##### Table of Contents









SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549





Form 10-K





|           |  |                                                                                             
|---------- |  | --------------------------------------------------------------------------------------------
|(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, 2004                                                 
|          
|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





TERAYON COMMUNICATION SYSTEMS, INC.


(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)


|                                                                          |  |                                                
|------------------------------------------------------------------------- |  | -----------------------------------------------
|DELAWARE(STATE OR OTHER JURISDICTION OF
    INCORPORATION OR ORGANIZATION |  | 77-0328533(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)





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)


þ o


o


þ o






DOCUMENTS INCORPORATED BY REFERENCE














---










INDEX


TERAYON COMMUNICATION SYSTEMS, INC.


|              |  |                                                                                                                      |     |          |    | 
|------------- |  | -------------------------------------------------------------------------------------------------------------------- | --- | -------- | -- | 
|              |  |                                                                                                                      |     | Page No. |   
|              |  |                                                                                                                      |     |          |   
|PART I       
|Item 1.       |  | BUSINESS                                                                                                             |     |          | 3  | 
|Item 2.       |  | PROPERTIES                                                                                                           |     |          | 11 | 
|Item 3.       |  | LEGAL PROCEEDINGS                                                                                                    |     |          | 11 | 
|Item 4.       |  | SUBMISSION OF MATTERS TO A VOTE OF SECURITY
    HOLDERS                                                              |     |          | 13 | 
|             
|PART II      
|Item 5.       |  | MARKET FOR REGISTRANTS COMMON EQUITY,
    RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY
    SECURITIES |     |          | 13 | 
|Item 6.       |  | SELECTED FINANCIAL DATA                                                                                              |     |          | 16 | 
|Item 7.       |  | MANAGEMENTS DISCUSSION AND ANALYSIS
    OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS                            |     |          | 17 | 
|Item 7A.      |  | QUANTITATIVE AND QUALITATIVE DISCLOSURES
    ABOUT MARKET RISK                                                       |     |          | 54 | 
|Item 8.       |  | FINANCIAL STATEMENTS AND SUPPLEMENTARY
    DATA                                                                      |     |          | 56 | 
|Item 9.       |  | CHANGES IN AND DISAGREEMENTS WITH
    ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE                             |     |          | 93 | 
|Item 9A.      |  | CONTROLS AND PROCEDURES                                                                                              |     |          | 93 | 
|Item 9B.      |  | OTHER INFORMATION                                                                                                    |     |          | 95 | 
|             
|PART III     
|Item 10.      |  | DIRECTORS AND EXECUTIVE OFFICERS OF THE
    REGISTRANT                                                               |     |          | 95 | 
|Item 11.      |  | EXECUTIVE COMPENSATION                                                                                               |     |          | 95 | 
|Item 12.      |  | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL
    OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS                   |     |          | 95 | 
|Item 13.      |  | CERTAIN RELATIONSHIPS AND RELATED
    TRANSACTIONS                                                                   |     |          | 95 | 
|Item 14.      |  | PRINCIPAL ACCOUNTANT FEES AND SERVICES                                                                               |     |          | 96 | 
|             
|PART IV      
|Item 15.      |  | EXHIBITS, FINANCIAL STATEMENT SCHEDULES                                                                              |     |          | 96 | 
|SIGNATURES    |  |                                                                                                                      | 100 |         
|EXHIBIT 10.1 
|EXHIBIT 10.26
|EXHIBIT 10.27
|EXHIBIT 10.28
|EXHIBIT 10.33
|EXHIBIT 21.1 
|EXHIBIT 23.1 
|EXHIBIT 31.1 
|EXHIBIT 31.2 
|EXHIBIT 32.1 
|EXHIBIT 32.2 



1



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##### Table of Contents



SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS






| |   |                                                                                                                                                                                                                                                                                                  
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Our belief our current cash balances will be sufficient to
    satisfy our cash requirements for at least the next
    12 months;                                                                                                                                                                
|
| |  | Our belief that we are well positioned to capitalize on the
    emerging video market because of the success our digital video
    solution (DVS) products have had with the major U.S. cable
    operators and satellite providers, as well as our current
    success in digital ad insertion; 
|
| |  | Our belief that our full transition to an original design
    manufacturer in Asia during 2005 may allow us to remain
    competitive in the marketplace and maintain favorable margins on
    our products;                                                                                     
|
| |  | Our expectation that, to the extent we are successful in
    shifting our product mix to higher margin DVS product revenues,
    our margins may increase;                                                                                                                                       
|
| |  | Our belief that we are well positioned to capitalize on the
    growing demand for broadband providers to provide advanced video
    services to their subscribers;                                                                                                                              
|
| |  | Our belief that the ongoing migration of major broadband
    providers to all-digital networks represents a significant
    opportunity for companies like us with products and technologies
    that enable them to maximize their bandwidth and to utilize
    important new transport methods;
|
| |  | Our belief that television providers will increasingly rely on
    overlay to maintain or even increase their advertising revenues
    and that our digital video processing systems will enable them
    to more cost-effectively do this;                                                      
|
| |  | Our belief that cable, digital broadcast satellite and
    telecommunications companies will continue their investments in
    equipment to provide advanced services in a cost-effective
    manner to increase average revenues per unit from their
    subscribers;                           
|
| |  | Our expectation that research and development expenses will
    continue to decrease in 2005; and                                                                                                                                                                                                
|
| |  | Our expectation that general and administrative expenses will
    continue to decrease in 2005.                                                                                                                                                                                                  

Forward are not guarantees of
future performance and .
The contained in this report
are based on information that is currently available to us and
expectations and assumptions that we deemed reasonable at the
time the statements were made. We do not undertake any forward-looking statements in this
report or in any of our other communications, except as required
by law. All such forward-looking statements should be read as of
the time the statements were made and with the recognition that may not be complete or
accurate at a later date.




2



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PART I







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

Overview










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





| |                                     
| | ------------------------------------
| | Expansion of the all-digital network





| |                                                                                        
| | ---------------------------------------------------------------------------------------
| | Ability to leverage network infrastructures to offer multiple
    products and services



3



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| |                                                         
| | --------------------------------------------------------
| | Broadband providers must combat ad skipping technologies





| |                                                                                            
| | -------------------------------------------------------------------------------------------
| | Continued network investment to support new product
    requirements in competitive markets





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







4



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





| |   |                                                                                                                                                                                                                                                          
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | capitalize on the increasing demand for advanced video services,
    including HDTV and VOD, by leveraging our strength 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 broadband providers;            
|
| |  | increase the distribution capabilities of our DVS products
    through reseller channels including developing new and expanding
    existing system integration partnerships such as Harmonic, Inc,
    Tandberg Television, Ltd, and Thomson Electronics
|
| |  | selectively enhance our HAS product portfolio to increase the
    value-added services for broadband providers to offer to their
    subscribers; and                                                                                                    
|
| |  | improve margins through focused product cost-reduction efforts
    and by streamlining operational activities across all product
    lines.                                                                                                              





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



| |             
| | ------------
| | DVS products





5



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| |             
| | ------------
| | HAS products









| |                                 
| | --------------------------------
| | Product research and development









6



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Customers








| |                        
| | -----------------------
| | Adelphia Communications



















Market Competition








7



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| |   |                                                                              
| | - | -----------------------------------------------------------------------------
| |  | 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 service providers; and                                    
|
| |  | in the HAS market, compliance with industry specifications and
    standards.



Sales and Marketing








International Sales






8



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Customer Service and Technical Support




Backlog




Manufacturing










Intellectual Property




9



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Access to our reports




10



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##### Table of Contents





Employees









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










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







11



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12



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









|   |                      
|-- | ---------------------
|1. | Election of Directors

|               |  |     |            |  |          |  |           | 
|-------------- |  | --- | ---------- |  | -------- |  | --------- | 
|Nominee        |  | For |            |  | Withheld | 
|               |  |     |            |  |          | 
|Jerry D. Chase |  |     | 67,458,655 |  |          |  | 1,038,909 | 
|Zaki Rakib     |  |     | 67,227,409 |  |          |  | 1,270,155 | 
|Mark Slaven    |  |     | 67,334,317 |  |          |  | 1,163,247 | 



|   |                                                                                                                                      
|-- | -------------------------------------------------------------------------------------------------------------------------------------
|2. | Ratification of the appointment of Ernst & Young LLP as
    the registrants auditors for the fiscal year ended
    December 31, 2004

|           |  |         |         |  |         |  |        | 
|---------- |  | ------- | ------- |  | ------- |  | ------ | 
|For        |  | Against |         |  | Abstain | 
|           |  |         |         |  |         | 
|67,855,478 |  |         | 558,429 |  |         |  | 53,657 | 




PART II







|        |                                                                                                                         
|------- | ------------------------------------------------------------------------------------------------------------------------
|Item 5. | Market for the Registrants Common Equity, Related
    Stockholder Matters and Issuer Purchases of Equity
    Securities



13



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|      |                |      |   |      |     |  |   |      | 
|----- | -------------- | ---- | - | ---- | --- |  | - | ---- | 
|      |                | High |   |      | Low | 
|      |                |      |   |      |     | 
|2004: |                |      |   |      |     |  |   |     
|      | First Quarter  |      | $ | 6.25 |     |  | $ | 2.96 | 
|      | Second Quarter |      | $ | 3.99 |     |  | $ | 1.66 | 
|      | Third Quarter  |      | $ | 2.38 |     |  | $ | 1.44 | 
|      | Fourth Quarter |      | $ | 2.98 |     |  | $ | 1.52 | 
|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 | 







|                                                                  |  |                     |            |  |                     |                 |              |                      |  |  |            |    
|----------------------------------------------------------------- |  | ------------------- | ---------- |  | ------------------- | --------------- | ------------ | -------------------- |  |  | ---------- | ---
|                                                                  |  |                     |            |  |                     | Common stock    |             
|                                                                  |  |                     |            |  |                     | available for   |             
|                                                                  |  |                     |            |  |                     | future issuance |             
|                                                                  |  | Common stock to     |            |  |                     |                 | under equity |                     
|                                                                  |  | be issued upon      |            |  | Weighted-average    |                 |              | compensation         | 
|                                                                  |  | exercise of         |            |  | exercise price of   |                 |              | plans (excluding     | 
|                                                                  |  | outstanding options |            |  | outstanding options |                 |              | securities reflected | 
|                                                                  |  | and rights          |            |  | and rights          |                 |              | in column (a))       | 
|Plan Category                                                     |  | (a)                 |            |  | (b)                 |                 |              | (c)                  | 
|                                                                  |  |                     |            |  |                     |                 |              |                      | 
|Equity compensation plans approved by Terayon stockholders(1)     |  |                     | 9,875,526  |  |                     | $               | 4.16         |                      |  |  | 6,704,961  |    
|Equity compensation plans not approved by Terayon stockholders(2) |  |                     | 6,927,312  |  |                     | $               | 6.96         |                      |  |  | 5,212,115  |    
|                                                                  |  |                     |            |  |                     |                 |              |                      | 
|Totals                                                            |  |                     | 16,802,838 |  |                     | $               | 5.32         |                      |  |  | 11,917,076 | (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 common stock outstanding under the
    Terayon Communication Systems, Inc. 1999 Non-Officer Equity
    Incentive Plan, as amended. See Note 10 in Notes to
    Consolidated Financial Statements.                                                                                                                                                                                                                                                                                                                 
|  
|3. | Includes 1,202,733 shares of common stock available for
    purchase under the Terayon Communication Systems, Inc. 1998
    Employee Stock Purchase Plan.                                                                                                                                                                                                                                                                                                                                                                                      

14



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





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







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





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







15



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



|                                                                 |                                                                              |                                       |         |        |      |   |         |        |  |   |         |         |  |      |          |         |  |   |          |         | 
|---------------------------------------------------------------- | ---------------------------------------------------------------------------- | ------------------------------------- | ------- | ------ | ---- | - | ------- | ------ |  | - | ------- | ------- |  | ---- | -------- | ------- |  | - | -------- | ------- | 
|                                                                 |                                                                              | Years Ended December 31,              |        
|                                                                 |                                                                              |                                       |        
|                                                                 |                                                                              | 2004                                  |         |        | 2003 |   |         | 2002   |  |   | 2001    |         |  | 2000 |         
|                                                                 |                                                                              |                                       |         |        |      |   |         |        |  |   |         |         |  |      |         
|                                                                 |                                                                              | (In thousands, except per share data) |        
|Consolidated statement of operations data:                       |                                                                              |                                       |         |        |      |   |         |        |  |   |         |         |  |      |          |         |  |   |          |        
|Revenues                                                         |                                                                              | $                                     | 150,538 |        |      | $ | 133,485 |        |  | $ | 129,403 |         |  | $    | 279,481  |         |  | $ | 339,549  |        
|Cost of goods sold                                               |                                                                              |                                       | 106,920 |        |      |   | 101,034 |        |  |   | 100,949 |         |  |      | 263,117  |         |  |   | 289,531  |        
|                                                                 |                                                                              |                                       |         |        |      |   |         |        |  |   |         |         |  |      |         
|Gross profit                                                     |                                                                              |                                       | 43,618  |        |      |   | 32,451  |        |  |   | 28,454  |         |  |      | 16,364   |         |  |   | 50,018   |        
|                                                                 |                                                                              |                                       |         |        |      |   |         |        |  |   |         |         |  |      |         
|Operating expenses:                                              |                                                                              |                                       |         |        |      |   |         |        |  |   |         |         |  |      |          |         |  |   |          |        
|                                                                 | Research and development                                                     |                                       |         | 33,959 |      |   |         | 42,839 |  |   |         | 58,696  |  |      |          | 79,927  |  |   |          | 68,270  | 
|Cost of product development assistance agreement                 |                                                                              |                                       |        |        |      |   |        |        |  |   |        |         |  |      |         |         |  |   | 9,563    |        
|                                                                 | In-process research and development                                          |                                       |         |       |      |   |         |       |  |   |         |        |  |      |          |        |  |   |          | 30,535  | 
|                                                                 | Sales and marketing                                                          |                                       |         | 24,145 |      |   |         | 26,781 |  |   |         | 35,704  |  |      |          | 55,701  |  |   |          | 45,261  | 
|                                                                 | General and administrative                                                   |                                       |         | 11,216 |      |   |         | 12,127 |  |   |         | 14,715  |  |      |          | 31,309  |  |   |          | 24,809  | 
|                                                                 | Goodwill amortization                                                        |                                       |         |       |      |   |         |       |  |   |         |        |  |      |          | 25,410  |  |   |          | 59,057  | 
|                                                                 | Restructuring charges (net), executive severance and asset
    write-offs(1) |                                       |         | 11,159 |      |   |         | 2,803  |  |   |         | 8,922   |  |      |          | 587,149 |  |   |          |        | 
|                                                                 |                                                                              |                                       |         |        |      |   |         |        |  |   |         |         |  |      |         
|                                                                 | Total operating expenses                                                     |                                       |         | 80,479 |      |   |         | 84,550 |  |   |         | 118,037 |  |      |          | 779,496 |  |   |          | 237,495 | 
|                                                                 |                                                                              |                                       |         |        |      |   |         |        |  |   |         |         |  |      |         
|Loss from operations                                             |                                                                              |                                       | (36,861 | )      |      |   | (52,099 | )      |  |   | (89,583 | )       |  |      | (763,132 | )       |  |   | (187,477 | )      
|Interest income (expense) and other income (expense), net        |                                                                              |                                       | 254     |        |      |   | 2,062   |        |  |   | (3,481  | )       |  |      | 44       |         |  |   | 6,710    |        
|Gain on early retirement of debt(2)                              |                                                                              |                                       |        |        |      |   |        |        |  |   | 49,089  |         |  |      | 185,327  |         |  |   |         |        
|Income tax benefit (expense)                                     |                                                                              |                                       | 76      |        |      |   | (316    | )      |  |   | (238    | )       |  |      | 13,915   |         |  |   |         |        
|                                                                 |                                                                              |                                       |         |        |      |   |         |        |  |   |         |         |  |      |         
|Net loss                                                         |                                                                              | $                                     | (36,531 | )      |      | $ | (50,353 | )      |  | $ | (44,213 | )       |  | $    | (563,846 | )       |  | $ | (180,767 | )      
|                                                                 |                                                                              |                                       |         |        |      |   |         |        |  |   |         |         |  |      |         
|Basic and diluted net loss per share                             |                                                                              | $                                     | (0.48   | )      |      | $ | (0.68   | )      |  | $ | (0.61   | )       |  | $    | (8.25    | )       |  | $ | (2.95    | )      
|                                                                 |                                                                              |                                       |         |        |      |   |         |        |  |   |         |         |  |      |         
|Shares used in computing basic and diluted net loss per share(3) |                                                                              |                                       | 75,861  |        |      |   | 74,212  |        |  |   | 72,803  |         |  |      | 68,331   |         |  |   | 61,349   |        
|                                                                 |                                                                              |                                       |         |        |      |   |         |        |  |   |         |         |  |      |         

