       
|
| | 4. On November 6, 2003, the Company
    filed a report on Form 8-K announcing it intention to offer
    common stock that would result in the issuance of approximately
    10,800,000 shares of common stock.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|
| | 5. On November 19, 2003, the Company
    filed a report on Form 8-K announcing that it had withdrawn
    its previously announced public offering of
    10,800,000 shares of common stock under its shelf
    registration statement.                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|
| | 6. On November 21, 2003, the Company
    filed a report on Form 8-K announcing the filing of its
    Amended and Restated Certificate of Incorporation, Amendment to
    the Amended and Restated Certificate of Incorporation and Bylaws
    regarding indemnification of its officers, employees and other
    agents as set forth in the Delaware General Corporation Law.                                                                                                                                                                                                                                                                                                                      
|
| | 7. On December 16, 2003, the Company
    filed a report on Form 8-K reaffirming its fourth quarter
    financial guidance and that profitability was targeted for
    second quarter 2004. The company also unveiled details of its
    patent-pending FlexCMTS architecture.                                                                                                                                                                                                                                                                                                                                                                                                                    

|        |   |                     |  |                                                                                                                                                       
|------- | - | ------------------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |   |                    
|Number  |   | Exhibit Description
|        |   |                    
|        | 3 | .1                  |  | Amended and Restated Certificate of Incorporation
    of Terayon Communication Systems, Inc.(14)                                                      
|        | 3 | .2                  |  | Bylaws of Terayon Communication
    Systems, Inc.(14)                                                                                                 
|        | 3 | .3                  |  | Certificate of Amendment to Amended and Restated
    Certificate of Incorporation of Terayon Communication
    Systems, Inc.(14)                      
|        | 3 | .4                  |  | Certificate of Designation of Series A
    Junior Participating Preferred Stock.(7)                                                                   
|        | 4 | .1                  |  | Specimen Common Stock Certificate.(2)                                                                                                                 
|        | 4 | .2                  |  | Amended and Restated Information and Registration
    Rights Agreement dated April 6, 1998.(1)                                                        
|        | 4 | .3                  |  | Form of Security for Terayon Communication
    Systems, Inc.s 5% Convertible Subordinated Notes
    due August 1, 2007.(5)                           
|        | 4 | .4                  |  | Registration Rights Agreement by and among
    Terayon Communication Systems, Inc. and Deutsche Bank
    Securities, Inc. and Lehman Brothers, Inc.(5)
|        | 4 | .5                  |  | Indenture between Terayon Communication
    Systems, Inc. and State Street Bank and Trust Company of
    California, N.A. dated July 26, 2000.(5)     
|        | 4 | .6                  |  | Rights Agreement between Terayon Communication
    Systems, Inc. and Fleet National Bank dated
    February 6, 2001.(6)                               

