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UNITED STATES  SECURITIES AND EXCHANGE COMMISSION


WASHINGTON, D.C. 20549


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FORM 10-Q






|| X |
        QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
        ACT OF 1934  
|---------------------------------------------------------------------------------------------------------------
|FOR
        THE QUARTERLY PERIOD ENDED MARCH 31, 2004                                                          
|                                                                                                               
||    |
        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 0-27427                                                                         



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ALTIGEN COMMUNICATIONS, INC.


(Exact name of Registrant as specified in its charter)





|DELAWARE                                                                              |  | 94-3204299                                      
|------------------------------------------------------------------------------------- |  | ------------------------------------------------
|(State
          or other jurisdiction ofincorporation or organization)               |  | (I.R.S.
          EmployerIdentification Number)
|                                                                                      |  |                                                 
|4555
          Cushing Parkway                                                        |  |                                                 
|Fremont, CA                                                                           |  | 94538                                           
|(address
          of principal executive offices)                                    |  | (zip
          code)                            
|                                                                                      |  |                                                 
|Registrants
          telephone number, including area code:(510)
          252-9712




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





Indicate
  by check mark whether the registrant is an accelerated filer.     YES  ||    NO   |X|





The number of shares of our common stock outstanding as of May 11, 2004 was: 14,330,299 shares





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Table of Contents





|PART
          I. FINANCIAL INFORMATION |                                                                                                                                        
|--------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------
|                                        |                                                                                                                                        
|Item
          1.                       | Unaudited
          Condensed Consolidated Financial Statements                                                                        
|                                        |                                                                                                                                        
|                                        | Unaudited
          Condensed Consolidated Balance Sheets as ofMarch 31, 2004 and September
          30, 2003                         
|                                        |                                                                                                                                        
|                                        | Unaudited
          Condensed Consolidated Statements of Operations forthe Three and Six
          Months Ended March 31, 2004 and 2003
|                                        |                                                                                                                                        
|                                        | Unaudited
          Condensed Consolidated Statements of Cash Flows forthe Six Months Ended
          March 31, 2004 and 2003          
|                                        |                                                                                                                                        
|                                        | Notes
          to Unaudited Condensed Consolidated Financial Statements                                                               
|                                        |                                                                                                                                        
|Item
          2.                       | Managements
          Discussion and Analysis of Financial Condition and Results of Operations                                        
|                                        |                                                                                                                                        
|Item
          3.                       | Quantitative
          and Qualitative Disclosures about Market Risk                                                                   
|                                        |                                                                                                                                        
|Item
          4.                       | Controls
          and Procedures                                                                                                      
|                                        |                                                                                                                                        
|PART
          II. OTHER INFORMATION    |                                                                                                                                        
|                                        |                                                                                                                                        
|Item
          1.                       | Legal
          Proceedings                                                                                                            
|                                        |                                                                                                                                        
|Item
          2.                       | Changes
          in Securities and Use of Proceeds                                                                                    
|                                        |                                                                                                                                        
|Item
          3.                       | Defaults
          Upon Senior Securities                                                                                              
|                                        |                                                                                                                                        
|Item
          4.                       | Submission
          of Matters to a Vote of Security Holders                                                                          
|                                        |                                                                                                                                        
|Item
          5                        | Other
          Information                                                                                                            
|                                        |                                                                                                                                        
|Item
          6.                       | Exhibits
          and Reports on Form 8-K                                                                                             
|                                        |                                                                                                                                        
|SIGNATURE                               | 27                                                                                                                                     
|                                        |                                                                                                                                        
|EXHIBIT
          INDEX                 | 28                                                                                                                                     




2


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## PART I.
FINANCIAL INFORMATION

## Item 1. Unaudited
Condensed Consolidated Financial Statements



ALTIGEN COMMUNICATIONS, INC. AND SUBSIDIARY


UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS


(in thousands, except share and per share amounts)