16



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|                                                  |  |                                       |            |   |      |   |          |      |  |   |          |   |  |      |          |   |  |   |           |  
|------------------------------------------------- |  | ------------------------------------- | ---------- | - | ---- | - | -------- | ---- |  | - | -------- | - |  | ---- | -------- | - |  | - | --------- | -
|                                                  |  | Years Ended December 31,              |           
|                                                  |  |                                       |           
|                                                  |  | 2004                                  |            |   | 2003 |   |          | 2002 |  |   | 2001     |   |  | 2000 |         
|                                                  |  |                                       |            |   |      |   |          |      |  |   |          |   |  |      |         
|                                                  |  | (In thousands, except per share data) |           
|Consolidated Balance Sheet Data:                  |  |                                       |            |   |      |   |          |      |  |   |          |   |  |      |          |   |  |   |           |  
|Cash, cash equivalents and short-term investments |  | $                                     | 97,735     |   |      | $ | 138,640  |      |  | $ | 206,503  |   |  | $    | 333,888  |   |  | $ | 562,457   |  
|Working capital                                   |  |                                       | 109,054    |   |      |   | 137,548  |      |  |   | 172,829  |   |  |      | 316,175  |   |  |   | 547,938   |  
|Total assets                                      |  |                                       | 153,734    |   |      |   | 215,240  |      |  |   | 275,710  |   |  |      | 466,646  |   |  |   | 1,426,727 |  
|Long-term obligations (less current portion)      |  |                                       | 68,049     |   |      |   | 68,199   |      |  |   | 68,580   |   |  |      | 178,641  |   |  |   | 500,477   |  
|Accumulated deficit                               |  |                                       | (1,024,091 | ) |      |   | (987,560 | )    |  |   | (937,207 | ) |  |      | (892,994 | ) |  |   | (329,148  | )
|Total stockholders equity                        |  | $                                     | 56,341     |   |      | $ | 91,388   |      |  | $ | 137,142  |   |  | $    | 180,304  |   |  | $ | 702,681   |  






|    |                                                                                                                                                                                
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | See Notes 5 and 6 of Notes to Consolidated Financial
    Statements for an explanation for restructuring charges,
    executive severance and asset write-offs.                
|   
|(2) | See Note 8 of Notes to Consolidated Financial Statements
    for an explanation of the repurchase of subordinated convertible
    notes and reclassification of related gains. 
|   
|(3) | See Note 2 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.






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





| |         
| | --------
| | Overview







17



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18



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Results of Operations




| |                                                             
| | ------------------------------------------------------------
| | Comparison of the years ended December 31, 2004 and
    2003



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

|         |  |                    |         |                 |  |           |         |  |  |  |    |  
|-------- |  | ------------------ | ------- | --------------- |  | --------- | ------- |  |  |  | -- | -
|         |  | For the Year Ended |         |                
|         |  | December 31,       |         |                
|         |  |                    |         | Annual % Change
|         |  | 2004               |         | 2003            |  | 2004/2003
|         |  |                    |         |                 |  |          
|         |  | (In thousands)     |         |                
|Revenues |  | $                  | 150,538 |                 |  | $         | 133,485 |  |  |  | 13 | %



Revenues by Groups of Similar Products


|                     |       |                    |   |        |                 |  |   |           |         |  |  |     |    |  
|-------------------- | ----- | ------------------ | - | ------ | --------------- |  | - | --------- | ------- |  |  | --- | -- | -
|                     |       | For the Year Ended |   |        |                
|                     |       | December 31,       |   |        |                
|                     |       |                    |   |        | Annual % Change | 
|                     |       | 2004               |   |        | 2003            |  |   | 2004/2003 |        
|                     |       |                    |   |        |                 |  |   |           |        
|                     |       | (In thousands)     |   |        |                
|Revenues by product: |       |                    |   |        |                 |  |   |           |         |  |  |    
|                     | DVS   |                    | $ | 36,979 |                 |  | $ | 17,710    |         |  |  | 109 | % 
|                     | HAS   |                    |   | 72,152 |                 |  |   | 64,808    |         |  |  | 11  | % 
|                     | CMTS  |                    |   | 31,539 |                 |  |   | 47,486    |         |  |  | (34 | )%
|                     | Other |                    |   | 9,868  |                 |  |   | 3,481     |         |  |  | 183 | % 
|                     |       |                    |   |        |                 |  |   |           |        
|                     |       | Total              |   | $      | 150,538         |  |   | $         | 133,485 |  |  |     | 13 | %
|                     |       |                    |   |        |                 |  |   |           |        







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Revenues by Geographic Region


|                              |                                   |                    |   |        |                 |  |   |           |         |  |  |     |    |  
|----------------------------- | --------------------------------- | ------------------ | - | ------ | --------------- |  | - | --------- | ------- |  |  | --- | -- | -
|                              |                                   | For the Year Ended |   |        |                
|                              |                                   | December 31,       |   |        |                
|                              |                                   |                    |   |        | Annual % Change | 
|                              |                                   | 2004               |   |        | 2003            |  |   | 2004/2003 |        
|                              |                                   |                    |   |        |                 |  |   |           |        
|                              |                                   | (In thousands)     |   |        |                
|Revenues by geographic areas: |                                   |                    |   |        |                 |  |   |           |         |  |  |    
|                              | United States                     |                    | $ | 83,212 |                 |  | $ | 74,341    |         |  |  | 12  | % 
|                              | Americas, excluding United States |                    |   | 4,126  |                 |  |   | 3,713     |         |  |  | 11  | % 
|                              | EMEA, excluding Israel            |                    |   | 29,348 |                 |  |   | 17,635    |         |  |  | 66  | % 
|                              | Israel                            |                    |   | 6,681  |                 |  |   | 7,038     |         |  |  | (5  | )%
|                              | Asia, excluding Japan             |                    |   | 17,999 |                 |  |   | 9,575     |         |  |  | 88  | % 
|                              | Japan                             |                    |   | 9,172  |                 |  |   | 21,183    |         |  |  | (57 | )%
|                              |                                   |                    |   |        |                 |  |   |           |        
|                              |                                   | Total              |   | $      | 150,538         |  |   | $         | 133,485 |  |  |     | 13 | %
|                              |                                   |                    |   |        |                 |  |   |           |        





| |                      
| | ---------------------
| | Significant Customers



Related Party Revenues


|                        |                              |                    |       |       |                 |   |       |           |  |  |      |     |  
|----------------------- | ---------------------------- | ------------------ | ----- | ----- | --------------- | - | ----- | --------- |  |  | ---- | --- | -
|                        |                              | For the Year Ended |       |       |                
|                        |                              | December 31,       |       |       |                
|                        |                              |                    |       |       | Annual % Change |  
|                        |                              | 2004               |       |       | 2003            |   |       | 2004/2003 | 
|                        |                              |                    |       |       |                 |   |       |           | 
|                        |                              | (In thousands)     |       |       |                
|Related party revenues: |                              |                    |       |       |                 |   |       |           |  |  |      |    
|Rogers revenues         |                              | $                  | 0     |       |                 | $ | 1,453 |           |  |  | (100 | )% 
|Harmonic revenues       |                              |                    | 9,916 |       |                 |   | 3,241 |           |  |  | 206  | %  
|                        |                              |                    |       |       |                 |   |       |           | 
|                        | Total related party revenues |                    | $     | 9,916 |                 |   | $     | 4,694     |  |  |      | 111 | %
|                        |                              |                    |       |       |                 |   |       |           | 



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Cost of Goods Sold and Gross Profit


|                               |  |                    |         |                 |  |           |         |  |  |  |     |  
|------------------------------ |  | ------------------ | ------- | --------------- |  | --------- | ------- |  |  |  | --- | -
|                               |  | For the Year Ended |         |                
|                               |  | December 31,       |         |                
|                               |  |                    |         | Annual % Change
|                               |  | 2004               |         | 2003            |  | 2004/2003
|                               |  |                    |         |                 |  |          
|                               |  | (In thousands)     |         |                
|Cost of product revenues       |  | $                  | 103,150 |                 |  | $         | 99,261  |  |  |  | 4   | %
|Cost of related party revenues |  |                    | 3,770   |                 |  |           | 1,773   |  |  |  | 113 | %
|                               |  |                    |         |                 |  |           |         |  |  |  |     |  
|Total cost of goods sold       |  |                    | 106,920 |                 |  |           | 101,034 |  |  |  | 6   | %
|                               |  |                    |         |                 |  |           |         |  |  |  |     |  
|Gross profit                   |  | $                  | 43,618  |                 |  | $         | 32,451  |  |  |  | 34  | %
|                               |  |                    |         |                 |  |           |         |  |  |  |     |  









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Operating Expenses


|                           |  |                    |        |                 |  |           |        |  |  |  |     |   
|-------------------------- |  | ------------------ | ------ | --------------- |  | --------- | ------ |  |  |  | --- | --
|                           |  | For the Year Ended |        |                
|                           |  | December 31,       |        |                
|                           |  |                    |        | Annual % Change
|                           |  | 2004               |        | 2003            |  | 2004/2003
|                           |  |                    |        |                 |  |          
|                           |  | (In thousands)     |        |                
|Research and development   |  | $                  | 33,959 |                 |  | $         | 42,839 |  |  |  | (21 | )%
|Sales and marketing        |  | $                  | 24,145 |                 |  | $         | 26,781 |  |  |  | (10 | )%
|General and administrative |  | $                  | 11,216 |                 |  | $         | 12,127 |  |  |  | (8  | )%

Research and Development


Sales and Marketing


General and Administrative


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Restructuring Charges, Executive Severance and Asset
Write-offs


|                                                                |  |                    |        |   |      |   |       |  
|--------------------------------------------------------------- |  | ------------------ | ------ | - | ---- | - | ----- | -
|                                                                |  | For the Year Ended |       
|                                                                |  | December 31,       |       
|                                                                |  |                    |       
|                                                                |  | 2004               |        |   | 2003 |  
|                                                                |  |                    |        |   |      |  
|                                                                |  | (In thousands)     |       
|Restructuring charges                                           |  | $                  | 6,792  |   |      | $ | 2,745 |  
|Executive severance                                             |  |                    | 3,451  |   |      |   |      |  
|Long-lived assets written-off                                   |  |                    | 2,393  |   |      |   | 417   |  
|                                                                |  |                    |        |   |      |  
|Subtotal                                                        |  |                    | 12,636 |   |      |   | 3,162 |  
|Restructuring (recovery/change in estimate in prior year plans) |  |                    | (1,477 | ) |      |   | (359  | )
|                                                                |  |                    |        |   |      |  
|Restructuring charges, executive severance and asset write-offs |  | $                  | 11,159 |   |      | $ | 2,803 |  
|                                                                |  |                    |        |   |      |  

Restructuring












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Executive Severance






Asset Write-offs


Non-operating Expenses


|                 |  |                    |        |                 |  |           |        |   |  |  |     |   
|---------------- |  | ------------------ | ------ | --------------- |  | --------- | ------ | - |  |  | --- | --
|                 |  | For the Year Ended |        |                
|                 |  | December 31,       |        |                
|                 |  |                    |        | Annual % Change
|                 |  | 2004               |        | 2003            |  | 2004/2003
|                 |  |                    |        |                 |  |          
|                 |  | (In thousands)     |        |                
|Interest income  |  | $                  | 1,982  |                 |  | $         | 2,917  |   |  |  | (32 | )%
|Interest expense |  | $                  | (3,294 | )               |  | $         | (3,279 | ) |  |  | 0   | % 
|Other income     |  | $                  | 1,566  |                 |  | $         | 2,424  |   |  |  | (35 | )%

Interest Income


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Interest Expense


Other Income


Income Taxes


|                             |  |                |    |  |      |   |      |  
|---------------------------- |  | -------------- | -- |  | ---- | - | ---- | -
|                             |  | For the        |   
|                             |  | Year Ended     |   
|                             |  | December 31,   |   
|                             |  |                |   
|                             |  | 2004           |    |  | 2003 |  
|                             |  |                |    |  |      |  
|                             |  | (In thousands) |   
|Income tax (expense) benefit |  | $              | 76 |  |      | $ | (316 | )