104



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##### Table of Contents



|        |    |                     |  |                                                                                                                                                                                                      
|------- | -- | ------------------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |    |                    
|Number  |    | Exhibit Description
|        |    |                    
|        | 10 | .1                  |  | Form of Indemnity Agreement between Terayon
    Communication Systems, Inc. and each of its directors and
    officers.(1)                                                                           
|        | 10 | .2                  |  | 1995 Stock Option Plan, as amended on
    March 26, 1996.(1)                                                                                                                                         
|        | 10 | .3                  |  | 1997 Equity Incentive Plan, as amended on
    July 31, 2000.(9)                                                                                                                                      
|        | 10 | .4                  |  | 1998 Employee Stock Purchase Plan, as amended on
    May 22, 2002.(12)                                                                                                                               
|        | 10 | .5                  |  | 1998 Non-Employee Directors Stock Option Plan as
    amended on May 22, 2002.(1)                                                                                                                     
|        | 10 | .6                  |  | 1998 Employee Stock Purchase Plan Offering for
    Foreign Employees, adopted July 31, 2000.(7)                                                                                                      
|        | 10 | .7                  |  | 1999 Non-Officer Equity Incentive Plan, as
    amended May 28, 2003.(13)                                                                                                                             
|        | 10 | .8                  |  | Form of Non-Statutory Stock Option Agreement Used
    in Connection with the 1999 Non-Officer Equity Incentive Plan.(4)                                                                              
|        | 10 | .9                  |  | Azrieli Center Offices Lease Agreement, dated
    January 23, 2002, between Canit HaShalom Investments Ltd.
    and Terayon Communication Systems, Inc.(9)                                           
|        | 10 | .10                 |  | Azrieli Center Agreement to Transfer Lease Rights
    dated 23rd day of January, 2000(11)                                                                                                            
|        | 10 | .11                 |  | Employment Agreement, between Terayon
    Communication Systems, Inc. and Zaki Rakib dated February
    1993.(1)                                                                                     
|        | 10 | .12                 |  | Data Over Cable Service Interface Specifications
    License Agreement, dated December 21, 2001, between Terayon
    Communication Systems, Inc. and Cable Television
    Laboratories, Inc.(9)      
|        | 10 | .13                 |  | Amendment to DOCSIS IPR Agreement to cover DOCSIS
    2.0, dated December 21, 2001, between Terayon Communication
    Systems, Inc. and Cable Television
    Laboratories, Inc.(9)                   
|        | 10 | .14                 |  | Data Over Cable Service Interface Specifications
    License Agreement, dated December 21, 2001, between Imedia
    Semiconductor Corporation and Cable Television
    Laboratories, Inc.(9)         
|        | 10 | .15                 |  | Amendment to DOCSIS IPR Agreement to cover DOCSIS
    2.0, dated December 21, 2001, between Imedia Semiconductor
    Corporation and Cable Television Laboratories, Inc.(9)                          
|        | 10 | .16                 |  | Lease Agreement, dated September 18, 1996,
    between Sobrato Interests III and VeriFone.(10)                                                                                                       
|        | 10 | .17                 |  | Sublease, dated April 1, 2002, by and
    between Terayon Communication Systems, Inc. and
    Hewlett-Packard Company.(10)                                                                           
|        | 10 | .18                 |  | Aircraft Lease Agreement, dated February 8,
    2002, between Terayon Communication Systems, Inc. and
    General Electric Capital Corporation.(11)                                                  
|        | 10 | .19                 |  | Letter of Credit Agreement, dated
    February 8, 2002, between Terayon Communication
    Systems, Inc. and General Electric Capital Corporation.(11)                                                
|        | 10 | .20                 |  | Employment Agreement, dated January 24,
    2003, between Terayon Communication Systems, Inc. and
    Arthur T. Taylor.(11)                                                                          
|        | 10 | .21                 |  | Employment Agreement dated July 3, 2003,
    between Terayon Communication Systems, Inc. and Doug
    Sabella.(13)                                                                                   
|        | 10 | .22                 |  | Employment Agreement dated September 28,
    1999, between Terayon Communication Systems, Inc. and
    Edward Lopez.(13)                                                                             
|        | 10 | .23                 |  | Executive Compensation Plan, as adopted
    May 28, 2003.(13)                                                                                                                                        
|        | 10 | .24                 |  | Agreement dated January 9, 2004, between
    Terayon Communication Systems, Inc. and
    YAS Corporation.                                                                                            
|        | 10 | .25                 |  | First Amendment to Aircraft Lease Agreement,
    dated December 31, 2003, between Terayon Communication
    Systems, Inc. and General Electric Capital Corporation.                                  
|        | 10 | .26                 |  | Form of Severance Agreements (Change of Control)
    entered into by Zaki Rakib, Shlomo Rakib, Edward Lopez, Arthur
    T. Taylor, and Douglas Sabella and the Registrant dated
    January 14, 2004.
|        | 10 | .27                 |  | Code of Business Conduct.                                                                                                                                                                            
|        | 10 | .28                 |  | Notification Letter of Intent to Terminate or
    Sublease the Aircraft Lease Agreement, dated March 12, 2004.                                                                                       
|        | 21 | .1                  |  | List of Subsidiaries.                                                                                                                                                                                

105



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##### Table of Contents



|        |    |                     |  |                                                                                                            
|------- | -- | ------------------- |  | -----------------------------------------------------------------------------------------------------------
|Exhibit |    |                    
|Number  |    | Exhibit Description
|        |    |                    
|        | 23 | .1                  |  | Consent of Ernst & Young LLP Independent
    Auditors.                                                     
|        | 24 | .1                  |  | Power of Attorney (see page 108 of this
    Annual Report Form 10-K)                                       
|        | 31 | .1                  |  | Certification of the Chief Executive Officer
    Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
|        | 31 | .2                  |  | Certification of the Chief Financial Officer
    Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
|        | 32 | .1                  |  | Certification of the Chief Executive Officer
    Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
|        | 32 | .2                  |  | Certification of the Chief Financial Officer
    Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.