|                                                                                                       |  | March
          31,2004 |        | September
          30,2003 |  
|------------------------------------------------------------------------------------------------------ |  | ----------------------- | ------ | --------------------------- | -
|                                                                                                       |  |                         |        |                             |  
|                                                                                                       |  | (unaudited)             |        |                             |  
|                                                                                                       |  |                         |        |                             |  
|ASSETS                                                                                                 |  |                         |        |                             |  
|Current
          assets:                                                                              |  |                         |        |                             |  
|Cash
          and cash equivalents                                                                    |  | $                       | 6,629  |                             | $
|Short-term
          investments                                                                       |  | 2,751                   |        | 1,598                       |  
|Accounts
        receivable, net of allowances of $59 and $60 at March 31, 2004 and                    |  |                         |        |                             |  
|September
          30, 2003, respectively                                                             |  | 1,895                   |        | 1,521                       |  
|Inventories                                                                                            |  | 797                     |        | 910                         |  
|Prepaid
          expenses and other current assets                                                    |  | 157                     |        | 193                         |  
|                                                                                                       |  |                         |        |                             |  
|Total
          current assets                                                                         |  | 12,229                  |        | 12,770                      |  
|                                                                                                       |  |                         |        |                             |  
|Property
          and equipment:                                                                      |  |                         |        |                             |  
|Furniture
          and equipment                                                                      |  | 1,822                   |        | 1,853                       |  
|Computer
          software                                                                            |  | 948                     |        | 941                         |  
|                                                                                                       |  |                         |        |                             |  
|                                                                                                       |  | 2,770                   |        | 2,794                       |  
|Less:
          Accumulated depreciation and amortization                                              |  | (2,611                  | )      | (2,549                      | )
|                                                                                                       |  |                         |        |                             |  
|Net
          property and equipment                                                                   |  | 159                     |        | 245                         |  
|                                                                                                       |  |                         |        |                             |  
|Other
          non-current assets:                                                                    |  |                         |        |                             |  
|Long-term
          investment                                                                         |  | 195                     |        | 195                         |  
|Long-term
          deposit                                                                            |  | 50                      |        |                            |  
|                                                                                                       |  |                         |        |                             |  
|Total
          other non-current assets                                                               |  | 245                     |        | 195                         |  
|                                                                                                       |  |                         |        |                             |  
|Total
          assets                                                                                 |  | $                       | 12,633 |                             | $
|                                                                                                       |  |                         |        |                             |  
|                                                                                                       |  |                         |        |                             |  
|LIABILITIES
          AND STOCKHOLDERS EQUITY                                                         |  |                         |        |                             |  
|Current
          liabilities:                                                                         |  |                         |        |                             |  
|Accounts
          payable                                                                             |  | $                       | 533    |                             | $
|Accrued
          liabilities:                                                                         |  |                         |        |                             |  
|Payroll
          and related benefits                                                                 |  | 304                     |        | 276                         |  
|Warranty
          (Note 3)                                                                            |  | 659                     |        | 644                         |  
|Marketing                                                                                              |  | 204                     |        | 253                         |  
|Other                                                                                                  |  | 417                     |        | 462                         |  
|Deferred
          revenue                                                                             |  | 344                     |        | 412                         |  
|                                                                                                       |  |                         |        |                             |  
|Total
          current liabilities                                                                    |  | 2,461                   |        | 2,920                       |  
|                                                                                                       |  |                         |        |                             |  
|                                                                                                       |  |                         |        |                             |  
|Stockholders
          equity:                                                                        |  |                         |        |                             |  
|Convertible
          preferred stock, $0.001 par value; Authorized  5,000,000 shares;                |  |                         |        |                             |  
|None issued and outstanding at March 31, 2004 and September 30, 2003                                   |  |                        |        |                            |  
|Common
          stock, $0.001 par value; Authorized  50,000,000 shares;                              |  |                         |        |                             |  
|Outstanding
         15,273,976 shares at March 31, 2004 and 15,054,442 shares at                     |  |                         |        |                             |  
|September
        30, 2003                                                                             |  | 15                      |        | 15                          |  
|Treasury
          stock at cost  1,063,895 shares at March 31, 2004 and September
          30, 2003 |  | (1,014                  | )      | (1,014                      | )
|Additional
          paid-in capital                                                                   |  | 62,327                  |        | 62,152                      |  
|Accumulated
          deficit                                                                          |  | (51,156                 | )      | (50,863                     | )
|                                                                                                       |  |                         |        |                             |  
|Total
          stockholders equity                                                                   |  | 10,172                  |        | 10,290                      |  
|                                                                                                       |  |                         |        |                             |  
|Total
          liabilities and stockholders equity                                                   |  | $                       | 12,633 |                             | $
|                                                                                                       |  |                         |        |                             |  




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





3


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ALTIGEN COMMUNICATIONS, INC. AND SUBSIDIARY


UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS


(in thousands, except per share amounts)





|                                                              | Three
          Months Ended March 31, |        | Six
          Months Ended March 31, |  
|------------------------------------------------------------- | -------------------------------------- | ------ | ------------------------------------ | -
|                                                              |                                        |        |                                      |  
|                                                              | 2004                                   |        | 2003                                 |  
|                                                              |                                        |        |                                      |  
|Revenues,
          net                                       | $                                      | 3,293  |                                      | $
|Cost
          of revenues                                    |                                        | 1,250  |                                      |  
|                                                              |                                        |        |                                      |  
|Gross
          profit                                        |                                        | 2,043  |                                      |  
|                                                              |                                        |        |                                      |  
|Operating
          expenses:                                 |                                        |        |                                      |  
|Research
          and development                            |                                        | 819    |                                      |  
|Sales
          and marketing                                 |                                        | 1,033  |                                      |  
|General
          and administrative                          |                                        | 459    |                                      |  
|Deferred
          stock compensation (Note 4)                |                                        | --     |                                      |  
|                                                              |                                        |        |                                      |  
|Total
          operating expenses                            |                                        | 2,311  |                                      |  
|                                                              |                                        |        |                                      |  
|Loss
          from operations                                |                                        | (268   | )                                    |  
|Interest
          and other income, net                      |                                        | 22     |                                      |  
|                                                              |                                        |        |                                      |  
|Net
          loss                                            | $                                      | (246   | )                                    | $
|                                                              |                                        |        |                                      |  
|Basic
          and diluted net loss per share                | $                                      | (0.02  | )                                    | $
|                                                              |                                        |        |                                      |  
|Shares
          used in computing basic and diluted net loss |                                        |        |                                      |  
|per
          share                                           |                                        | 14,160 |                                      |  
|                                                              |                                        |        |                                      |  