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 | %





Revenues by Groups of Similar Products


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

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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  | % 
|                              | Americas excluding United States |                    |   | 3,713           |         |           |   | 20,530 |         |  |  | (82 | )%
|                              | EMEA excluding Israel            |                    |   | 17,635          |         |           |   | 11,381 |         |  |  | 55  | % 
|                              | Israel                           |                    |   | 7,038           |         |           |   | 8,283  |         |  |  | (15 | )%
|                              | Asia excluding Japan             |                    |   | 9,575           |         |           |   | 11,845 |         |  |  | (19 | )%
|                              | Japan                            |                    |   | 21,183          |         |           |   | 36,214 |         |  |  | (42 | )%
|                              |                                  |                    |   |                 |         |           |   |        |         |  |  |    
|                              |                                  | Total              |   | $               | 133,485 |           |   | $      | 129,403 |  |  |     | 3  | %
|                              |                                  |                    |   |                 |         |           |   |        |         |  |  |    



Significant Customers




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 | )%
|                        |                              |                    |       |                 |  |           |       |       |  |  |     |    



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Cost of Goods Sold and Gross Profit


|                               |  |                    |         |  |          |   |         |             |  |  |     |   
|------------------------------ |  | ------------------ | ------- |  | -------- | - | ------- | ----------- |  |  | --- | --
|                               |  | For the Year Ended |         |  |         
|                               |  | December 31,       |         |  |         
|                               |  |                    |         |  | Annual % |  
|                               |  | 2003               |         |  | 2002     |   |         | Change 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  | % 
|                               |  |                    |         |  |          |   |         |             | 







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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


Sales and Marketing


General and Administrative


Restructuring Charges 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 charges and asset write-offs |  | $                  | 2,803 |   |      | $ | 8,922 | 
|                                           |  |                    |       |   |      |  

Restructuring Charges




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Asset Write-offs




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 Expense


Other Expense


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Gain on early retirement of debt


Income Taxes


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



Litigation


Item 3 Legal Proceedings


Off-Balance Sheet Financings and Liabilities




Liquidity and Capital Resources












30



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Contractual Obligations




|                                               |  |       |       |                        |        |   |      |       |  |     |       |  |       |         |     |  |  |   |     | 
|---------------------------------------------- |  | ----- | ----- | ---------------------- | ------ | - | ---- | ----- |  | --- | ----- |  | ----- | ------- | --- |  |  | - | --- | 
|                                               |  |       |       | Payments Due by Period |       
|                                               |  |       |       |                        |       
|                                               |  |       |       | Less than              |        |   | 1-3  |       |  | 4-5 |       |  | After |        
|                                               |  | Total |       |                        | 1 Year |   |      | Years |  |     | Years |  |       | 5 Years |    
|                                               |  |       |       |                        |        |   |      |       |  |     |       |  |       |         |    
|Unconditional Purchase Obligations             |  | $     | 30.0  |                        |        | $ | 30.0 |       |  | $   |      |  |       | $       |    |  |  | $ |    | 
|Long Term Debt and other Long Term Obligations |  |       | 67.2  |                        |        |   | 0.1  |       |  |     | 65.8  |  |       |         |    |  |  |   | 1.3 | 
|Facilities Operating Lease Obligations         |  |       | 18.3  |                        |        |   | 6.0  |       |  |     | 6.5   |  |       |         | 5.6 |  |  |   | 0.2 | 
|Aircraft Operating Lease Obligations           |  |       | 3.1   |                        |        |   | 1.5  |       |  |     | 1.6   |  |       |         |    |  |  |   |    | 
|                                               |  |       |       |                        |        |   |      |       |  |     |       |  |       |         |    
|Total Contractual Commitments                  |  | $     | 118.6 |                        |        | $ | 37.6 |       |  | $   | 73.9  |  |       | $       | 5.6 |  |  | $ | 1.5 | 
|                                               |  |       |       |                        |        |   |      |       |  |     |       |  |       |         |    



31



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|                             |  |           |     |                                     |           |   |     |       |  |   |       |  |  |         |     |  |  |   |   | 
|---------------------------- |  | --------- | --- | ----------------------------------- | --------- | - | --- | ----- |  | - | ----- |  |  | ------- | --- |  |  | - | - | 
|                             |  |           |     | Amount of Commitment Expiration Per
|                             |  |           |     | Period                             
|                             |  | Total     |     |                                     |          
|                             |  | Amounts   |     |                                     | Less than |   |     | 1-3   |  |   | 4-5   |  |  | Over   
|                             |  | Committed |     |                                     | 1 Year    |   |     | Years |  |   | Years |  |  | 5 Years
|                             |  |           |     |                                     |           |   |     |       |  |   |       |  |  |        
|Deposits                     |  | $         | 7.5 |                                     |           | $ | 0.0 |       |  | $ | 7.5   |  |  | $       |    |  |  | $ |  | 
|Standby Letters of Credit    |  |           | 0.5 |                                     |           |   | 0.0 |       |  |   | 0.2   |  |  |         | 0.3 |  |  |   |  | 
|                             |  |           |     |                                     |           |   |     |       |  |   |       |  |  |         |    
|Total Commercial Commitments |  | $         | 8.0 |                                     |           | $ |    |       |  | $ | 7.7   |  |  | $       | 0.3 |  |  | $ |  | 
|                             |  |           |     |                                     |           |   |     |       |  |   |       |  |  |         |    



Critical Accounting Policies




Use of Estimate




| |   |                                                                                                                                                                                     
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | 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.  



Revenue Recognition




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Allowance for Doubtful Accounts


Inventory Valuation






33



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##### Table of Contents







Impairment of Long-Lived Assets


Warranty Reserves


Restructuring and Other Related Charges


Contingencies


Taxes


34



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Impact of Recently Issued Accounting Standards






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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







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





| |   |                                                                                                   
| | - | --------------------------------------------------------------------------------------------------
| |  | 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;                  

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| |   |                                                                                                                                                                                     
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | 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.                                                                                             





| |   |                                                                         
| | - | ------------------------------------------------------------------------
| |  | 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 and obsolete inventory;                    
|
| |  | delays in reducing the cost of our products;                            
|
| |  | the costs of manufacturing our products; and                            
|
| |  | the effectiveness of our cost reduction measures.                       





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











| |                                                                                                                                                                                                                                                                                                                                                                               
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Recent changes in senior management and the reductions in
    workforce associated with our restructuring efforts could
    disrupt the operation of our business, distract our management
    from focusing on revenue- generating efforts, result in the
    erosion of employee morale, and impair our ability to respond
    rapidly to growth opportunities in the future



38



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







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



39



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





40



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| |                                                                                                                                                    
| | ---------------------------------------------------------------------------------------------------------------------------------------------------
| | Our video products and applications must achieve
    widespread market acceptance to advance the growth of our
    digital video solutions business





| |                                                                                                                                                       
| | ------------------------------------------------------------------------------------------------------------------------------------------------------
| | The emerging market trend to standardize the digital video
    technology may challenge our ability to continue to grow our
    digital video business



41



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| |                                                                                                                                                                                                                            
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We depend on broadband providers capital spending
    for a substantial portion of our revenue and any decrease or
    delay in capital spending would negatively impact our operating
    results and financial condition





| |   |                                                                                                                        
| | - | -----------------------------------------------------------------------------------------------------------------------
| |  | 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.                                                                                           



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



42



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| |                                                                                 
| | --------------------------------------------------------------------------------
| | We must achieve cost reductions or increase revenues to
    attain profitability









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









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



43



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







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







44



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





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





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





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





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



45



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





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





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





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

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| |   |                                                                                                   
| | - | --------------------------------------------------------------------------------------------------
| |  | 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.                                                               











| |                                                                                                          
| | ---------------------------------------------------------------------------------------------------------
| | Exchange rate fluctuations could cause a decline in our
    financial condition and results of operations







| |                                                                                                                                               
| | ----------------------------------------------------------------------------------------------------------------------------------------------
| | The deployment process for our equipment may be lengthy
    and may delay the receipt of new orders and cause fluctuations
    in our revenues



47



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





| |   |                                                       
| | - | ------------------------------------------------------
| |  | 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.                   







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



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













| |                                                                                                                                                                                                                                                                                    
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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



49



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





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







| |   |                                      
| | - | -------------------------------------
| |  | cost effective;                      
|
| |  | brought to market in a timely manner;

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| |   |                                                                        
| | - | -----------------------------------------------------------------------
| |  | in accordance with evolving industry standards and
    architecture; or
|
| |  | fail to achieve market acceptance.                                     





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







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





| |   |                                                                                                                                                                      
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | 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.                                                                                                       





| |   |                                                                                         
| | - | ----------------------------------------------------------------------------------------
| |  | issue common stock that would dilute our current
    stockholders percentage ownership;
|
| |  | assume liabilities;                                                                     

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| |   |                                                                                                                                                    
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------
| |  | 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.                                                                                                                      







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





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





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



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| |                                                                                                                                                                                                                                            
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Compliance with changing laws and regulations relating to
    corporate governance and public disclosure has resulted, and
    will continue to result, in the incurrence of additional
    expenses associated with being a public company









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





| |   |                                                                 
| | - | ----------------------------------------------------------------
| |  | 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;        

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| |   |                                                                                                                              
| | - | -----------------------------------------------------------------------------------------------------------------------------
| |  | 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.                                                                      





| |                                                                                                                                                                                                                         
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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





| |                                                                                                                                                                        
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Newly adopted accounting regulations that require
    companies to expense stock options will result in a decrease in
    our earnings and our stock price may decline.






Item 7a.Quantitative
and Qualitative Disclosures About Market Risk


Interest Rate Risk


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Foreign Currency Risk


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

TERAYON COMMUNICATION SYSTEMS, INC.


INDEX TO CONSOLIDATED FINANCIAL STATEMENTS


|                                                                                |  |      |       | 
|------------------------------------------------------------------------------- |  | ---- | ----- | 
|                                                                                |  | Page |      
|                                                                                |  |      |      
|Reports of Ernst & Young LLP, Independent Registered
    Public Accounting Firm |  |      | 57    | 
|Consolidated Balance Sheets                                                     |  |      | 60    | 
|Consolidated Statements of Operations                                           |  |      | 61    | 
|Consolidated Statements of Stockholders Equity                                 |  |      | 62-63 | 
|Consolidated Statements of Cash Flows                                           |  |      | 64    | 
|Notes to Consolidated Financial Statements                                      |  |      | 65    | 

56



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Report Of Ernst & Young LLP, Independent
Registered


Public Accounting Firm


The Board of Directors and Stockholders


Terayon Communication Systems, Inc.












| |                      
| | ---------------------
| | /s/ Ernst & Young LLP





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Report of Independent Registered Public Accounting Firm on
Internal Control over Financial Reporting


The Board of Directors and Shareholders of


Terayon Communications Systems, Inc.














| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Management identified a material weakness due to insufficient
    controls related to the identification, capture, and timely
    communication of financially significant information between
    certain parts of the organization and the finance department to
    enable the finance department to account for transactions in a
    complete and timely manner. As a result of this material
    weakness, management recorded an adjustment in the quarter ended
    September 30, 2004 to record termination benefits paid to a
    former executive.
|
| | Management also identified a material weakness for insufficient
    controls related to the preparation and review of the annual
    consolidated financial statements and accompanying footnote
    disclosures. The insufficient controls include a lack of
    sufficient personnel with technical accounting expertise in the
    finance department and inadequate review and approval procedures
    to prepare external financial statements in accordance with
    generally accepted accounting principles (GAAP). As a result of
    this          

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| |                                                                                                                                                                        
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | material weakness, management made substantial revisions to its
    2004 annual consolidated financial statements and footnote
    disclosures before they were issued.







| |                      
| | ---------------------
| | /s/ Ernst & Young LLP





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TERAYON COMMUNICATION SYSTEMS, INC.