---



| |     |                                                                                                                                        
| | --- | ---------------------------------------------------------------------------------------------------------------------------------------
| | (1) | Incorporated by reference to exhibits to our
    Registration Statement on Form S-1 filed on June 16,
    1998 (File No. 333-56911).   
|
| | (2) | Incorporated by reference to exhibits to our
    Registration Statement on Form S-1/ A filed on
    July 31, 1998 (File No. 333-69699).
|
| | (3) | Incorporated by reference to our Report on
    Form 10-Q filed on November 15, 1999.                                                   
|
| | (4) | Incorporated by reference to our Registration
    Statement on Form S-8 filed on December 29, 1999.                                    
|
| | (5) | Incorporated by reference to our Registration
    Statement on Form S-3 filed on October 24, 2000 (File
    No. 333-48536).            
|
| | (6) | Incorporated by reference to our Report on
    Form 8-K filed on February 9, 2001.                                                     
|
| | (7) | Incorporated by reference to our Report on
    Form 10-K filed on April 2, 2001.                                                       
|
| | (8) | Incorporated by reference to our Report on
    Form 10-Q filed on May 15, 2001.                                                        
|
| | (9) | Incorporated by reference to our Report on
    Form 10-K filed on April 1, 2002.                                                       



|     |                                                                                                                
|---- | ---------------------------------------------------------------------------------------------------------------
|(10) | Incorporated by reference to our Report on
    Form 10-Q filed on May 15, 2002.                                
|    
|(11) | Incorporated by reference to our Report on
    Form 10-K filed on March 27, 2003.                              
|    
|(12) | Incorporated by reference to our Report on
    Registration Statement on Form S-8 filed on August 30,
    2002.
|    
|(13) | Incorporated by reference to our Report on
    Form 10-Q filed on August 14, 2003.                             
|    
|(14) | Incorporated by reference to our Report on
    Form 8-K filed on November 21, 2003.                            

106



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##### Table of Contents



SCHEDULE II

VALUATION AND QUALIFYING ACCOUNTS

|                             |                                 |                |   |            |  |            |  |           |  |  |  |        |  |  |   |        | 
|---------------------------- | ------------------------------- | -------------- | - | ---------- |  | ---------- |  | --------- |  |  |  | ------ |  |  | - | ------ | 
|                             |                                 | Balance        |   | Additions  |  |            |  |          
|                             |                                 | at             |   | Charged to |  |            |  | Balance  
|                             |                                 | Beginning      |   | Costs and  |  |            |  | at End   
|                             |                                 | of Period      |   | Expenses   |  | Write-offs |  | of Period
|                             |                                 |                |   |            |  |            |  |          
|                             |                                 |               
|                             |                                 | (In thousands)
|Year ended December 31, 2001 |                                 |                |   |            |  |            |  |           |  |  |  |        |  |  |   |       
|                             | Allowance for doubtful accounts |                | $ | 6,542      |  |            |  | 4,494     |  |  |  | 3,829  |  |  | $ | 7,207  | 
|                             | Excess and obsolescence         |                | $ | 16,323     |  |            |  | 24,670    |  |  |  | 3,812  |  |  | $ | 37,181 | 
|Year ended December 31, 2002 |                                 |                |   |            |  |            |  |           |  |  |  |        |  |  |   |       
|                             | Allowance for doubtful accounts |                | $ | 7,207      |  |            |  | 1,090     |  |  |  | 4,778  |  |  | $ | 3,519  | 
|                             | Excess and obsolescence         |                | $ | 37,181     |  |            |  | 4,336     |  |  |  | 16,044 |  |  | $ | 25,473 | 
|Year ended December 31, 2003 |                                 |                |   |            |  |            |  |           |  |  |  |        |  |  |   |       
|                             | Allowance for doubtful accounts |                | $ | 3,519      |  |            |  | 166       |  |  |  | 94     |  |  | $ | 3,591  | 
|                             | Excess and obsolescence         |                | $ | 25,473     |  |            |  | 4,086     |  |  |  | 17,269 |  |  | $ | 12,290 | 