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





4


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ALTIGEN COMMUNICATIONS, INC. AND SUBSIDIARY


UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


(in thousands)





|                                                                            |  | Six Months Ended March 31, |      
|--------------------------------------------------------------------------- |  | -------------------------- | -----
|                                                                            |  |                            |      
|                                                                            |  | 2004                       |      
|                                                                            |  |                            |      
|                                                                            |  |                            |      
|CASH FLOWS FROM OPERATING ACTIVITIES:                                       |  |                            |      
|Net loss                                                                    |  | $                          | (292 
|Adjustments to reconcile net loss to net cash used in operating activities: |  |                            |      
|Depreciation and amortization                                               |  | 62                         |      
|Amortization of deferred stock compensation                                 |  |                           |      
|Changes in operating assets and liabilities                                 |  |                            |      
|Accounts receivable                                                         |  | (374                       | )    
|Inventories                                                                 |  | 112                        |      
|Prepaid expenses and other current assets                                   |  | 36                         |      
|Accounts payable                                                            |  | (340                       | )    
|Accrued liabilities                                                         |  | (51                        | )    
|Deferred revenue                                                            |  | (68                        | )    
|                                                                            |  |                            |      
|Net cash used in operating activities                                       |  | (915                       | )    
|                                                                            |  |                            |      
|CASH FLOWS FROM INVESTING ACTIVITIES:                                       |  |                            |      
|Purchases of short-term investments                                         |  | (11,752                    | )    
|Proceeds from sale and maturities of short-term investments                 |  | 10,599                     |      
|Changes in other non-current assets                                         |  | (50                        | )    
|Purchases of property and equipment                                         |  | 24                         |      
|                                                                            |  |                            |      
|Net cash (used in) provided by investing activities                         |  | (1,179                     | )    
|                                                                            |  |                            |      
|CASH FLOWS FROM FINANCING ACTIVITIES:                                       |  |                            |      
|Proceeds from issuances of common stock                                     |  | 175                        |      
|Collection of promissory note from officer/stockholder                      |  |                           |      
|                                                                            |  |                            |      
|Net cash provided by financing activities                                   |  | 175                        |      
|                                                                            |  |                            |      
|NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                        |  | (1,919                     | )    
|CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD                              |  | 8,548                      |      
|                                                                            |  |                            |      
|CASH AND CASH EQUIVALENTS, END OF PERIOD                                    |  | $                          | 6,629
|                                                                            |  |                            |      
|                                                                            |  |                            |      
|NONCASH INVESTING ACTIVITIES:                                               |  |                            |      
|Unrealized gain on short term investments                                   |  | $                          |     
|                                                                            |  |                            |      




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





5


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## ALTIGEN
COMMUNICATIONS, INC. AND SUBSIDIARYNOTES TO UNAUDITED CONDENSED
CONSOLIDATED FINANCIAL STATEMENTS

## 1. SUMMARY OF
SIGNIFICANT ACCOUNTING POLICIES

## BASIS OF
PRESENTATION

AltiGen
Communications, Inc. designs, manufactures and markets next generation,
time-tested Internet protocol phone systems and contact centers that use both
the Internet and the public telephone network to take advantage of the
convergence of voice and data communications.

The accompanying unaudited
condensed consolidated financial statements have been prepared in conformity
with generally accepted accounting principles for interim financial information
and with the instructions for Form 10-Q and Article 10 of Regulation S-X.
Accordingly, certain information and footnote disclosures normally included in
financial statements prepared in accordance with generally accepted accounting
principles have been condensed, or omitted, pursuant to the rules and
regulations of the Securities and Exchange Commission (SEC). These unaudited
condensed consolidated financial statements reflect the operations of the
Company and its wholly-owned subsidiary. All significant intercompany
transactions and balances have been eliminated. In our opinion, these unaudited
condensed consolidated financial statements include all adjustments necessary
(which are of a normal and recurring nature) for a fair presentation of the
Companys financial position, results of operations and cash flows for the
periods presented.

These financial statements
should be read in conjunction with our audited consolidated financial statements
for the fiscal year ended September 30, 2003, included in the Companys
2003 Annual Report on Form 10-K filed with the SEC on December 29, 2003.
AltiGens results of operations for any interim period are not necessarily
indicative of the results of operations for any other interim period or for a
full fiscal year.

## CASH AND CASH
EQUIVALENTS AND SHORT-TERM INVESTMENTS

We consider all highly
liquid investments with an original maturity of three months or less from the
date of purchase to be cash equivalents. Short-term investments are in highly
liquid financial instruments with original maturities greater than three-months
but less than one year and are classified as available-for-sale
investments. Investments are reported at their fair value, with unrealized gains
and losses excluded from earnings and reported as a separate component of
stockholders equity. As of March 31, 2004, our cash and cash equivalents
consisted of commercial paper and cash deposited in checking and money market
accounts. For the six months ended March 31, 2004 and March 31, 2003, we did not
make any cash payments for interest or income taxes.

## INVENTORIES

Inventories (which include
costs associated with components assembled by third-party assembly
manufacturers, as well as internal labor and allocable overhead) are stated at
the lower of cost (first-in, first-out method) or market. Provisions, when
required, are made to reduce excess and obsolete inventories to their estimated
net realizable values. We regularly monitor inventory quantities on hand and
record a provision for excess and obsolete inventories based primarily on our
estimated forecast of product demand and production requirements for the next
six months. The components of inventories include (in thousands):

|                 |  | March 31,2004 |     | September 30,2003 |  
|---------------- |  | ------------- | --- | ----------------- | -
|                 |  |               |     |                   |  
|                 |  |               |     |                   |  
|Raw materials    |  | $             | 79  |                   | $
|Work-in-progress |  | 79            |     | 184               |  
|Finished goods   |  | 639           |     | 691               |  
|                 |  |               |     |                   |  
|                 |  | $             | 797 |                   | $
|                 |  |               |     |                   |  

## LONG-TERM
INVESTMENT

As of March 31, 2004, we
held an investment of common stock in a private Chinese telecommunication
company valued at approximately $195,000 accounted for using the cost method.
Our interest in the company is approximately 2%, which interest does not allow
us to exercise significant influence.