CONSOLIDATED BALANCE SHEETS


|                                              |                                                                                                    |                                                         |                           |            |      |         |        |           |    |         | 
|--------------------------------------------- | -------------------------------------------------------------------------------------------------- | ------------------------------------------------------- | ------------------------- | ---------- | ---- | ------- | ------ | --------- | -- | ------- | 
|                                              |                                                                                                    | December 31,                                            |                          
|                                              |                                                                                                    |                                                         |                          
|                                              |                                                                                                    | 2004                                                    |                           |            | 2003 |        
|                                              |                                                                                                    |                                                         |                           |            |      |        
|                                              |                                                                                                    | (In thousands,                                          |                          
|                                              |                                                                                                    | except share data)                                      |                          
|ASSETS                                       
|Current assets:                               |                                                                                                    |                                                         |                           |            |      |         |        |          
|                                              | Cash and cash equivalents                                                                          |                                                         | $                         | 43,218     |      |         | $      | 30,188    |   
|                                              | Short-term investment                                                                              |                                                         |                           | 54,517     |      |         |        | 108,452   |   
|                                              | Accounts receivable, less allowance for doubtful accounts of
    $1,289 in 2004 and $3,591 in 2003 |                                                         |                           | 16,554     |      |         |        | 29,199    |   
|                                              | Accounts receivable from related parties                                                           |                                                         |                           | 3,106      |      |         |        | 600       |   
|                                              | Other current receivables                                                                          |                                                         |                           | 1,044      |      |         |        | 3,662     |   
|                                              | Inventory, net                                                                                     |                                                         |                           | 17,144     |      |         |        | 16,364    |   
|                                              | Other current assets                                                                               |                                                         |                           | 2,042      |      |         |        | 2,883     |   
|                                              |                                                                                                    |                                                         |                           |            |      |        
|                                              |                                                                                                    |                                                         | Total current assets      |            |      | 137,625 |        |           |    | 191,348 | 
|Property and equipment, net                   |                                                                                                    |                                                         | 5,760                     |            |      |         | 11,871 |          
|Restricted cash                               |                                                                                                    |                                                         | 8,827                     |            |      |         | 9,212  |          
|Other assets, net                             |                                                                                                    |                                                         | 1,522                     |            |      |         | 2,809  |          
|                                              |                                                                                                    |                                                         |                           |            |      |        
|                                              |                                                                                                    |                                                         | Total assets              |            | $    | 153,734 |        |           | $  | 215,240 | 
|                                              |                                                                                                    |                                                         |                           |            |      |        
|                                             
|LIABILITIES AND STOCKHOLDERS EQUITY         
|Current liabilities:                          |                                                                                                    |                                                         |                           |            |      |         |        |          
|                                              | Accounts payable                                                                                   |                                                         | $                         | 7,845      |      |         | $      | 26,049    |   
|                                              | Accrued payroll and related expenses                                                               |                                                         |                           | 4,181      |      |         |        | 6,537     |   
|                                              | Deferred revenues                                                                                  |                                                         |                           | 2,579      |      |         |        | 3,423     |   
|                                              | Accrued warranty expenses                                                                          |                                                         |                           | 3,870      |      |         |        | 5,509     |   
|                                              | Accrued restructuring and executive severance                                                      |                                                         |                           | 3,902      |      |         |        | 2,647     |   
|                                              | Accrued vendor cancellation charges                                                                |                                                         |                           | 521        |      |         |        | 2,869     |   
|                                              | Accrued other liabilities                                                                          |                                                         |                           | 4,317      |      |         |        | 5,284     |   
|                                              | Interest payable                                                                                   |                                                         |                           | 1,356      |      |         |        | 1,358     |   
|                                              | Current portion of capital lease obligations                                                       |                                                         |                           |           |      |         |        | 124       |   
|                                              |                                                                                                    |                                                         |                           |            |      |        
|                                              |                                                                                                    |                                                         | Total current liabilities |            |      | 28,571  |        |           |    | 53,800  | 
|Long-term obligations                         |                                                                                                    |                                                         | 2,077                     |            |      |         | 3,118  |          
|Accrued restructuring and executive severance |                                                                                                    |                                                         | 1,664                     |            |      |         | 1,853  |          
|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 2004 and 2003   |                           |            |     |         |        |           |   |        
|                                              | Common stock, $0.001 par value:                                                                    |                                                         |                           |            |      |         |        |           |   
|                                              |                                                                                                    | Authorized shares  200,000,000                         |                           |            |      |         |        |           |    |        
|                                              |                                                                                                    | Issued  76,454,161 in 2004 and 75,031,097 in 2003      |                           |            |      |         |        |           |    |        
|                                              |                                                                                                    | Outstanding  76,298,152 in 2004 and 74,875,088 in 2003 |                           |            | 76   |         |        |           | 75 |        
|                                              | Additional paid in capital                                                                         |                                                         |                           | 1,083,711  |      |         |        | 1,082,036 |   
|                                              | Accumulated deficit                                                                                |                                                         |                           | (1,024,091 | )    |         |        | (987,560  | ) 
|                                              | Deferred compensation                                                                              |                                                         |                           |           |      |         |        | (22       | ) 
|                                              | Treasury stock, at cost; 156,009 shares in 2004 and 2003                                           |                                                         |                           | (773       | )    |         |        | (773      | ) 
|                                              | Accumulated other comprehensive loss                                                               |                                                         |                           | (2,582     | )    |         |        | (2,368    | ) 
|                                              |                                                                                                    |                                                         |                           |            |      |        
|                                              | Total stockholders equity                                                                         |                                                         |                           | 56,341     |      |         |        | 91,388    |   
|                                              |                                                                                                    |                                                         |                           |            |      |        
|                                              | Total liabilities and stockholders equity                                                         |                                                         | $                         | 153,734    |      |         | $      | 215,240   |   
|                                              |                                                                                                    |                                                         |                           |            |      |        



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TERAYON COMMUNICATION SYSTEMS, INC.


CONSOLIDATED STATEMENTS OF OPERATIONS


|                                                              |                                                                           |                                       |         |         |         |   |         |         |         |   |         |         |         | 
|------------------------------------------------------------- | ------------------------------------------------------------------------- | ------------------------------------- | ------- | ------- | ------- | - | ------- | ------- | ------- | - | ------- | ------- | ------- | 
|                                                              |                                                                           | Years Ended December 31,              |        
|                                                              |                                                                           |                                       |        
|                                                              |                                                                           | 2004                                  |         |         | 2003    |   |         | 2002    |        
|                                                              |                                                                           |                                       |         |         |         |   |         |         |        
|                                                              |                                                                           | (In thousands, except per share data) |        
|Revenues:                                                     |                                                                           |                                       |         |         |         |   |         |         |         |   |         |        
|                                                              | Product revenues                                                          |                                       | $       | 140,622 |         |   | $       | 128,791 |         |   | $       | 120,306 |        
|                                                              | Related party product revenues                                            |                                       |         | 9,916   |         |   |         | 4,694   |         |   |         | 9,097   |        
|                                                              |                                                                           |                                       |         |         |         |   |         |         |        
|                                                              |                                                                           | Total revenues                        |         |         | 150,538 |   |         |         | 133,485 |   |         |         | 129,403 | 
|Cost of goods sold:                                           |                                                                           |                                       |         |         |         |   |         |         |         |   |         |        
|                                                              | Cost of product revenues                                                  |                                       |         | 103,150 |         |   |         | 99,261  |         |   |         | 92,497  |        
|                                                              | Cost of related party product revenue                                     |                                       |         | 3,770   |         |   |         | 1,773   |         |   |         | 8,452   |        
|                                                              |                                                                           |                                       |         |         |         |   |         |         |        
|                                                              |                                                                           | Total cost of goods sold              |         |         | 106,920 |   |         |         | 101,034 |   |         |         | 100,949 | 
|                                                              |                                                                           |                                       |         |         |         |   |         |         |        
|Gross profit                                                  |                                                                           |                                       | 43,618  |         |         |   | 32,451  |         |         |   | 28,454  |        
|Operating expenses:                                           |                                                                           |                                       |         |         |         |   |         |         |         |   |         |        
|                                                              | Research and development                                                  |                                       |         | 33,959  |         |   |         | 42,839  |         |   |         | 58,696  |        
|                                                              | Sales and marketing                                                       |                                       |         | 24,145  |         |   |         | 26,781  |         |   |         | 35,704  |        
|                                                              | General and administrative                                                |                                       |         | 11,216  |         |   |         | 12,127  |         |   |         | 14,715  |        
|                                                              | Restructuring charges (net), executive severance and asset
    write-offs |                                       |         | 11,159  |         |   |         | 2,803   |         |   |         | 8,922   |        
|                                                              |                                                                           |                                       |         |         |         |   |         |         |        
|                                                              |                                                                           | Total operating expenses              |         |         | 80,479  |   |         |         | 84,550  |   |         |         | 118,037 | 
|                                                              |                                                                           |                                       |         |         |         |   |         |         |        
|Loss from operations                                          |                                                                           |                                       | (36,861 | )       |         |   | (52,099 | )       |         |   | (89,583 | )      
|Interest income                                               |                                                                           |                                       | 1,982   |         |         |   | 2,917   |         |         |   | 6,838   |        
|Interest expense                                              |                                                                           |                                       | (3,294  | )       |         |   | (3,279  | )       |         |   | (6,174  | )      
|Other income (expense)                                        |                                                                           |                                       | 1,566   |         |         |   | 2,424   |         |         |   | (4,145  | )      
|Gain on early retirement of debt                              |                                                                           |                                       |        |         |         |   |        |         |         |   | 49,089  |        
|                                                              |                                                                           |                                       |         |         |         |   |         |         |        
|Loss before tax (expense) benefit                             |                                                                           |                                       | (36,607 | )       |         |   | (50,037 | )       |         |   | (43,975 | )      
|Income tax (expense) benefit                                  |                                                                           |                                       | 76      |         |         |   | (316    | )       |         |   | (238    | )      
|                                                              |                                                                           |                                       |         |         |         |   |         |         |        
|Net loss                                                      |                                                                           | $                                     | (36,531 | )       |         | $ | (50,353 | )       |         | $ | (44,213 | )      
|                                                              |                                                                           |                                       |         |         |         |   |         |         |        
|Basic and diluted net loss per share                          |                                                                           | $                                     | (0.48   | )       |         | $ | (0.68   | )       |         | $ | (0.61   | )      
|                                                              |                                                                           |                                       |         |         |         |   |         |         |        
|Shares used in computing basic and diluted net loss per share |                                                                           |                                       | 75,861  |         |         |   | 74,212  |         |         |   | 72,803  |        
|                                                              |                                                                           |                                       |         |         |         |   |         |         |        



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TERAYON COMMUNICATION SYSTEMS, INC.


CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY


|                                                                                     |                                                       |                                      |                    |   |            |   |    |             |  |       |           |               |  |              |                |   |         |       |      |               |  |   |        |      |        |        |         |  |  |   |      |   |  |   |         |      |         |         |  
|------------------------------------------------------------------------------------ | ----------------------------------------------------- | ------------------------------------ | ------------------ | - | ---------- | - | -- | ----------- |  | ----- | --------- | ------------- |  | ------------ | -------------- | - | ------- | ----- | ---- | ------------- |  | - | ------ | ---- | ------ | ------ | ------- |  |  | - | ---- | - |  | - | ------- | ---- | ------- | ------- | -
|                                                                                     |                                                       |                                      |                    |   |            |   |    |             |  |       |           | Accumulated   |  |              |                |   |         |       |     
|                                                                                     |                                                       |                                      |                    |   |            |   |    |             |  | Other |           |               |  |              |               
|                                                                                     |                                                       | Common Stock                         |                    |   | Additional |   |    |             |  |       |           | Comprehensive |  |              | Treasury Stock |   |         | Total |     
|                                                                                     |                                                       |                                      |                    |   | Paid-in    |   |    | Accumulated |  |       | Deferred  |               |  | Income       |                |   |         |       |      | Stockholders | 
|                                                                                     |                                                       | Shares                               |                    |   | Amount     |   |    | Capital     |  |       | Deficit   |               |  | Compensation |                |   | (Loss)  |       |      | Shares        |  |   | Amount |      |        | Equity |        
|                                                                                     |                                                       |                                      |                    |   |            |   |    |             |  |       |           |               |  |              |                |   |         |       |      |               |  |   |        |      |        |        |        
|                                                                                     |                                                       | (In thousands, except share amounts) |                   
|Balance at December 31, 2001                                                         |                                                       |                                      | 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 loss:                                                                  |                                                       |                                      |                    |   |            |   |    |             |  |       |           |               |  |              |                |   |         |       |      |               |  |   |        |      |        |        |         |  |  |   |      |   |  |   |         |     
|                                                                                     | Increase to unrealized loss 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 |     
|                                                                                     |                                                       |                                      |                    |   |            |   |    |             |  |       |           |               |  |              |                |   |         |       |      |               |  |   |        |      |        |        |        
|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 loss:                                                                  |                                                       |                                      |                    |   |            |   |    |             |  |       |           |               |  |              |                |   |         |       |      |               |  |   |        |      |        |        |         |  |  |   |      |   |  |   |         |     
|                                                                                     | Increase to unrealized loss 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  |     
|                                                                                     |                                                       |                                      |                    |   |            |   |    |             |  |       |           |               |  |              |                |   |         |       |      |               |  |   |        |      |        |        |        
|Exercise of options for cash to purchase common stock                                |                                                       |                                      | 225,645            |   |            |   |    |             |  |       | 490       |               |  |              |                |   |         |       |      |               |  |   |        |      |        |        |         |  |  |   |      |   |  |   | 490     |     
|Amortization of deferred compensation                                                |                                                       |                                      |                    |   |            |   |    |             |  |       |           |               |  |              |                |   |         |       | 17   |               |  |   |        |      |        |        |         |  |  |   |      |   |  |   | 17      |     
|Cancellation of unvested stock options                                               |                                                       |                                      |                    |   |            |   |    |             |  |       | (5        | )             |  |              |                |   |         |       | 5    |               |  |   |        |      |        |        |         |  |  |   |      |   |  |   |        |     
|Issuance of common stock for Employee Stock Purchase Plan                            |                                                       |                                      | 1,197,419          |   |            |   | 1  |             |  |       | 1,190     |               |  |              |                |   |         |       |      |               |  |   |        |      |        |        |         |  |  |   |      |   |  |   | 1,191   |     

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|                             |                                                       |                                      |                    |  |            |   |    |             |  |       |           |               |        |              |                |        |         |       |               |  |  |        |        |      |        |  |         |  |  |   |      |   |  |   |        |      |         |         |  
|---------------------------- | ----------------------------------------------------- | ------------------------------------ | ------------------ |  | ---------- | - | -- | ----------- |  | ----- | --------- | ------------- | ------ | ------------ | -------------- | ------ | ------- | ----- | ------------- |  |  | ------ | ------ | ---- | ------ |  | ------- |  |  | - | ---- | - |  | - | ------ | ---- | ------- | ------- | -
|                             |                                                       |                                      |                    |  |            |   |    |             |  |       |           | Accumulated   |        |              |                |        |         |       |              
|                             |                                                       |                                      |                    |  |            |   |    |             |  | Other |           |               |        |              |               
|                             |                                                       | Common Stock                         |                    |  | Additional |   |    |             |  |       |           | Comprehensive |        |              | Treasury Stock |        |         | Total |              
|                             |                                                       |                                      |                    |  | Paid-in    |   |    | Accumulated |  |       | Deferred  |               | Income |              |                |        |         |       | Stockholders | 
|                             |                                                       | Shares                               |                    |  | Amount     |   |    | Capital     |  |       | Deficit   |               |        | Compensation |                | (Loss) |         |       | Shares        |  |  | Amount |        |      | Equity | 
|                             |                                                       |                                      |                    |  |            |   |    |             |  |       |           |               |        |              |                |        |         |       |               |  |  |        |        |      |        | 
|                             |                                                       | (In thousands, except share amounts) |                   
|Comprehensive loss:          |                                                       |                                      |                    |  |            |   |    |             |  |       |           |               |        |              |                |        |         |       |               |  |  |        |        |      |        |  |         |  |  |   |      |   |  |   |        |     
|                             | Increase to unrealized loss on short-term investments |                                      |                    |  |            |   |    |             |  |       |           |               |        |              |                |        |         |       |               |  |  |        |        | (521 | )      |  |         |  |  |   |      |   |  |   |        | (521 | )      
|                             |                                                       | Cumulative translation adjustment    |                    |  |            |   |    |             |  |       |           |               |        |              |                |        |         |       |               |  |  |        |        |      | 307    |  |         |  |  |   |      |   |  |   |        |      | 307     |        
|                             |                                                       | Net loss                             |                    |  |            |   |    |             |  |       |           |               |        |              |                |        | (36,531 | )     |               |  |  |        |        |      |        |  |         |  |  |   |      |   |  |   |        |      | (36,531 | )      
|                             |                                                       |                                      |                    |  |            |   |    |             |  |       |           |               |        |              |                |        |         |       |               |  |  |        |        |      |        |  |        
|                             |                                                       |                                      | Comprehensive loss |  |            |   |    |             |  |       |           |               |        |              |                |        |         |       |               |  |  |        |        |      |        |  |         |  |  |   |      |   |  |   |        |      |         | (36,745 | )
|                             |                                                       |                                      |                    |  |            |   |    |             |  |       |           |               |        |              |                |        |         |       |               |  |  |        |        |      |        |  |        
|Balance at December 31, 2004 |                                                       |                                      | 76,298,152         |  |            | $ | 76 |             |  | $     | 1,083,711 |               |        | $            | (1,024,091     | )      |         | $     |              |  |  | $      | (2,582 | )    |        |  | 156,009 |  |  | $ | (773 | ) |  | $ | 56,341 |     
|                             |                                                       |                                      |                    |  |            |   |    |             |  |       |           |               |        |              |                |        |         |       |               |  |  |        |        |      |        |  |        



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TERAYON COMMUNICATION SYSTEMS, INC.