107



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##### Table of Contents






SIGNATURES

Pursuant to the requirements of Section 13
or 15(d) of the Securities Exchange Act of 1934, the Registrant
has caused this report to be signed on its behalf by the
undersigned, thereunto due authorized, in County of
Santa Clara, State of California, on the 15th day of March,
2004.



| |                                    
| | -----------------------------------
| | TERAYON COMMUNICATION SYSTEMS, INC.
|
| | /s/ DR. ZAKI RAKIB                 
| |                                    
| | Dr. Zaki Rakib                     
| | Chief Executive Officer            

Each person whose signature appears below
constitutes Dr. Zaki Rakib, Shlomo Rakib and Arthur Taylor
his true and lawful attorney-in-fact and agent, each acting
alone, with full power of substitution and resubstitution, for
him and in his name, place and stead, in any and all capacities,
to sign any or all amendments to this Annual Report on
Form 10-K, and to file the same, with all exhibits thereto,
and all documents in connection therewith, with the Securities
and Exchange Commission, granting unto said attorney-in-fact and
agent, full power and authority to do and perform each and every
act and thing requisite and necessary to be done in and about
the premises, as fully to all intents and purposes as he might
or could do in person, hereby ratifying and confirming all that
said attorney-in-fact and agent, each acting alone, or his or
her substitutes, may lawfully do or cause to be done by virtue
hereof.

Pursuant to the requirements of the Securities
Act of 1934, this report has been signed below by the following
persons on behalf of the Registrant and in the capacities and on
the dates indicated.

|                                     |  |                                                                          |  |                |  | 
|------------------------------------ |  | ------------------------------------------------------------------------ |  | -------------- |  | 
|                                     |  |                                                                          |  |               
|Signature                            |  | Title                                                                    |  | Date          
|                                     |  |                                                                          |  |               
|                                    
|/s/ ZAKI RAKIBDr. Zaki Rakib         |  | Chief Executive Officer and Director (Principal
    Executive Officer)   |  | March 15, 2004
|                                    
|/s/ ARTHUR T. TAYLORArthur T. Taylor |  | Chief Financial Officer (Principal Financial and
    Accounting Officer) |  | March 15, 2004
|                                    
|/s/ SHLOMO RAKIBShlomo Rakib         |  | President and Chairman of the Board of Directors                         |  | March 15, 2004
|                                    
|/s/ LEWIS SOLOMONLewis Solomon       |  | Director                                                                 |  | March 15, 2004
|                                    
|/s/ ALEK KRSTAJICAlek Krstajic       |  | Director                                                                 |  | March 15, 2004
|                                    
|/s/ DAVID WOODROWDavid Woodrow       |  | Director                                                                 |  | March 15, 2004
|                                    
|/s/ MARK SLAVENMark Slaven           |  | Director                                                                 |  | March 15, 2004