We perform a periodic
review of our investment for impairment. An investment is considered impaired
when a review of the investees operations and other indicators of
impairment indicate that the carrying value of the investment is not likely to
be recoverable. Such indicators include, but are not limited to, limited capital
resources, limited prospects of receiving additional financing, and limited
prospects for liquidity of the related securities. No write-downs were recorded
during the three months and six months ended March 31, 2004 and March 31, 2003.

6


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## REVENUE
RECOGNITION

We account for the
recognition of revenues in accordance with Statement of Position
(SOP) 97-2, Software Revenue Recognition. Revenues
consist of sales to end-users, including resellers, and to distributors.
Revenues from sales to end-users are recognized upon shipment, when risk of loss
has passed to the customer, collection of the receivable is reasonably assured,
persuasive evidence of an arrangement exists, and the price is fixed and
determinable. We provide for estimated sales returns and allowances and warranty
costs related to such sales at the time of shipment. Net revenues consist of
product revenues reduced by estimated sales returns and allowances. Sales to
distributors are made under terms allowing certain rights of return and
protection against subsequent price declines on our products held by its
distributors. Upon termination, any unsold products may be returned by the
distributor for a full refund. These agreements may be canceled by either party
based on specified notice. As a result of the above provisions, we defer
recognition of distributor revenues until such distributors resell our products
to their customers. The amounts deferred as a result of this policy are
reflected as deferred revenue in the accompanying consolidated
balance sheets. The related cost of revenue is also deferred and reported in the
consolidated balance sheets as inventory.

Software components
generally are not sold separately from our hardware components. Software
revenues consist of license revenues that are recognized upon the delivery of
application products. We provide limited post-contract customer support (PCS),
consisting primarily of technical support and bug fixes. In
accordance with SOP 97-2, revenue earned on software arrangements involving
multiple elements is allocated to each element based upon the relative fair
values of the elements. Although we provide PCS, the revenue allocated to this
element is recognized together with the initial licensing fee on delivery of the
software because: (1) the PCS fee is included with the initial licensing
fee; (2) the PCS included with the initial license fee is for one year or
less; (3) the estimated cost of providing PCS during the arrangement is
insignificant; and (4) unspecified upgrades/enhancements offered for
minimal or no cost during PCS arrangements historically have been and are
expected to continue to be minimal and infrequent. All estimated costs of
providing the services, including upgrades and enhancements are accrued for at
the time of delivery.

## STOCKBASED
COMPENSATION

We account for stock-based
compensation in accordance with the provisions of APB No. 25,
Accounting for Stock Issued to Employees, and comply with the
disclosure provisions of SFAS No. 123 as amended by SFAS No. 148,
Accounting for Stock-Based CompensationTransition and
Disclosures. Deferred compensation recognized under APB No. 25 is
amortized to expense using the graded vesting method. We account for stock
options issued to non-employees in accordance with the provisions of SFAS
No. 123 and EITF No. 96-18 under the fair value based method.

We adopted the
disclosure-only provisions of SFAS No. 123, and accordingly, no expense has
been recognized for options granted to employees under the various equity
incentive plans. We amortize deferred stock-based compensation over the vesting
periods of the applicable stock purchase rights and stock options, generally
four years. Had compensation expense been determined based on the fair value at
the grant date for awards, consistent with the provisions of SFAS No. 123,
the Companys pro forma net loss and net loss per share would be as follows
(in thousands, except per share data):

|                                                                                                                       |  | Three
            Months Ended March 31, |       | Six
            Months Ended March 31, |  
|---------------------------------------------------------------------------------------------------------------------- |  | ---------------------------------------- | ----- | -------------------------------------- | -
|                                                                                                                       |  |                                          |       |                                        |  
|                                                                                                                       |  | 2004                                     |       | 2003                                   |  
|                                                                                                                       |  |                                          |       |                                        |  
|Add:
          Total stockbased employee compensation expense included in reported
          net loss under APB No. 25 |  |                                          |      |                                        |  
|Deduct:
          Total stockbased compensation determined under fair value based method
          for all awards      |  |                                          | (494  | )                                      |  
|                                                                                                                       |  |                                          |       |                                        |  
|Pro
          forma net loss under SFAS No. 123                                                                        |  | $                                        | (740  | )                                      | $
|                                                                                                                       |  |                                          |       |                                        |  
|Basic
          and diluted  as reported                                                                              |  | $                                        | (0.02 | )                                      | $
|                                                                                                                       |  |                                          |       |                                        |  
|Basic
          and diluted  pro forma                                                                                |  | $                                        | (0.05 | )                                      | $
|                                                                                                                       |  |                                          |       |                                        |  

The fair value of each
option grant is estimated on the date of grant using the Black-Scholes option
pricing model, and is not subject to revaluation as a result of subsequent stock
price fluctuations. The following weighted-average assumptions are used:

7


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|                                 |  | Employee Stock Option Plansfor Three MonthsEnded March 31, |   | Employee Stock Option Planfor Six MonthsEnded March 31, |    
|-------------------------------- |  | ---------------------------------------------------------- | - | ------------------------------------------------------- | ---
|                                 |  |                                                            |   |                                                         |    
|                                 |  | 2004                                                       |   | 2003                                                    |    
|                                 |  |                                                            |   |                                                         |    
|Expected
        Life (in years) |  | 5                                                          |   |                                                         | 5  
|Risk-free
        interest rate  |  | 3.3                                                        | % |                                                         | 3.1
|Volatility                       |  | 109                                                        | % |                                                         | 100
|Expected
        dividend        |  | 0.0                                                        | % |                                                         | 0.0
|                                 |  |                                                            |   |                                                         |    




|                                 |  | Employee
        Stock Purchase Plansfor Three MonthsEnded March 31, |   | Employee
        Stock Purchase Planfor Six MonthsEnded March 31, |    
|-------------------------------- |  | -------------------------------------------------------------------- | - | ----------------------------------------------------------------- | ---
|                                 |  |                                                                      |   |                                                                   |    
|                                 |  | 2004                                                                 |   | 2003                                                              |    
|                                 |  |                                                                      |   |                                                                   |    
|Expected
        Life (in years) |  | 0.5                                                                  |   |                                                                   | 0.5
|Risk-free
        interest rate  |  | 1.4                                                                  | % |                                                                   | 1.5
|Volatility                       |  | 108                                                                  | % |                                                                   | 100
|Expected
        dividend        |  | 0.0                                                                  | % |                                                                   | 0.0
|                                 |  |                                                                      |   |                                                                   |    

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

## COMPUTATION OF
BASIC AND DILUTED NET LOSS PER SHARE

Historical net loss per
share has been calculated under SFAS No. 128, Earnings per
Share. SFAS No. 128 requires companies to compute earnings per share
under two methods (basic and diluted). Basic net loss per share is calculated by
dividing net loss by the weighted average shares of common stock outstanding
during the period. Basic and diluted net loss per share numbers were identical
as potential common shares resulting from the exercise of stock options are
antidilutive.

For the three and six months
  ended March 31, 2004 and March 31, 2003, 2,629,100 shares and 2,665,173 shares
  of common stock options with a weighted average exercise price of $4.77 and
  $4.41, respectively, were excluded from the diluted net income per share computation.

## COMPREHENSIVE
INCOME

Comprehensive loss for us consists
of net loss plus the effect of foreign currency translation adjustments and
other unrealized gains and losses, which were not material for each of the three
and six months ended March 31, 2004 and March 31, 2003, respectively.
Accordingly, comprehensive loss closely approximates actual net loss.

## SEGMENT
REPORTING

We are organized and
operate as one operating segment. We operate primarily in one geographic area,
the Americas.

Net revenue by geographic
region based on customer location for the three and six months ended March 31,
2004 and March 31, 2003, respectively, were as follows:

|              |  | Three
            Months Ended March 31, |     | Six
            Months Ended March 31, | 
|------------- |  | ---------------------------------------- | --- | -------------------------------------- | 
|              |  |                                          |     |                                        | 
|              |  | 2004                                     |     | 2003                                   | 
|              |  |                                          |     |                                        | 
|Americas      |  |                                          | 90  | %                                      | 
|International |  |                                          | 10  | %                                      | 
|              |  |                                          |     |                                        | 
|              |  |                                          | 100 | %                                      | 
|              |  |                                          |     |                                        | 




8


---

International is comprised
  of revenues from China, Taiwan, the United Kingdom and Norway. The Taiwan revenue
  included sales to affiliate, which comprised 3% and 1% for the three and six
  months ended March 31, 2004, respectively.

Net revenue by customers
that individually accounted for more than 10% of our revenue for the three and
six months ended March 31, 2004 and March 31, 2003, respectively, were as
follows:

|                     |  | Three
            Months Ended March 31, |     | Six
            Months Ended March 31, | 
|-------------------- |  | ---------------------------------------- | --- | -------------------------------------- | 
|                     |  |                                          |     |                                        | 
|                     |  | 2004                                     |     | 2003                                   | 
|                     |  |                                          |     |                                        | 
|AltiSys              |  |                                          | 15  | %                                      | 
|Ingram
        Micro |  |                                          | 14  | %                                      | 
|Synnex               |  |                                          | 47  | %                                      | 
|Other                |  |                                          | 24  | %                                      | 
|                     |  |                                          |     |                                        | 
|                     |  |                                          | 100 | %                                      | 
|                     |  |                                          |     |                                        | 

On June 2003, we signed a
  new distributor agreement with Graybar Electric Company. Net revenues from Graybar
  were 7% and 4% for the three and six months ended March 31, 2004, respectively.

All significant long-lived
  assets are located in the United States for all periods presented.

## 2. RECENT
ACCOUNTING PRONOUNCEMENTS

In December 2002, the
Emerging Issues Task Force (EITF) reached a consensus on EITF
No. 00-21, Revenue Arrangements with Multiple Deliverables.
This pronouncement addresses certain aspects of the accounting by a vendor for
arrangements under which it will perform multiple revenue- generating
activities. The guidance in this pronouncement was effective for revenue
arrangements entered into in fiscal periods beginning after June 15, 2003.
The adoption of EITF 00-21 did not have an effect on our consolidated financial
statements.

The Financial Accounting
Standards Board (FASB) issued Interpretation No. 46 (FIN
46), Consolidation of Variable Interest Entities, in January
2003, and a revised interpretation of FIN 46 (FIN 46-R) in December
2003. FIN 46 requires certain variable interest entities (VIEs) to
be consolidated by the primary beneficiary of the entity if the equity investors
in the entity do not have the characteristics of a controlling financial
interest or do not have sufficient equity at risk for the entity to finance its
activities without additional subordinated financial support from other parties.
The adoption of FIN 46 did not have an impact on the Companys financial
position. For all arrangements entered into after January 31, 2003, the Company
is required to continue to apply FIN 46 through April 30, 2004, after that date
the Company is required to adopt the provisions of FIN 46-R for those
arrangements on May 1, 2004. For arrangements entered into prior to February 1,
2003, the Company is required to adopt the provisions of FIN 46-R on May 1,
2004. The Company does not expect the adoption of FIN 46-R to have an impact on
the financial position, results of operations or cash flows of the Company.