CONSOLIDATED STATEMENTS OF CASH FLOWS


|                                                                                |                                                     |                                                     |         |         |       |   |          |         |       |   |          |         |         |  
|------------------------------------------------------------------------------- | --------------------------------------------------- | --------------------------------------------------- | ------- | ------- | ----- | - | -------- | ------- | ----- | - | -------- | ------- | ------- | -
|                                                                                |                                                     | Years Ended December 31,                            |        
|                                                                                |                                                     |                                                     |        
|                                                                                |                                                     | 2004                                                |         |         | 2003  |   |          | 2002    |      
|                                                                                |                                                     |                                                     |         |         |       |   |          |         |      
|                                                                                |                                                     | (In thousands)                                      |        
|Operating activities:                                                           |                                                     |                                                     |         |         |       |   |          |         |       |   |          |        
|Net loss                                                                        |                                                     | $                                                   | (36,531 | )       |       | $ | (50,353  | )       |       | $ | (44,213  | )      
|Adjustments to reconcile net loss to net cash used in operating
    activities: |                                                     |                                                     |         |         |       |   |          |         |       |   |          |        
|                                                                                | Settlement of Net Servicos account receivable       |                                                     |         |        |       |   |          |        |       |   |          | 1,118   |        
|                                                                                | Depreciation and amortization                       |                                                     |         | 6,416   |       |   |          | 9,369   |       |   |          | 11,572  |        
|                                                                                | Write-off and amortization of intangible assets     |                                                     |         |        |       |   |          |        |       |   |          | 3,972   |        
|                                                                                | Amortization of deferred compensation               |                                                     |         | 17      |       |   |          | 53      |       |   |          | 476     |        
|                                                                                | Gain on early retirement of debt                    |                                                     |         |        |       |   |          |        |       |   |          | (49,089 | )      
|                                                                                | Inventory provision                                 |                                                     |         | 11,980  |       |   |          | 4,086   |       |   |          | 6,109   |        
|                                                                                | Impairment of investment                            |                                                     |         |        |       |   |          |        |       |   |          | 4,500   |        
|                                                                                | Write-off of fixed assets                           |                                                     |         | 2,393   |       |   |          | 497     |       |   |          | 2,987   |        
|                                                                                | Compensation expense for issuance of common stock   |                                                     |         |        |       |   |          | 70      |       |   |          |        |        
|                                                                                | Value of common and preferred stock warrants issued |                                                     |         |        |       |   |          | 45      |       |   |          | 26      |        
|Net changes in operating assets and liabilities:                                |                                                     |                                                     |         |         |       |   |          |         |       |   |          |        
|                                                                                | Accounts receivable, net                            |                                                     |         | 12,645  |       |   |          | (12,844 | )     |   |          | 26,211  |        
|                                                                                | Accounts receivable from related parties            |                                                     |         | (2,506  | )     |   |          | 242     |       |   |          | 3,164   |        
|                                                                                | Inventory                                           |                                                     |         | (12,760 | )     |   |          | (12,193 | )     |   |          | 4,065   |        
|                                                                                | Other assets                                        |                                                     |         | 5,131   |       |   |          | 7,281   |       |   |          | 443     |        
|                                                                                | Accounts payable                                    |                                                     |         | (18,204 | )     |   |          | 2,129   |       |   |          | (18,901 | )      
|                                                                                | Accrued payroll and related expenses                |                                                     |         | (2,356  | )     |   |          | 310     |       |   |          | (3,214  | )      
|                                                                                | Deferred revenues                                   |                                                     |         | (844    | )     |   |          | 2,926   |       |   |          | (3,672  | )      
|                                                                                | Accrued warranty expenses                           |                                                     |         | (1,639  | )     |   |          | (3,098  | )     |   |          | 239     |        
|                                                                                | Accrued restructuring charges                       |                                                     |         | 1,066   |       |   |          | (2,254  | )     |   |          | (1,443  | )      
|                                                                                | Accrued vendor cancellation charges                 |                                                     |         | (2,348  | )     |   |          | (12,335 | )     |   |          | (3,426  | )      
|                                                                                | Other accrued liabilities                           |                                                     |         | (2,008  | )     |   |          | (2,331  | )     |   |          | (6,725  | )      
|                                                                                | Interest payable                                    |                                                     |         | (2      | )     |   |          | 3       |       |   |          | (1,918  | )      
|                                                                                |                                                     |                                                     |         |         |       |   |          |         |      
|Net cash used in operating activities                                           |                                                     |                                                     | (39,550 | )       |       |   | (68,397  | )       |       |   | (67,719  | )      
|                                                                                |                                                     |                                                     |         |         |       |   |          |         |      
|Investing activities:                                                           |                                                     |                                                     |         |         |       |   |          |         |       |   |          |        
|Purchases of short-term investments                                             |                                                     |                                                     | (54,517 | )       |       |   | (243,652 | )       |       |   | (288,186 | )      
|Proceeds from sales and maturities of short-term investments                    |                                                     |                                                     | 107,931 |         |       |   | 224,154  |         |       |   | 434,346  |        
|Purchases of property and equipment                                             |                                                     |                                                     | (2,698  | )       |       |   | (3,831   | )       |       |   | (7,186   | )      
|                                                                                |                                                     |                                                     |         |         |       |   |          |         |      
|Net cash provided by (used in) investing activities                             |                                                     |                                                     | 50,716  |         |       |   | (23,329  | )       |       |   | 138,974  |        
|                                                                                |                                                     |                                                     |         |         |       |   |          |         |      
|Financing activities:                                                           |                                                     |                                                     |         |         |       |   |          |         |       |   |          |        
|Principal payments on capital leases                                            |                                                     |                                                     | (124    | )       |       |   | (66      | )       |       |   | (127     | )      
|Payments on repurchase of common stock                                          |                                                     |                                                     |        |         |       |   |         |         |       |   | (5       | )      
|Repurchase of convertible subordinated notes                                    |                                                     |                                                     |        |         |       |   |         |         |       |   | (57,627  | )      
|Proceeds from issuance of common stock                                          |                                                     |                                                     | 1,681   |         |       |   | 3,729    |         |       |   | 3,872    |        
|                                                                                |                                                     |                                                     |         |         |       |   |          |         |      
|                                                                                |                                                     | Net cash provided by (used in) financing activities |         |         | 1,557 |   |          |         | 3,663 |   |          |         | (53,887 | )
|Effect of foreign currency exchange rate changes                                |                                                     |                                                     | 307     |         |       |   | 1,172    |         |       |   | (563     | )      
|                                                                                |                                                     |                                                     |         |         |       |   |          |         |      
|Net (decrease) increase in cash and cash equivalents                            |                                                     |                                                     | (13,030 | )       |       |   | (86,891  | )       |       |   | 16,805   |        
|Cash and cash equivalents at beginning of year                                  |                                                     |                                                     | 30,188  |         |       |   | 117,079  |         |       |   | 100,274  |        
|Cash and cash equivalents at end of year                                        |                                                     | $                                                   | 43,218  |         |       | $ | 30,188   |         |       | $ | 117,079  |        
|                                                                                |                                                     |                                                     |         |         |       |   |          |         |      
|Supplemental disclosures of cash flow information:                              |                                                     |                                                     |         |         |       |   |          |         |       |   |          |        
|Cash paid for income taxes                                                      |                                                     | $                                                   | 138     |         |       | $ | 194      |         |       | $ | 714      |        
|Cash paid for interest                                                          |                                                     | $                                                   | 3,268   |         |       | $ | 3,262    |         |       | $ | 8,387    |        
|Supplemental non-cash investing and financing activities:                       |                                                     |                                                     |         |         |       |   |          |         |       |   |          |        
|Deferred compensation relating to common stock issued to
    non-employees      |                                                     | $                                                   |        |         |       | $ | 53       |         |       | $ | 38       |        



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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS




|   |             
|-- | ------------
|1. | Organization



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







|   |                                           
|-- | ------------------------------------------
|2. | Summary of Significant Accounting Policies



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





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





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





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



65



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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)












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











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





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





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



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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)






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





|                                                              |  |                          |         |   |      |   |         |      |  |   |         |  
|------------------------------------------------------------- |  | ------------------------ | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                              |  | Years Ended December 31, |        
|                                                              |  |                          |        
|                                                              |  | 2004                     |         |   | 2003 |   |         | 2002 | 
|                                                              |  |                          |         |   |      |   |         |      | 
|Net loss                                                      |  | $                        | (36,531 | ) |      | $ | (50,353 | )    |  | $ | (44,213 | )
|                                                              |  |                          |         |   |      |   |         |      | 
|Shares used in computing basic and diluted net loss per share |  |                          | 75,861  |   |      |   | 74,212  |      |  |   | 72,803  |  
|                                                              |  |                          |         |   |      |   |         |      | 
|Basic and diluted net loss per share                          |  | $                        | (0.48   | ) |      | $ | (0.68   | )    |  | $ | (0.61   | )
|                                                              |  |                          |         |   |      |   |         |      | 





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





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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)








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





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



|                |  |              |        |  |      |   |        | 
|--------------- |  | ------------ | ------ |  | ---- | - | ------ | 
|                |  | December 31, |       
|                |  |              |       
|                |  | 2004         |        |  | 2003 |  
|                |  |              |        |  |      |  
|Finished goods  |  | $            | 13,763 |  |      | $ | 14,264 | 
|Work-in process |  |              | 1,501  |  |      |   | 660    | 
|Raw materials   |  |              | 1,880  |  |      |   | 1,440  | 
|                |  |              |        |  |      |  
|                |  | $            | 17,144 |  |      | $ | 16,364 | 
|                |  |              |        |  |      |  





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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)








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





|                                          |  |              |         |   |      |   |         |  
|----------------------------------------- |  | ------------ | ------- | - | ---- | - | ------- | -
|                                          |  | December 31, |        
|                                          |  |              |        
|                                          |  | 2004         |         |   | 2003 |  
|                                          |  |              |         |   |      |  
|Software and computers                    |  | $            | 21,415  |   |      | $ | 23,273  |  
|Furniture and equipment                   |  |              | 21,623  |   |      |   | 23,816  |  
|Leasehold improvements                    |  |              | 5,021   |   |      |   | 4,935   |  
|Automobiles                               |  |              | 16      |   |      |   | 16      |  
|                                          |  |              |         |   |      |  
|Property and equipment                    |  |              | 48,075  |   |      |   | 52,040  |  
|Accumulated depreciation and Amortization |  |              | (42,315 | ) |      |   | (40,169 | )
|                                          |  |              |         |   |      |  
|Property and equipment, net               |  | $            | 5,760   |   |      | $ | 11,871  |  
|                                          |  |              |         |   |      |  





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





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



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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)






| |                     
| | --------------------
| | Warranty Obligations





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





|                                                                                               |  |                          |         |   |      |   |         |      |  |   |         |  
|---------------------------------------------------------------------------------------------- |  | ------------------------ | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                                                               |  | Years Ended December 31, |        
|                                                                                               |  |                          |        
|                                                                                               |  | 2004                     |         |   | 2003 |   |         | 2002 | 
|                                                                                               |  |                          |         |   |      |   |         |      | 
|Net loss                                                                                       |  | $                        | (36,531 | ) |      | $ | (50,353 | )    |  | $ | (44,213 | )
|Add: Stock-based compensation under APB 25                                                     |  |                          | 22      |   |      |   | 123     |      |  |   | 476     |  
|Deduct: Stock option compensation expense determined under fair
    value-based method         |  |                          | (13,741 | ) |      |   | (22,210 | )    |  |   | (33,718 | )
|Employee stock purchase plan compensation expense determined
    under fair value-based method |  |                          | (928    | ) |      |   | (1,712  | )    |  |   | (1,990  | )
|                                                                                               |  |                          |         |   |      |   |         |      | 
|Pro forma net loss                                                                             |  | $                        | (51,178 | ) |      | $ | (74,152 | )    |  | $ | (79,445 | )
|                                                                                               |  |                          |         |   |      |   |         |      | 
|Pro forma basic and diluted net loss per share                                                 |  | $                        | (0.67   | ) |      | $ | (1.00   | )    |  | $ | (1.09   | )
|                                                                                               |  |                          |         |   |      |   |         |      | 



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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)


Accumulated Other Comprehensive Loss






|                                                         |  |              |        |   |      |   |        |  
|-------------------------------------------------------- |  | ------------ | ------ | - | ---- | - | ------ | -
|                                                         |  | Years Ended  |       
|                                                         |  | December 31, |       
|                                                         |  |              |       
|                                                         |  | 2004         |        |   | 2003 |  
|                                                         |  |              |        |   |      |  
|Cumulative translation adjustments                       |  | $            | (2,093 | ) |      | $ | (2,400 | )
|Unrealized gain/(loss) on available-for-sale investments |  |              | (489   | ) |      |   | 32     |  
|                                                         |  |              |        |   |      |  
|Total accumulated other comprehensive loss               |  | $            | (2,582 | ) |      | $ | (2,368 | )
|                                                         |  |              |        |   |      |  