108



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##### Table of Contents



EXHIBIT INDEX

|        |    |                     |  |                                                                                                                                                                                                
|------- | -- | ------------------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |    |                    
|Number  |    | Exhibit Description
|        |    |                    
|        | 3  | .1                  |  | Amended and Restated Certificate of Incorporation
    of Terayon Communication Systems, Inc.(14)                                                                                               
|        | 3  | .2                  |  | Bylaws of Terayon Communication
    Systems, Inc.(14)                                                                                                                                          
|        | 3  | .3                  |  | Certificate of Amendment to Amended and Restated
    Certificate of Incorporation of Terayon Communication
    Systems, Inc.(7)                                                                
|        | 3  | .4                  |  | Certificate of Designation of Series A
    Junior Participating Preferred Stock.(7)                                                                                                            
|        | 4  | .1                  |  | Specimen Common Stock Certificate.(2)                                                                                                                                                          
|        | 4  | .2                  |  | Amended and Restated Information and Registration
    Rights Agreement dated April 6, 1998.(1)                                                                                                 
|        | 4  | .3                  |  | Form of Security for Terayon Communication
    Systems, Inc.s 5% Convertible Subordinated Notes
    due August 1, 2007.(5)                                                                    
|        | 4  | .4                  |  | Registration Rights Agreement by and among
    Terayon Communication Systems, Inc. and Deutsche Bank
    Securities, Inc. and Lehman Brothers, Inc.(5)                                         
|        | 4  | .5                  |  | Indenture between Terayon Communication
    Systems, Inc. and State Street Bank and Trust Company of
    California, N.A. dated July 26, 2000.(5)                                              
|        | 4  | .6                  |  | Rights Agreement between Terayon Communication
    Systems, Inc. and Fleet National Bank dated
    February 6, 2001.(6)                                                                        
|        | 10 | .1                  |  | Form of Indemnity Agreement between Terayon
    Communication Systems, Inc. and each of its directors and
    officers.(1)                                                                     
|        | 10 | .2                  |  | 1995 Stock Option Plan, as amended on
    March 26, 1996.(1)                                                                                                                                   
|        | 10 | .3                  |  | 1997 Equity Incentive Plan, as amended on
    July 31, 2000.(9)                                                                                                                                
|        | 10 | .4                  |  | 1998 Employee Stock Purchase Plan, as amended on
    May 22, 2002.(12)                                                                                                                         
|        | 10 | .5                  |  | 1998 Non-Employee Directors Stock Option Plan as
    amended on May 22, 2002.(1)                                                                                                               
|        | 10 | .6                  |  | 1998 Employee Stock Purchase Plan Offering for
    Foreign Employees, adopted July 31, 2000.(7)                                                                                                
|        | 10 | .7                  |  | 1999 Non-Officer Equity Incentive Plan, as
    amended May 28, 2003.(13)                                                                                                                       
|        | 10 | .8                  |  | Form of Non-Statutory Stock Option Agreement Used
    in Connection with the 1999 Non-Officer Equity Incentive Plan.(4)                                                                        
|        | 10 | .9                  |  | Azrieli Center Offices Lease Agreement, dated
    January 23, 2002, between Canit HaShalom Investments Ltd.
    and Terayon Communication Systems, Inc.(9)                                     
|        | 10 | .10                 |  | Azrieli Center Agreement to Transfer Lease Rights
    dated 23rd day of January, 2000(11)                                                                                                      
|        | 10 | .11                 |  | Employment Agreement, between Terayon
    Communication Systems, Inc. and Zaki Rakib dated February
    1993.(1)                                                                               
|        | 10 | .12                 |  | Data Over Cable Service Interface Specifications
    License Agreement, dated December 21, 2001, between Terayon
    Communication Systems, Inc. and Cable Television
    Laboratories, Inc.(9)
|        | 10 | .13                 |  | Amendment to DOCSIS IPR Agreement to cover DOCSIS
    2.0, dated December 21, 2001, between Terayon Communication
    Systems, Inc. and Cable Television
    Laboratories, Inc.(9)             
|        | 10 | .14                 |  | Data Over Cable Service Interface Specifications
    License Agreement, dated December 21, 2001, between Imedia
    Semiconductor Corporation and Cable Television
    Laboratories, Inc.(9)   
|        | 10 | .15                 |  | Amendment to DOCSIS IPR Agreement to cover DOCSIS
    2.0, dated December 21, 2001, between Imedia Semiconductor
    Corporation and Cable Television Laboratories, Inc.(9)                    
|        | 10 | .16                 |  | Lease Agreement, dated September 18, 1996,
    between Sobrato Interests III and VeriFone.(10)                                                                                                 
|        | 10 | .17                 |  | Sublease, dated April 1, 2002, by and
    between Terayon Communication Systems, Inc. and
    Hewlett-Packard Company.(10)                                                                     
|        | 10 | .18                 |  | Aircraft Lease Agreement, dated February 8,
    2002, between Terayon Communication Systems, Inc. and
    General Electric Capital Corporation.(11)                                            
|        | 10 | .19                 |  | Letter of Credit Agreement, dated
    February 8, 2002, between Terayon Communication
    Systems, Inc. and General Electric Capital Corporation.(11)                                          
|        | 10 | .20                 |  | Employment Agreement, dated January 24,
    2003, between Terayon Communication Systems, Inc. and
    Arthur T. Taylor.(11)                                                                    