In April 2003, the
FASB issued SFAS No. 149, Amendment of SFAS No. 133 on
Derivative Instruments and Hedging Activities. SFAS No. 149 amends
and clarifies accounting for derivative instruments, including certain
derivative instruments embedded in other contracts, and for hedging activities
under SFAS No. 133. SFAS No. 149 was effective for contracts entered
into or modified after June 30, 2003 and did not have an impact on our
consolidated financial statements.

In May 2003, the FASB
issued SFAS No. 150, Accounting for Certain Financial Instruments with
Characteristics of both Liabilities and Equity, which requires that
certain financial instruments be presented as liabilities that were previously
presented as equity or as temporary equity. Such instruments include mandatory
redeemable preferred and common stock, and certain options and warrants. SFAS
No. 150 is effective for financial instruments entered into or modified after
May 31, 2003 and was effective at the beginning of the first interim period
beginning after June 15, 2003. In November 2003, the FASB issued FASB Staff
Position (FSP) No. 150-3, Effective Date, Disclosures, and
Transition for Mandatorily Redeemable Financial Instruments of Certain Nonpublic
Entities and Certain Mandatorily Redeemable Noncontrolling Interests under SFAS
No. 150, which defers the effective date for various provisions of SFAS No. 150.
As of March 31, 2004, we had no financial instruments within the scope of this
pronouncement.

## 3. WARRANTY

We provide a one year
warranty for hardware products starting upon shipment to end-users. We
historically have experienced minimal warranty costs. Factors that affect our
warranty liability include the number of installed units, historical experience
and managements judgment regarding anticipated rates of warranty claims
and cost per claim. We assess the adequacy of our recorded warranty liability
every quarter and make adjustments to the liability if necessary.

Changes in our warranty
liability for the three and six months ended March 31, 2004 and March 31, 2003,
respectively, are as follows (in thousands):

9


---



|                                                                |  | Three
            Months Ended March 31, |     | Six
            Months Ended March 31, |  
|--------------------------------------------------------------- |  | ---------------------------------------- | --- | -------------------------------------- | -
|                                                                |  |                                          |     |                                        |  
|                                                                |  | 2004                                     |     | 2003                                   |  
|                                                                |  |                                          |     |                                        |  
|Beginning
            balance                                   |  | $                                        | 670 |                                        | $
|Provisions
            for warranty liability                   |  | 24                                       |     | 79                                     |  
|Warranty
            cost including labor, components and scrap |  |                                          | (35 | )                                      |  
|                                                                |  |                                          |     |                                        |  
|Ending
            balance                                      |  | $                                        | 659 |                                        | $
|                                                                |  |                                          |     |                                        |  

## 4. DEFERRED
STOCK COMPENSATION

In connection with the
issuance of certain stock options to employees in fiscal years 1999 and 1998, we
recorded deferred stock compensation in the aggregate amount of approximately
$3,892,000, which represents the difference between the deemed fair value of our
common stock and the exercise price of stock options at the date of grant. We
have fully amortized the deferred stock compensation in fiscal year 2003.

The amortization of
deferred stock compensation relates to the following items in the accompanying
unaudited condensed consolidated statements of operations (in thousands):

|                                     |  | Three
            Months Ended March 31, |   | Six
            Months Ended March 31, |  
|------------------------------------ |  | ---------------------------------------- | - | -------------------------------------- | -
|                                     |  |                                          |   |                                        |  
|                                     |  | 2004                                     |   | 2003                                   |  
|                                     |  |                                          |   |                                        |  
|Research
            and development |  | $                                        |  |                                        | $
|Sales
            and marketing      |  |                                          |  |                                        |  
|General
            and admistrative |  |                                          |  |                                        |  
|                                     |  |                                          |   |                                        |  
|Ending
            balance           |  | $                                        |  |                                        | $
|                                     |  |                                          |   |                                        |  

## 5. COMMITMENTS
AND CONTINGENCIES

Commitments


We lease our facility under
an operating lease agreement expiring on February 2009. Rent expense for
this operating lease totaled approximately $112,000 and $274,000 for the three
and six months ended March 31, 2004, respectively as compared to $206,000 and
$408,000 for the three and six months ended March 31, 2003. Minimum future lease
payments under a noncancellable operating lease as of March 31, 2004 are as
follows (in thousands):

|Fiscal
            Year |  |     |      
|----------------------- |  | --- | -----
|2004                    |  | 148 |      
|2005                    |  | 248 |      
|2006                    |  | 256 |      
|2007                    |  | 264 |      
|2008                    |  | 271 |      
|Thereafter              |  | 92  |      
|                        |  |     |      
|                        |  | $   | 1,279
|                        |  |     |      

Contingencies


We may become party to
litigation in the normal course of our business. Litigation in general, and
intellectual property and securities litigation in particular, can be expensive
and disruptive to normal business operations. Moreover, the results of complex
litigation are difficult to predict.