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





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





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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




|   |                                    
|-- | -----------------------------------
|3. | Fair Value of Financial Instruments







|                                          |       |                   |        |        |            |       |            |   |           |       |      |      |      |   |        |        |        | 
|----------------------------------------- | ----- | ----------------- | ------ | ------ | ---------- | ----- | ---------- | - | --------- | ----- | ---- | ---- | ---- | - | ------ | ------ | ------ | 
|                                          |       | December 31, 2004 |       
|                                          |       |                   |       
|                                          |       |                   |        | Gross  |            | Gross |            |   | Estimated |      
|                                          |       | Amortized         |        |        | Unrealized |       | Unrealized |   |           | Fair  |     
|Short-term investments                    |       | Cost              |        |        | Gains      |       | Losses     |   |           | Value |     
|                                          |       |                   |        |        |            |       |            |   |           |       |     
|                                          |       | (In thousands)    |       
|Investments maturing in less than 1 year: |       |                   |        |        |            |       |            |   |           |       |      |      |      |   |        |       
|Government agency obligations             |       | $                 | 8,000  |        |            | $     |           |   |           | $     | (72  | )    |      | $ | 7,928  |       
|                                          |       |                   |        |        |            |       |            |   |           |       |      |     
|                                          | Total |                   |        | 8,000  |            |       |            |  |           |       |      | (72  | )    |   |        | 7,928  |       
|Investments maturing in 1-2 years:        |       |                   |        |        |            |       |            |   |           |       |      |      |      |   |        |       
|Government agency obligations             |       |                   | 47,006 |        |            |       |           |   |           |       | (417 | )    |      |   | 46,589 |       
|                                          |       |                   |        |        |            |       |            |   |           |       |      |     
|                                          | Total |                   |        | 47,006 |            |       |            |  |           |       |      | (417 | )    |   |        | 46,589 |       
|                                          |       |                   |        |        |            |       |            |   |           |       |      |     
|                                          |       | Total             |        | $      | 55,006     |       |            | $ |          |       |      | $    | (489 | ) |        | $      | 54,517 | 
|                                          |       |                   |        |        |            |       |            |   |           |       |      |     

|                                          |       |                   |        |        |            |   |       |            |    |           |       |     |     |   |        |        |         | 
|----------------------------------------- | ----- | ----------------- | ------ | ------ | ---------- | - | ----- | ---------- | -- | --------- | ----- | --- | --- | - | ------ | ------ | ------- | 
|                                          |       | December 31, 2003 |       
|                                          |       |                   |       
|                                          |       |                   |        | 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                          |       | $                 | 38,940 |        |            | $ |      |            |    | $         | (12   | )   |     | $ | 38,928 |       
|Fixed income corporate securities         |       |                   | 2,223  |        |            |   | 1     |            |    |           |      |     |     |   | 2,224  |       
|Government agency obligations             |       |                   | 7,918  |        |            |   | 1     |            |    |           |      |     |     |   | 7,919  |       
|                                          |       |                   |        |        |            |   |       |            |    |           |       |    
|                                          | Total |                   |        | 49,081 |            |   |       | 2          |    |           |       | (12 | )   |   |        | 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             |        | $      | 108,420    |   |       | $          | 70 |           |       | $   | (38 | ) |        | $      | 108,452 | 
|                                          |       |                   |        |        |            |   |       |            |    |           |       |    



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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




|   |            
|-- | -----------
|4. | Commitments



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









|                       |  |           |        | 
|---------------------- |  | --------- | ------ | 
|                       |  | Operating |       
|                       |  | Leases    |       
|                       |  |           |       
|2005                   |  | $         | 7,452  | 
|2006                   |  |           | 4,900  | 
|2007                   |  |           | 3,177  | 
|2008                   |  |           | 3,087  | 
|2009                   |  |           | 2,579  | 
|Thereafter             |  |           | 188    | 
|                       |  |           |       
|Total minimum payments |  | $         | 21,383 | 
|                       |  |           |       





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



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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)










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





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







|   |                      
|-- | ---------------------
|5. | Accrued Severance Pay





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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)






|                             |  |           |        |  
|---------------------------- |  | --------- | ------ | -
|                             |  | Executive |       
|                             |  | Severance |       
|                             |  |           |       
|Balance at December 31, 2003 |  | $         |       |  
|Charges                      |  |           | 3,451  |  
|Cash payments                |  |           | (3,020 | )
|                             |  |           |       
|Balance at December 31, 2004 |  | $         | 431    |  
|                             |  |           |       





6.     Restructuring Charges, net
and Asset Write-offs


SFAS No. 146 Accounting for Costs Associated
with Exit or Disposal Activities, Employers Accounting for
Post Employment Benefits.




| |                    
| | -------------------
| | 2004 Restructurings



75



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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)
















|                             |  |              |        |          |             |   |        |            |  |   |       |   |  |   |        |  
|---------------------------- |  | ------------ | ------ | -------- | ----------- | - | ------ | ---------- |  | - | ----- | - |  | - | ------ | -
|                             |  |              |        | Aircraft |             |   | Excess |            |  |  
|                             |  | Involuntary  |        |          | Lease       |   |        | Leased     |  |   |      
|                             |  | Terminations |        |          | Termination |   |        | Facilities |  |   | Total |  
|                             |  |              |        |          |             |   |        |            |  |   |       |  
|Balance at December 31, 2003 |  | $            |       |          |             | $ |       |            |  | $ |      |   |  | $ |       |  
|Charges                      |  |              | 2,297  |          |             |   | 934    |            |  |   | 2,523 |   |  |   | 5,754  |  
|Cash payments                |  |              | (1,467 | )        |             |   | (1,194 | )          |  |   | (850  | ) |  |   | (3,511 | )
|Changes in estimates         |  |              | (238   | )        |             |   | 952    |            |  |   | 325   |   |  |   | 1,039  |  
|                             |  |              |        |          |             |   |        |            |  |   |       |  
|Balance at December 31, 2004 |  | $            | 592    |          |             | $ | 692    |            |  | $ | 1,998 |   |  | $ | 3,282  |  
|                             |  |              |        |          |             |   |        |            |  |   |       |  

76



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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




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





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





|                             |  |              |        |            |           |   |        |       |  |   |        |  
|---------------------------- |  | ------------ | ------ | ---------- | --------- | - | ------ | ----- |  | - | ------ | -
|                             |  |              |        | Excess     |           |   |       
|                             |  |              |        | Leased     |           |   |       
|                             |  |              |        | Facilities |           |   |       
|                             |  |              |        | and        |           |   |       
|                             |  | Involuntary  |        |            | Cancelled |   |        |      
|                             |  | Terminations |        |            | Contracts |   |        | Total | 
|                             |  |              |        |            |           |   |        |       | 
|Charges                      |  | $            | 2,319  |            |           | $ | 1,322  |       |  | $ | 3,641  |  
|Cash payments                |  |              | (2,131 | )          |           |   |       |       |  |   | (2,131 | )
|Reclassifications            |  |              | (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  |  
|Cash payments                |  |              |       |            |           |   |       |       |  |   |       |  
|Reclassifications            |  |              |       |            |           |   | (1,088 | )     |  |   | (1,088 | )
|Change in estimate           |  |              |       |            |           |   | (100   | )     |  |   | (100   | )
|                             |  |              |        |            |           |   |        |       | 
|Balance at December 31, 2004 |  | $            |       |            |           | $ | 15     |       |  | $ | 15     |  
|                             |  |              |        |            |           |   |        |       | 



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



77



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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)






|                             |  |              |        |            |           |   |        |       |  |   |        |  
|---------------------------- |  | ------------ | ------ | ---------- | --------- | - | ------ | ----- |  | - | ------ | -
|                             |  |              |        | Excess     |           |   |       
|                             |  |              |        | Leased     |           |   |       
|                             |  |              |        | Facilities |           |   |       
|                             |  |              |        | and        |           |   |       
|                             |  | Involuntary  |        |            | Cancelled |   |        |      
|                             |  | Terminations |        |            | Contracts |   |        | Total | 
|                             |  |              |        |            |           |   |        |       | 
|Charges                      |  | $            | 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 | )
|Reclassifications            |  |              | (1,177 | )          |           |   | 1,177  |       |  |   |       |  
|                             |  |              |        |            |           |   |        |       | 
|Balance at December 31, 2002 |  |              |       |            |           |   | 5,243  |       |  |   | 5,243  |  
|Cash payments                |  |              |       |            |           |   | (1,685 | )     |  |   | (1,685 | )
|Change in estimate           |  |              |       |            |           |   | (261   | )     |  |   | (261   | )
|                             |  |              |        |            |           |   |        |       | 
|Balance at December 31, 2003 |  |              |       |            |           |   | 3,297  |       |  |   | 3,297  |  
|Cash payments                |  |              |       |            |           |   | (1,170 | )     |  |   | (1,170 | )
|Reclassifications            |  |              |       |            |           |   | 1,088  |       |  |   | 1,088  |  
|Change in estimate           |  |              |       |            |           |   | (1,377 | )     |  |   | (1,377 | )
|                             |  |              |        |            |           |   |        |       | 
|Balance at December 31, 2004 |  | $            |       |            |           | $ | 1,838  |       |  | $ | 1,838  |  
|                             |  |              |        |            |           |   |        |       | 



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







78



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##### Table of Contents



TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)






|   |                                   
|-- | ----------------------------------
|7. | Impairment of Long-Term Investment





|   |                               
|-- | ------------------------------
|8. | Convertible Subordinated Notes











|   |              
|-- | -------------
|9. | Contingencies



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



79



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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)


















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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)














81



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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)






|    |                     
|--- | --------------------
|10. | Stockholders Equity



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







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



82



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##### Table of Contents



TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




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



|                             |  |              |            | 
|---------------------------- |  | ------------ | ---------- | 
|                             |  | December 31, |           
|                             |  | 2004         |           
|                             |  |              |           
|Common stock options         |  |              | 28,719,914 | 
|Employee stock purchase plan |  |              | 1,202,733  | 
|                             |  |              |           
|Total                        |  |              | 29,922,647 | 
|                             |  |              |           



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



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





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







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





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



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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)










84



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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




|                             |                    |               |            |                     |           |  |            |                  |   |   |      |       | 
|---------------------------- | ------------------ | ------------- | ---------- | ------------------- | --------- |  | ---------- | ---------------- | - | - | ---- | ----- | 
|                             |                    |               |            | Options Outstanding |          
|                             |                    | Options       |            |                     |           | 
|                             |                    | Available for |            |                     | Number of |  |            | Weighted-Average |  
|                             |                    | Grant         |            |                     | Shares    |  |            | Exercise Price   |  
|                             |                    |               |            |                     |           |  |            |                  |  
|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 |      
|                             | Options authorized |               |            | 3,000,000           |           |  |            |                 |   |   |      |       | 
|Options granted              |                    |               | (4,738,944 | )                   |           |  | 4,738,944  |                  |   | $ | 1.95 |      
|                             | Options exercised  |               |            |                    |           |  |            | (225,645         | ) |   | $    | 2.19  | 
|                             | Options canceled   |               |            | 5,174,420           |           |  |            | (5,174,420       | ) |   | $    | 5.18  | 
|                             |                    |               |            |                     |           |  |            |                  |  
|Balance at December 31, 2004 |                    |               | 11,917,076 |                     |           |  | 16,802,838 |                  |   | $ | 5.37 |      
|                             |                    |               |            |                     |           |  |            |                  |  



|                         |       |                     |           |            |                     |  |          |          |  |   |             |          |  |          |           |            |  |   |       |      | 
|------------------------ | ----- | ------------------- | --------- | ---------- | ------------------- |  | -------- | -------- |  | - | ----------- | -------- |  | -------- | --------- | ---------- |  | - | ----- | ---- | 
|                         |       | Options Outstanding |           |            |                    
|                         |       |                     |           |            | Options Exercisable | 
|                         |       |                     |           | Weighted   |                     |  |          |          |  |  
|                         |       |                     |           | Average    |                     |  | Weighted |          |  |   |             | Weighted | 
|                         |       |                     |           | Remaining  |                     |  | Average  |          |  |   |             | Average  | 
|                         |       | Shares              |           |            | Contractual         |  |          | Exercise |  |   | Exercisable |          |  | Exercise |          
|Range of Exercise Prices |       | Outstanding         |           |            | Life                |  |          | Price    |  |   | Options     |          |  | Price    |          
|                         |       |                     |           |            |                     |  |          |          |  |   |             |          |  |          |          
|$0.00 - $1.99            |       |                     | 3,777,098 |            |                     |  | 9.48     |          |  | $ | 1.74        |          |  |          | 162,549   |            |  | $ | 1.26  |     
|$2.46 - $4.26            |       |                     | 3,562,965 |            |                     |  | 8.40     |          |  |   | 2.44        |          |  |          | 1,963,959 |            |  |   | 2.45  |     
|$4.27 - $6.50            |       |                     | 3,312,257 |            |                     |  | 7.22     |          |  |   | 4.59        |          |  |          | 1,998,096 |            |  |   | 4.85  |     
|$6.51 - $8.39            |       |                     | 5,348,910 |            |                     |  | 6.12     |          |  |   | 6.80        |          |  |          | 5,220,337 |            |  |   | 6.80  |     
|$8.51 - $123.50          |       |                     | 801,608   |            |                     |  | 5.34     |          |  |   | 29.23       |          |  |          | 735,213   |            |  |   | 30.94 |     
|                         |       |                     |           |            |                     |  |          |          |  |   |             |          |  |          |          
|                         | Total |                     |           | 16,802,838 |                     |  |          | 7.54     |  |   | $           | 5.37     |  |          |           | 10,080,154 |  |   | $     | 7.24 | 
|                         |       |                     |           |            |                     |  |          |          |  |   |             |          |  |          |          



Employee Stock Purchase Plan




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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)








|     |                              |           |  |            |   |               |  |          |  |  |  |         |  |  |  |     |  
|---- | ---------------------------- | --------- |  | ---------- | - | ------------- |  | -------- |  |  |  | ------- |  |  |  | --- | -
|     |                              | Risk Free |  |            |   | Weighted      |  |         
|     |                              | Interest  |  | Volatility |   | Average       |  | Dividend
|     |                              | Rates     |  | Factor     |   | Expected Life |  | Yield   
|     |                              |           |  |            |   |               |  |         
|2002 |                              |           |  |            |   |               |  |          |  |  |  |         |  |  |  |    
|     | Stock option plans           |           |  | 4.22       | % |               |  | 1.50     |  |  |  | 5.0 yrs |  |  |  | 0.0 | %
|     | Employee stock purchase plan |           |  | 4.36       | % |               |  | 1.50     |  |  |  | 0.5 yrs |  |  |  | 0.0 | %
|2003 |                              |           |  |            |   |               |  |          |  |  |  |         |  |  |  |    
|     | Stock option plans           |           |  | 2.67       | % |               |  | 0.87     |  |  |  | 5.0 yrs |  |  |  | 0.0 | %
|     | Employee stock purchase plan |           |  | 2.88       | % |               |  | 1.54     |  |  |  | 0.5 yrs |  |  |  | 0.0 | %
|2004 |                              |           |  |            |   |               |  |          |  |  |  |         |  |  |  |    
|     | Stock option plans           |           |  | 3.47       | % |               |  | 0.79     |  |  |  | 5.0 yrs |  |  |  | 0.0 | %
|     | Employee stock purchase plan |           |  | 1.27       | % |               |  | 1.54     |  |  |  | 0.5 yrs |  |  |  | 0.0 | %