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##### Table of Contents



|        |    |                     |  |                                                                                                                                                                                                      
|------- | -- | ------------------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |    |                    
|Number  |    | Exhibit Description
|        |    |                    
|        | 10 | .21                 |  | Employment Agreement dated July 3, 2003,
    between Terayon Communication Systems, Inc. and Doug
    Sabella.(13)                                                                                   
|        | 10 | .22                 |  | Employment Agreement dated September 28,
    1999, between Terayon Communication Systems, Inc. and
    Edward Lopez.(13)                                                                             
|        | 10 | .23                 |  | Executive Compensation Plan, as adopted
    May 28, 2003.(13)                                                                                                                                        
|        | 10 | .24                 |  | Agreement dated January 9, 2004, between
    Terayon Communication Systems, Inc. and
    YAS Corporation.                                                                                            
|        | 10 | .25                 |  | First Amendment to Aircraft Lease Agreement,
    dated December 31, 2003, between Terayon Communication
    Systems, Inc. and General Electric Capital Corporation.                                  
|        | 10 | .26                 |  | Form of Severance Agreements (Change of Control)
    entered into by Zaki Rakib, Shlomo Rakib, Edward Lopez, Arthur
    T. Taylor, and Douglas Sabella and the Registrant dated
    January 14, 2004.
|        | 10 | .27                 |  | Code of Business Conduct.                                                                                                                                                                            
|        | 10 | .28                 |  | Notification Letter of Intent to Terminate or
    Sublease the Aircraft Lease Agreement, dated March 12, 2004.                                                                                       
|        | 21 | .1                  |  | List of Subsidiaries.                                                                                                                                                                                
|        | 23 | .1                  |  | Consent of Ernst & Young LLP Independent
    Auditors.                                                                                                                                               
|        | 24 | .1                  |  | Power of Attorney (see page 108 of this
    Annual Report Form 10-K)                                                                                                                                 
|        | 31 | .1                  |  | Certification of the Chief Executive Officer
    Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                          
|        | 31 | .2                  |  | Certification of the Chief Financial Officer
    Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                          
|        | 32 | .1                  |  | Certification of the Chief Executive Officer
    Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                          
|        | 32 | .2                  |  | Certification of the Chief Financial Officer
    Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                          



---



| |     |                                                                                                                                        
| | --- | ---------------------------------------------------------------------------------------------------------------------------------------
| | (1) | Incorporated by reference to exhibits to our
    Registration Statement on Form S-1 filed on June 16,
    1998 (File No. 333-56911).   
|
| | (2) | Incorporated by reference to exhibits to our
    Registration Statement on Form S-1/ A filed on
    July 31, 1998 (File No. 333-69699).
|
| | (3) | Incorporated by reference to our Report on
    Form 10-Q filed on November 15, 1999.                                                   
|
| | (4) | Incorporated by reference to our Registration
    Statement on Form S-8 filed on December 29, 1999.                                    
|
| | (5) | Incorporated by reference to our Registration
    Statement on Form S-3 filed on October 24, 2000 (File
    No. 333-48536).            
|
| | (6) | Incorporated by reference to our Report on
    Form 8-K filed on February 9, 2001.                                                     
|
| | (7) | Incorporated by reference to our Report on
    Form 10-K filed on April 2, 2001.                                                       
|
| | (8) | Incorporated by reference to our Report on
    Form 10-Q filed on May 15, 2001.                                                        
|
| | (9) | Incorporated by reference to our Report on
    Form 10-K filed on April 1, 2002.                                                       



|     |                                                                                                                
|---- | ---------------------------------------------------------------------------------------------------------------
|(10) | Incorporated by reference to our Report on
    Form 10-Q filed on May 15, 2002.                                
|    
|(11) | Incorporated by reference to our Report on
    Form 10-K filed on March 27, 2003.                              
|    
|(12) | Incorporated by reference to our Report on
    Registration Statement on Form S-8 filed on August 30,
    2002.
|    
|(13) | Incorporated by reference to our Report on
    Form 10-Q filed on August 14, 2003.                             
|    
|(14) | Incorporated by reference to our Report on
    Form 8-K filed on November 21, 2003.