10


---

On September 6, 2002,
Vertical Networks, Inc. filed suit against us in the United States District
Court for the Northern District of California, alleging infringement of Vertical
Networks United States Patents Nos. 6,266,341; 6,289,025; 6,292,482;
6,389,009; and 6,396,849. On October 28, 2002, Vertical Networks amended
its Complaint to add allegations of infringement of Patents Nos. 5,617,418 and
5,687,174. Vertical Networks filed a Second Amended Complaint on
November 20, 2002 to identify our products and/or activities that allegedly
infringe the seven patents-in-suit. Vertical Networks seeks a judgment of patent
infringement and an award of damages, including treble damages for alleged
willful infringement, and attorneys fees and costs. We filed an Answer and
Counterclaims for Declaratory Relief on December 9, 2002. On
December 26, 2002, Vertical Networks filed its Answer to our Counterclaims.
Vertical Networks served its Preliminary Infringement Contentions on us on
April 9, 2003 and we served its Preliminary Invalidity Contentions on
June 3, 2003, and July 14, 2003. To date, the parties have exchanged
some discovery, but no depositions have been taken, and no motions are currently
pending. On October 7, 2003, the parties filed a stipulation to stay this
action, pending the outcome of the reissue of some of the subject patents before
the United States Patent and Trademark Office. We believe we have strong
defenses and arguments in this dispute and intend to vigorously litigate our
position. Managements view is that any loss from this litigation is not
probable or estimable.

11


---

## Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

## FORWARD-LOOKING
INFORMATION

This report contains
certain forward-looking statements (within the meaning of Section 27A of
the Securities Act of 1933, as amended, and Section 21E of the Securities
Exchange Act of 1934, as amended) and information relating to us that are based
on the beliefs of our management as well as assumptions made by and information
currently available to our management. Additional forward looking statements may
be identified by the words anticipate, believe,
expect, intend, may, plan and
similar expressions, as they relate to us or our management.

The forward-looking
statements contained in this report reflect our judgment as of the date of this
report with respect to future events, the outcome of which is subject to certain
risks that may have a significant impact on our business, operating results or
financial condition. Investors are cautioned that these forward-looking
statements are inherently uncertain. Should one or more of these risks or
uncertainties materialize, or should underlying assumptions prove incorrect,
actual results or outcomes may vary materially from those described herein.
Although we believe that the expectations reflected in these forward-looking
statements are reasonable, we cannot guarantee future results, levels of
activity, performance or achievements. Our stockholders should carefully review
the cautionary statements contained in this Form 10-Q, including the
Certain Factors Affecting Business, Operating Results and Financial
Condition below.

## OVERVIEW

We provide converged
Internet protocol phone systems for small-to-medium sized businesses. We were
incorporated in California in May 1994 and began operations in
July 1994. We first recognized revenues from product sales of our Quantum
board and AltiWare software in July 1996. We generated net revenues of $3.3
million and $6.9 million for the second quarter and the first six months of
fiscal 2004. respectively, compared to net revenues of $2.4 million and $5.2
million for the second quarter and the first six months of fiscal 2003. As of
March 31, 2004, we had an accumulated deficit of $51.2 million.

We derive our revenues from
sales of our AltiServ system. Product revenues consist of sales to end-users
(including dealers) and to distributors. Revenues from product sales to
end-users and resellers are recognized upon shipment. We defer recognition of
revenue for sales to distributors until they resell our products to their
customers. Upon shipment, we also provide a reserve for the estimated cost that
may be incurred for product warranty. Under our distribution contracts, a
distributor has the right, in certain circumstances, to return products it
determines are overstocked, so long as it provides an offsetting purchase order
for products in an amount equal to or greater than the dollar value of the
returned products. In addition, we provide distributors protection from
subsequent price reductions.

Our cost of revenues
consists of component and material costs, direct labor costs, provisions for
excess and obsolete inventory, warranty costs and overhead related to the
manufacturing of our products. We have experienced operating losses and negative
cash flows from operations in each period since our inception. Several factors
that have affected, and will continue to affect, our revenue growth include the
state of the economy, the market acceptance of our products, our ability to add
new resellers and our ability to design, develop, and release new products. We
engage a third-party assembler, which, in the three months ended March 31, 2004,
was principally All Quality Services in San Jose, to insert the hardware
components into the printed circuit board. We selected our manufacturing partner
with the goals of ensuring a reliable supply of high-quality finished products
and lowering per unit product costs as a result of manufacturing economies of
scale. We cannot assure that we will maintain the volumes required to realize
these economies of scale or when or if such cost reductions will occur. The
failure to obtain such cost reductions, or maintain such inductions if they
occur, could materially adversely affect our gross margins and operating
results.

We continue to focus on
developing enhancements to our current products to provide greater functionality
and increased capabilities, based on our market research, customer feedback and
our competitors product offerings. We also continue to focus on creating
new product offerings. In particular, we are focusing on developing products
that allow us to enhance our position in our target market segment and to enter
new geographical markets. Additionally, we intend to continue to focus on
selling our products to small-to-medium sized businesses and branch offices of
larger corporations, which are offices with less than 500 employees, with
particular emphasis in the Internet protocol phone systems segment of the
telecommunications market. Also, we plan to continue to recruit additional
resellers and distributors that focus on selling phone systems to our target
customers. There can be no assurance, however, that we will be successful in
developing any new products or enhancements to existing products, entering new
geographical or product markets or expanding our network of resellers and
distributors. We believe that the adoption rate for this new technology is much
faster with small-to-medium sized businesses because they do not have
significant investment on their books for traditional phone systems. We believe
that these businesses are looking for call center type administration to
increase the productivity and efficiency of their contacts with customers.
Assuming the continued market trends, successful product enhancements, the
introduction of the call center products, the beginning of sales activities in
the United Kingdom and Norway, continuing growth in the Chinese marketplace, and
the status quo of the North American economy, we expect to see continued revenue
growth for the next quarter.