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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




|    |             
|--- | ------------
|11. | Income Taxes



|          |         |                |                |      |      |   |     |      |     |   |     |     |     |   | 
|--------- | ------- | -------------- | -------------- | ---- | ---- | - | --- | ---- | --- | - | --- | --- | --- | - | 
|          |         | Years Ended    |               
|          |         | December 31,   |               
|          |         |                |               
|          |         | 2004           |                |      | 2003 |   |     | 2002 |    
|          |         |                |                |      |      |   |     |      |    
|          |         | (In thousands) |               
|Current:  |         |                |                |      |      |   |     |      |     |   |     |    
|          | Federal |                | $              |     |      |   | $   |     |     |   | $   |    |    
|          | State   |                |                | 40   |      |   |     |     |     |   |     | 20  |    
|          | Foreign |                |                | (116 | )    |   |     | 316  |     |   |     | 218 |    
|          |         |                |                |      |      |   |     |      |    
|          |         | Total current  |                |      | (76  | ) |     |      | 316 |   |     |     | 238 |  
|Deferred: |         |                |               |      |      |   |    |      |     |   |    |    
|          | Federal |                |                |     |      |   |     |     |     |   |     |    |    
|          | State   |                |                |     |      |   |     |     |     |   |     |    |    
|          | Foreign |                |                |     |      |   |     |     |     |   |     |    |    
|          |         |                |                |      |      |   |     |      |    
|          |         |                | Total deferred |      |      |  |     |      |     |  |     |     |     |  | 
|Total     |         | $              | (76            | )    |      | $ | 316 |      |     | $ | 238 |    
|          |         |                |                |      |      |   |     |      |    



|                                                        |  |                          |         |   |      |   |         |      |  |   |         |  
|------------------------------------------------------- |  | ------------------------ | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                        |  | Years Ended December 31, |        
|                                                        |  |                          |        
|                                                        |  | 2004                     |         |   | 2003 |   |         | 2002 | 
|                                                        |  |                          |         |   |      |   |         |      | 
|Tax benefit at U.S. statutory rate                      |  | $                        | (12,812 | ) |      | $ | (17,624 | )    |  | $ | (15,391 | )
|Loss for which no tax benefit is currently recognizable |  |                          | 12,747  |   |      |   | 17,536  |      |  |   | 15,391  |  
|Other, net                                              |  |                          | (11     | ) |      |   | 404     |      |  |   | 238     |  
|                                                        |  |                          |         |   |      |   |         |      | 
|                                                        |  | $                        | (76     | ) |      | $ | 316     |      |  | $ | 238     |  
|                                                        |  |                          |         |   |      |   |         |      | 



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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




|                     |                                   |                                      |   |         |          |   |   |         |          |  
|-------------------- | --------------------------------- | ------------------------------------ | - | ------- | -------- | - | - | ------- | -------- | -
|                     |                                   | December 31,                         |  
|                     |                                   |                                      |  
|                     |                                   | 2004                                 |   |         | 2003     |  
|                     |                                   |                                      |   |         |          |  
|Deferred tax assets: |                                   |                                      |   |         |          |   |   |        
|                     | Net operating loss carry forwards |                                      | $ | 145,066 |          |   | $ | 149,862 |         
|                     | Tax credit carry forwards         |                                      |   | 16,245  |          |   |   | 19,505  |         
|                     |                                   | Reserves and accruals                |   |         | 10,132   |   |   |         | 9,949    |  
|                     |                                   | Capitalized research and development |   |         | 4,172    |   |   |         | 8,761    |  
|                     | Intangible asset amortization     |                                      |   | 30,051  |          |   |   | 38,864  |         
|                     | Other, net                        |                                      |   | 14,891  |          |   |   | 12,130  |         
|                     |                                   |                                      |   |         |          |  
|                     |                                   | Gross deferred tax assets            |   |         | 220,557  |   |   |         | 239,071  |  
|                     |                                   | Valuation allowance                  |   |         | (220,557 | ) |   |         | (239,071 | )
|                     |                                   |                                      |   |         |          |  
|                     |                                   | Total deferred tax assets            |   | $       |         |   |   | $       |         |  
|                     |                                   |                                      |   |         |          |  









|    |                          
|--- | -------------------------
|12. | Defined Contribution Plan





|    |                    
|--- | -------------------
|13. | Segment Information



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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




|                  |           |                                   |       |   |        |         |  |      |        |         |  |   |        |         | 
|----------------- | --------- | --------------------------------- | ----- | - | ------ | ------- |  | ---- | ------ | ------- |  | - | ------ | ------- | 
|                  |           | Years Ended December 31,          |      
|                  |           |                                   |      
|                  |           | 2004                              |       |   | 2003   |         |  | 2002 |       
|                  |           |                                   |       |   |        |         |  |      |       
|                  |           | (In thousands)                    |      
|Geographic areas: |           |                                   |       |   |        |         |  |      |        |         |  |  
|                  | Revenues: |                                   |       |   |        |         |  |      |        |         |  |   |       
|                  |           | United States                     |       | $ | 83,212 |         |  | $    | 74,341 |         |  | $ | 41,150 |        
|                  |           | Americas, excluding United States |       |   | 4,126  |         |  |      | 3,713  |         |  |   | 20,530 |        
|                  |           | EMEA excluding Israel             |       |   | 29,348 |         |  |      | 17,635 |         |  |   | 11,381 |        
|                  |           | Israel                            |       |   | 6,681  |         |  |      | 7,038  |         |  |   | 8,283  |        
|                  |           | Asia excluding Japan              |       |   | 17,999 |         |  |      | 9,575  |         |  |   | 36,214 |        
|                  |           | Japan                             |       |   | 9,172  |         |  |      | 21,183 |         |  |   | 11,845 |        
|                  |           |                                   |       |   |        |         |  |      |       
|                  |           |                                   | Total |   | $      | 150,538 |  |      | $      | 133,485 |  |   | $      | 129,403 | 
|                  |           |                                   |       |   |        |         |  |      |       

|                   |                                   |                      |              |        |         |         |   |        |         |         | 
|------------------ | --------------------------------- | -------------------- | ------------ | ------ | ------- | ------- | - | ------ | ------- | ------- | 
|                   |                                   | December 31,         |             
|                   |                                   |                      |             
|                   |                                   | 2004                 |              |        | 2003    |        
|                   |                                   |                      |              |        |         |        
|                   |                                   | (In thousands)       |             
|Long-lived assets: |                                   |                      |              |        |         |         |   |       
|                   | United States                     |                      | $            | 4,423  |         |         | $ | 9,555  |        
|                   | Americas, excluding United States |                      |              | 402    |         |         |   | 810    |        
|                   | EMEA excluding Israel             |                      |              | 131    |         |         |   | 176    |        
|                   | Israel                            |                      |              | 687    |         |         |   | 1,157  |        
|                   | Asia                              |                      |              | 117    |         |         |   | 173    |        
|                   |                                   |                      |              |        |         |        
|                   | Total long-lived assets           |                      |              | 5,760  |         |         |   | 11,871 |        
|                   |                                   | Total current assets |              |        | 137,625 |         |   |        | 191,348 |        
|                   | Other assets                      |                      |              | 10,349 |         |         |   | 12,021 |        
|                   |                                   |                      |              |        |         |        
|                   |                                   |                      | Total assets |        | $       | 153,734 |   |        | $       | 215,240 | 
|                   |                                   |                      |              |        |         |        



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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




|    |                           
|--- | --------------------------
|14. | Related Party Transactions











|    |                   
|--- | ------------------
|15. | Product Warranties



|                                                           |  |           |       |  |            |  |       |             |  |         |        |   |  |   |       | 
|---------------------------------------------------------- |  | --------- | ----- |  | ---------- |  | ----- | ----------- |  | ------- | ------ | - |  | - | ----- | 
|                                                           |  | Balance   |       |  | Additions  |  |       |             |  | Balance |       
|                                                           |  | at        |       |  | Charged to |  |       |             |  | at End  |       
|                                                           |  | Beginning |       |  | Costs and  |  |       |             |  | of      |       
|                                                           |  | of Period |       |  | Expenses   |  |       | Settlements |  |         | Period |  
|                                                           |  |           |       |  |            |  |       |             |  |         |        |  
|Year ended December 31, 2002
    Accrued warranty expenses |  | $         | 8,368 |  |            |  | 2,730 |             |  |         | (2,491 | ) |  | $ | 8,607 | 
|Year ended December 31, 2003
    Accrued warranty expenses |  | $         | 8,607 |  |            |  | 2,287 |             |  |         | (5,385 | ) |  | $ | 5,509 | 
|Year ended December 31, 2004
    Accrued warranty expenses |  | $         | 5,509 |  |            |  | 1,450 |             |  |         | (3,089 | ) |  | $ | 3,870 | 

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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




| |                                                                        
| | -----------------------------------------------------------------------
| | Guarantees, Including Indirect Guarantees of Indebtedness
    of Others





|    |                       
|--- | ----------------------
|16. | Sale of Certain Assets









|    |                  
|--- | -----------------
|17. | Subsequent Events



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TERAYON COMMUNICATION SYSTEMS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)






|    |                                   
|--- | ----------------------------------
|18. | Unaudited Quarterly Financial Data



|                                                                             |  |         |         |   |        |   |        |       |  |   |         |   |  |   |        |  
|---------------------------------------------------------------------------- |  | ------- | ------- | - | ------ | - | ------ | ----- |  | - | ------- | - |  | - | ------ | -
|                                                                             |  | Quarter |        
|                                                                             |  |         |        
|2004                                                                         |  | First   |         |   | Second |   |        | Third |  |   | Fourth  |  
|                                                                             |  |         |         |   |        |   |        |       |  |   |         |  
|Total revenues                                                               |  | $       | 41,168  |   |        | $ | 42,782 |       |  | $ | 37,202  |   |  | $ | 29,386 |  
|Gross profit                                                                 |  |         | 12,397  |   |        |   | 15,122 |       |  |   | 6,270   |   |  |   | 9,829  |  
|Restructuring charges (net), executive severance and asset
    write-offs(1) |  |         | 3,367   |   |        |   | 3,579  |       |  |   | 1,463   |   |  |   | 2,750  |  
|Net loss                                                                     |  |         | (10,247 | ) |        |   | (4,861 | )     |  |   | (13,520 | ) |  |   | (7,903 | )
|Basic and diluted net loss per share                                         |  | $       | (0.14   | ) |        | $ | (0.06  | )     |  | $ | (0.18   | ) |  | $ | (0.10  | )

|                                                                             |  |         |         |   |        |   |         |       |  |   |        |   |  |   |        |  
|---------------------------------------------------------------------------- |  | ------- | ------- | - | ------ | - | ------- | ----- |  | - | ------ | - |  | - | ------ | -
|                                                                             |  | Quarter |        
|                                                                             |  |         |        
|2003                                                                         |  | First   |         |   | Second |   |         | Third |  |   | Fourth |  
|                                                                             |  |         |         |   |        |   |         |       |  |   |        |  
|Total revenues                                                               |  | $       | 22,268  |   |        | $ | 30,599  |       |  | $ | 37,628 |   |  | $ | 42,990 |  
|Gross profit                                                                 |  |         | 2,675   |   |        |   | 6,863   |       |  |   | 10,194 |   |  |   | 12,719 |  
|Restructuring charges (net), executive severance 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  | )








|    |                                                                                  
|--- | ---------------------------------------------------------------------------------
|(1) | See Note 6 for an explanation for restructuring charges and
    asset write-offs.

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






Item
9A.Controls
and Procedures




| |                                                  
| | -------------------------------------------------
| | Evaluation of Disclosure Controls and Procedures.













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| |                                                                      
| | ---------------------------------------------------------------------
| | Managements Report on Internal Control over
    Financial Reporting.

Internal Control  Integrated Framework






| |                                                                                                                                                                                                                                                                                                               
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (1) pertain to the maintenance of records that, in
    reasonable detail, accurately and fairly reflect our
    transactions and dispositions of assets;                                                                                                                                                      
|
| | (2) provide reasonable assurance that transactions are
    recorded as necessary to permit preparation of financial
    statements in accordance with GAAP, and that our receipts and
    expenditures are being made only in accordance with
    authorizations of our management and board of directors; and
|
| | (3) provide reasonable assurance regarding prevention or
    timely detection of unauthorized acquisition, use, or
    disposition of our assets that could have a material effect on
    the financial statements.                                                                                           













Changes in internal control over financial reporting.


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| |                                                  
| | -------------------------------------------------
| | Remediation Steps to Address Material Weaknesses.



Documentation of Internal Communication with Our Finance
Department.


Additional Experienced Finance Personnel.




| |                                                                                                                                                                                                                         
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (i) a commitment to promptly hire a permanent Vice
    President of Finance/controller;                                                                                                                                 
|
| | (ii) hiring into our finance department an additional
    person with SEC reporting experience;                                                                                                                         
|
| | (iii) increasing staffing in the finance department;                                                                                                                                                                    
|
| | (iv) developing procedures to train new employees and/or
    consultants in the finance department on our disclosure
    procedures and controls, our company and our actions in the
    previous reporting periods; and
|
| | (v) improving the review process that occurs prior to
    providing the initial draft of the periodic report to our
    independent auditors for review.                                                                






|         |                  
|-------- | -----------------
|Item 9B. | Other Information






PART III







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








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








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








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



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






PART IV







|         |                                        
|-------- | ---------------------------------------
|Item 15. | Exhibits, Financial Statement Schedules





| |                                                                                                                                                                                                                                 
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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:



| |   |                                                                                                                                                                                                                                                
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | * | Reports of Independent Registered Public Accounting Firm.                                                                                                                                                                                      
|
| | * | Consolidated Balance Sheets, as of December 31, 2004 and
    2003.                                                                                                                                                                             
|
| | * | 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, 2004, 2003, and 2002.



| |                                                                                                                                                                                                                                                                                                                                   
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 2. Consolidated Financial Statement Schedules. The
    following consolidated financial statement schedule of Terayon
    Communication Systems, Inc. is 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, 2004, 2003 and 2002.



| |                                                                                                                                                                                                            
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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.



| |                                                                                                                                                           
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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.

|        |    |    |                     |                                                                                                                                                       
|------- | -- | -- | ------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------
|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.(6)                                                                   
|        | 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.                                   

96



---



##### Table of Contents



|        |    |     |                     |                                                                                                                                                                                                
|------- | -- | --- | ------------------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |    |     |                    
|Number  |    |     | Exhibit Description
|        |    |     |                    
|        | 10 | .2  |                     | 1995 Stock Option Plan, as amended.(1)                                                                                                                                                         
|        | 10 | .3  |                     | 1997 Equity Incentive Plan, as amended.(9)                                                                                                                                                     
|        | 10 | .4  |                     | 1998 Employee Stock Purchase Plan, as amended.(12)                                                                                                                                             
|        | 10 | .5  |                     | 1998 Non-Employee Directors Stock Option Plan as amended.(1)                                                                                                                                   
|        | 10 | .6  |                     | 1998 Employee Stock Purchase Plan Offering for Foreign
    Employees.(7)                                                                                                                       
|        | 10 | .7  |                     | 1999 Non-Officer Equity Incentive Plan, as amended.(13)                                                                                                                                        
|        | 10 | .8  |                     | Azrieli Center Offices Lease Agreement, dated January 23,
    2002, between Canit HaShalom Investments Ltd. and Terayon
    Communication Systems, Inc.(9)                                     
|        | 10 | .9  |                     | Azrieli Center Agreement to Transfer Lease Rights dated
    23rd day of January, 2000(11)                                                                                                      
|        | 10 | .10 |                     | Data Over Cable Service Interface Specifications License
    Agreement, dated December 21, 2001, between Terayon
    Communication Systems, Inc. and Cable Television Laboratories,
    Inc.(9)
|        | 10 | .11 |                     | 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 | .12 |                     | Data Over Cable Service Interface Specifications License
    Agreement, dated December 21, 2001, between Imedia
    Semiconductor Corporation and Cable Television Laboratories,
    Inc.(9)   
|        | 10 | .13 |                     | 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 | .14 |                     | Lease Agreement, dated September 18, 1996, between Sobrato
    Interests III and VeriFone.(10)                                                                                                 
|        | 10 | .15 |                     | Sublease, dated April 1, 2002, by and between Terayon
    Communication Systems, Inc. and Hewlett-Packard Company.(10)                                                                         
|        | 10 | .16 |                     | Aircraft Lease Agreement, dated February 8, 2002, between
    Terayon Communication Systems, Inc. and General Electric Capital
    Corporation.(11)                                            
|        | 10 | .17 |                     | Letter of Credit Agreement, dated February 8, 2002, between
    Terayon Communication Systems, Inc. and General Electric Capital
    Corporation.(11)                                          
|        | 10 | .18 |                     | Agreement dated January 23, 2004, between Terayon
    Communication Systems, Inc. and YAS Corporation(15).                                                                                     
|        | 10 | .19 |                     | First Amendment to Aircraft Lease Agreement, dated
    December 31, 2003, between Terayon Communication Systems,
    Inc. and General Electric Capital Corporation.(17)                        
|        | 10 | .20 |                     | Code of Business Conduct.(17)                                                                                                                                                                  
|        | 10 | .21 |                     | Notification Letter of Intent to Terminate or Sublease the
    Aircraft Lease Agreement dated March 12, 2004.(17)                                                                              
|        | 10 | .22 |                     | Employment Agreement dated July 22, 2004 between Terayon
    Communication Systems, Inc. and Jerry D. Chase(16).                                                                               
|        | 10 | .23 |                     | Severance Agreement dated July 22, 2004, between Terayon
    Communication Systems, Inc. and Jerry D. Chase(16).                                                                               
|        | 10 | .24 |                     | Proprietary Information and Inventions Agreement dated
    July 22, 2004 between Terayon Communication Systems, Inc.
    and Jerry D. Chase(16).                                               
|        | 10 | .25 |                     | Aircraft Sublease Agreement dated August 24, 2004 between
    Terayon Communication Systems, Inc. and United Furniture
    Equipment Rental, Inc.(16).                                         
|        | 10 | .26 |                     | Employment Agreement dated November 8, 2004 between Terayon
    Communication Systems, Inc. and Mark A. Richman.                                                                               
|        | 10 | .27 |                     | Form of Severance Agreement between Terayon Communication
    Systems, Inc. and Mark A. Richman.                                                                                               
|        | 10 | .28 |                     | Proprietary Information and Inventions Agreement dated
    November 10, 2004 between Terayon Communication Systems,
    Inc. and Mark A. Richman.                                              
|        | 10 | .29 |                     | Separation Agreement dated August 2, 2004 between Terayon
    Communication Systems, Inc. and Edward Lopez(16).                                                                                

97



---



##### Table of Contents



|        |    |     |                     |                                                                                                                        
|------- | -- | --- | ------------------- | -----------------------------------------------------------------------------------------------------------------------
|Exhibit |    |     |                    
|Number  |    |     | Exhibit Description
|        |    |     |                    
|        | 10 | .30 |                     | Form of Option Agreement for the Terayon Communication Systems,
    Inc. 1997 Equity Incentive Plan(18).               
|        | 10 | .31 |                     | Transition Agreement dated June 21, 2004, between Terayon
    Communication Systems, Inc. and Zaki Rakib(15).          
|        | 10 | .32 |                     | Employment Agreement dated June 21, 2004, between Terayon
    Communication Systems, Inc. and Selim (Shlomo) Rakib(15).
|        | 10 | .33 |                     | Form of Option Agreement for the Terayon Communication Systems,
    Inc. 1998 Non-Employee Directors Stock Option Plan 
|        | 21 | .1  |                     | List of Subsidiaries.                                                                                                  
|        | 23 | .1  |                     | Consent of Ernst & Young LLP, Independent Registered
    Public Accounting Firm.                                       
|        | 24 | .1  |                     | Power of Attorney (see signatures 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.                        
|    
|(15) | Incorporated by reference to our Report on Form 10-Q filed
    on July 27, 2004.                           
|    
|(16) | Incorporated by reference to our Report on Form 10-Q filed
    on November 9, 2004.                        
|    
|(17) | Incorporated by reference to our Report on Form 10-K filed
    on March 15, 2004.                          
|    
|(18) | Incorporated by reference to our Report on Form 8-K filed
    on September 14, 2004                        

98



---



##### 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, 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 | 
|Year ended December 31, 2004 |                                 |                |   |        |            |  |  |            |   |         |           |        |  |  |   |       
|                             | Allowance for doubtful accounts |                | $ | 3,591  |            |  |  | (2,101     | ) |         |           | 201    |  |  | $ | 1,289  | 
|                             | Excess and obsolescence         |                | $ | 12,290 |            |  |  | 11,980     |   |         |           | 11,554 |  |  | $ | 12,716 | 

99



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##### Table of Contents






SIGNATURES






| |                                    
| | -----------------------------------
| | TERAYON COMMUNICATION SYSTEMS, INC.
|
| | /s/ Jerry D. Chase                 
| |                                    
| | Jerry D. Chase                     
| | Chief Executive Officer            





|                                       |  |                                                                          |  |                |  | 
|-------------------------------------- |  | ------------------------------------------------------------------------ |  | -------------- |  | 
|Signature                              |  | Title                                                                    |  | Date          
|                                       |  |                                                                          |  |               
|                                      
|/s/ Jerry D. ChaseJerry
    D. Chase   |  | Chief Executive Officer and Director (Principal Executive
    Officer)   |  | March 15, 2005
|                                      
|/s/ Mark A. RichmanMark
    A. Richman |  | Chief Financial Officer (Principal Financial and Accounting
    Officer) |  | March 15, 2005
|                                      
|/s/ Dr. Zaki RakibDr.
    Zaki Rakib   |  | Chairman of the Board of Directors                                       |  | March 15, 2005
|                                      
|/s/ Shlomo RakibShlomo
    Rakib       |  | Director                                                                 |  | March 15, 2005
|                                      
|/s/ Lewis SolomonLewis
    Solomon     |  | Director                                                                 |  | March 15, 2005
|                                      
|/s/ Alek KrstajicAlek
    Krstajic     |  | Director                                                                 |  | March 15, 2005
|                                      
|/s/ David WoodrowDavid
    Woodrow     |  | Director                                                                 |  | March 15, 2005
|                                      
|/s/ Mark SlavenMark
    Slaven         |  | Director                                                                 |  | March 15, 2005

100



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##### Table of Contents



|                                                   |  |          |  |                |  | 
|-------------------------------------------------- |  | -------- |  | -------------- |  | 
|Signature                                          |  | Title    |  | Date          
|                                                   |  |          |  |               
|                                                  
|/s/ Dr. Matthew MillerDr.
    Matthew Miller       |  | Director |  | March 15, 2005
|                                                  
|/s/ Howard W. Speaks, Jr.Howard
    W. Speaks, Jr. |  | Director |  | March 15, 2005

101



---



##### Table of Contents



INDEX TO EXHIBITS


|        |    |     |                     |                                                                                                                                                                                                
|------- | -- | --- | ------------------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|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.(6)                                                                                                            
|        | 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.                                                                            
|        | 10 | .2  |                     | 1995 Stock Option Plan, as amended.(1)                                                                                                                                                         
|        | 10 | .3  |                     | 1997 Equity Incentive Plan, as amended.(9)                                                                                                                                                     
|        | 10 | .4  |                     | 1998 Employee Stock Purchase Plan, as amended.(12)                                                                                                                                             
|        | 10 | .5  |                     | 1998 Non-Employee Directors Stock Option Plan as amended.(1)                                                                                                                                   
|        | 10 | .6  |                     | 1998 Employee Stock Purchase Plan Offering for Foreign
    Employees.(7)                                                                                                                       
|        | 10 | .7  |                     | 1999 Non-Officer Equity Incentive Plan, as amended.(13)                                                                                                                                        
|        | 10 | .8  |                     | Azrieli Center Offices Lease Agreement, dated January 23,
    2002, between Canit HaShalom Investments Ltd. and Terayon
    Communication Systems, Inc.(9)                                     
|        | 10 | .9  |                     | Azrieli Center Agreement to Transfer Lease Rights dated
    23rd day of January, 2000(11)                                                                                                      
|        | 10 | .10 |                     | Data Over Cable Service Interface Specifications License
    Agreement, dated December 21, 2001, between Terayon
    Communication Systems, Inc. and Cable Television Laboratories,
    Inc.(9)
|        | 10 | .11 |                     | 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 | .12 |                     | Data Over Cable Service Interface Specifications License
    Agreement, dated December 21, 2001, between Imedia
    Semiconductor Corporation and Cable Television Laboratories,
    Inc.(9)   
|        | 10 | .13 |                     | 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 | .14 |                     | Lease Agreement, dated September 18, 1996, between Sobrato
    Interests III and VeriFone.(10)                                                                                                 
|        | 10 | .15 |                     | Sublease, dated April 1, 2002, by and between Terayon
    Communication Systems, Inc. and Hewlett-Packard Company.(10)                                                                         
|        | 10 | .16 |                     | Aircraft Lease Agreement, dated February 8, 2002, between
    Terayon Communication Systems, Inc. and General Electric Capital
    Corporation.(11)                                            
|        | 10 | .17 |                     | Letter of Credit Agreement, dated February 8, 2002, between
    Terayon Communication Systems, Inc. and General Electric Capital
    Corporation.(11)                                          
|        | 10 | .18 |                     | Agreement dated January 23, 2004, between Terayon
    Communication Systems, Inc. and YAS Corporation(15).                                                                                     
|        | 10 | .19 |                     | First Amendment to Aircraft Lease Agreement, dated
    December 31, 2003, between Terayon Communication Systems,
    Inc. and General Electric Capital Corporation.(17)                        



---



##### Table of Contents



|        |    |     |                     |                                                                                                                                                       
|------- | -- | --- | ------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |    |     |                    
|Number  |    |     | Exhibit Description
|        |    |     |                    
|        | 10 | .20 |                     | Code of Business Conduct.(17)                                                                                                                         
|        | 10 | .21 |                     | Notification Letter of Intent to Terminate or Sublease the
    Aircraft Lease Agreement dated March 12, 2004.(17)                                     
|        | 10 | .22 |                     | Employment Agreement dated July 22, 2004 between Terayon
    Communication Systems, Inc. and Jerry D. Chase(16).                                      
|        | 10 | .23 |                     | Severance Agreement dated July 22, 2004, between Terayon
    Communication Systems, Inc. and Jerry D. Chase(16).                                      
|        | 10 | .24 |                     | Proprietary Information and Inventions Agreement dated
    July 22, 2004 between Terayon Communication Systems, Inc.
    and Jerry D. Chase(16).      
|        | 10 | .25 |                     | Aircraft Sublease Agreement dated August 24, 2004 between
    Terayon Communication Systems, Inc. and United Furniture
    Equipment Rental, Inc.(16).
|        | 10 | .26 |                     | Employment Agreement dated November 8, 2004 between Terayon
    Communication Systems, Inc. and Mark A. Richman.                                      
|        | 10 | .27 |                     | Form of Severance Agreement between Terayon Communication
    Systems, Inc. and Mark A. Richman.                                                      
|        | 10 | .28 |                     | Proprietary Information and Inventions Agreement dated
    November 10, 2004 between Terayon Communication Systems,
    Inc. and Mark A. Richman.     
|        | 10 | .29 |                     | Separation Agreement dated August 2, 2004 between Terayon
    Communication Systems, Inc. and Edward Lopez(16).                                       
|        | 10 | .30 |                     | Form of Option Agreement for the Terayon Communication Systems,
    Inc. 1997 Equity Incentive Plan(18).                                              
|        | 10 | .31 |                     | Transition Agreement dated June 21, 2004, between Terayon
    Communication Systems, Inc. and Zaki Rakib(15).                                         
|        | 10 | .32 |                     | Employment Agreement dated June 21, 2004, between Terayon
    Communication Systems, Inc. and Selim (Shlomo) Rakib(15).                               
|        | 10 | .33 |                     | Form of Option Agreement for the Terayon Communication Systems,
    Inc. 1998 Non-Employee Directors Stock Option Plan                                
|        | 21 | .1  |                     | List of Subsidiaries.                                                                                                                                 
|        | 23 | .1  |                     | Consent of Ernst & Young LLP, Independent Registered
    Public Accounting Firm.                                                                      
|        | 24 | .1  |                     | Power of Attorney (see signatures 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.                                                    



---



##### Table of Contents





| |     |                                                                                 
| | --- | --------------------------------------------------------------------------------
| | (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.                        
|    
|(15) | Incorporated by reference to our Report on Form 10-Q filed
    on July 27, 2004.                           
|    
|(16) | Incorporated by reference to our Report on Form 10-Q filed
    on November 9, 2004.                        
|    
|(17) | Incorporated by reference to our Report on Form 10-K filed
    on March 15, 2004.                          
|    
|(18) | Incorporated by reference to our Report on Form 8-K filed
    on September 14, 2004