12


---

## CRITICAL
ACCOUNTING POLICIES

Revenue recognition.
Revenues consist of sales to end-users, including to resellers, and to
distributors. Revenues from sales to end-users are recognized upon shipment,
when risk of loss has passed to the customer, collection of the receivable is
reasonably assured, persuasive evidence of an arrangement exists, and the price
is fixed and determinable. We provide for estimated sales returns and allowances
and warranty costs related to such sales at the time of shipment. Net revenues
consist of product revenues reduced by estimated sales returns and allowances.
Sales to distributors are made under terms allowing certain rights of return and
protection against subsequent price declines on our products held by its
distributors. Upon termination, any unsold products may be returned by the
distributor for a full refund. These agreements may be canceled without cause by
either party following a specified notice period. As a result of the above
provisions, we defer recognition of distributor revenues until such distributors
resell our products to their customers. The amounts deferred as a result of this
policy are reflected as deferred revenue in the accompanying
consolidated balance sheets. The related cost of revenues is also deferred and
reported in the consolidated balance sheets as inventory. Our total deferred
revenue was $344,000 as of March 31, 2004.

Allowance for Doubtful
Accounts. The allowance for doubtful accounts is based on our assessment of
the collectibility of specific customer accounts and the aging of the accounts
receivable. If there were a deterioration of a major customers
creditworthiness, or actual defaults were higher than our historical experience,
we could be required to increase our allowance and our earnings could be
adversely affected. Our allowance for doubtful accounts was $59,000 of March 31,
2004.

Inventory. Inventory is stated at the lower of cost (first-in, first-out method) or market. Our inventory balance was
$0.8 million as of March 31, 2004. We regularly review value of inventory in detail, with consideration given to future customer
demand for our products, obsolescence from rapidly changing technology, and other factors. If actual market conditions are less
favorable than those projected by management, and our estimates prove to be inaccurate, we could be required to increase our
inventory provision and our gross margins could be adversely affected. Our inventory allowance was $2.7 million as of March 31,
2004.

Warranty.  We accrue for warranty costs based on estimated product return rates and the expected material and labor costs to
provide warranty services. If actual return rates and repair and replacement costs differ significantly from our estimates, our
gross margin could be adversely affected. The liability for product warranties was $659,000 as of March 31, 2004.

13


---

## Results of
Operations

The following table sets
forth consolidated statements of operations data for the periods indicated as a
percentage of net revenues.

|                                                        | Three
            Months Ended March 31, |       | Six
            Months Ended March 31, | 
|------------------------------------------------------- | ---------------------------------------- | ----- | -------------------------------------- | 
|                                                        |                                          |       |                                        | 
|                                                        | 2004                                     |       | 2003                                   | 
|                                                        |                                          |       |                                        | 
|                                                        | (unaudited)                              |       | (unaudited)                            | 
|Consolidated
            Statements of Operations Data: |                                          |       |                                        | 
|Revenues,
            net                               |                                          | 100.0 | %                                      | 
|Cost
            of revenues                            |                                          | 38.0  |                                        | 
|                                                        |                                          |       |                                        | 
|Gross
            profit                                |                                          | 62.0  |                                        | 
|Operating
            expenses:                         |                                          |       |                                        | 
|Research
            and development                    |                                          | 24.9  |                                        | 
|Sales
            and marketing                         |                                          | 31.4  |                                        | 
|General
            and administrative                  |                                          | 13.9  |                                        | 
|Deferred
            stock compensation                 |                                          | 0.0   |                                        | 
|                                                        |                                          |       |                                        | 
|Total
            operating expenses                    |                                          | 70.2  |                                        | 
|                                                        |                                          |       |                                        | 
|Loss
            from operations                        |                                          | (8.2  | )                                      | 
|Interest
            and other income, net              |                                          | 0.7   |                                        | 
|                                                        |                                          |       |                                        | 
|Net
            loss                                    |                                          | (7.5  | )%                                     | 
|                                                        |                                          |       |                                        | 

Revenues,
net. Revenues consist of sales to end users (including resellers) and
distributors.

Net Revenue by Products:

|                          |  | Three
          Months Ended March 31, |   | Six
          Months Ended March 31, |   
|------------------------- |  | -------------------------------------- | - | ------------------------------------ | --
|                          |  |                                        |   |                                      |   
|                          |  | 2004                                   |   | 2003                                 |   
|                          |  |                                        |   |                                      |   
|Telephone
        systems |  | 84                                     | % |                                      | 92
|Phones                    |  | 15                                     | % |                                      | 7 
|Product
        support   |  | 1                                      | % |                                      | 1 

Net Revenue by Geographic
  Area:

|              |  | Three
          Months Ended March 31, |   | Six
          Months Ended March 31, |    
|------------- |  | -------------------------------------- | - | ------------------------------------ | ---
|              |  |                                        |   |                                      |    
|              |  | 2004                                   |   | 2003                                 |    
|              |  |                                        |   |                                      |    
|Americas      |  | 90                                     | % |                                      | 96 
|International |  | 10                                     | % |                                      | 4  
|              |  |                                        |   |                                      |    
|              |  | 100                                    | % |                                      | 100
|              |  |                                        |   |                                      |    

Net Revenue by Customers:

|                         |  | Three
          Months Ended March 31, |   | Six
          Months Ended March 31, |    
|------------------------ |  | -------------------------------------- | - | ------------------------------------ | ---
|                         |  |                                        |   |                                      |    
|                         |  | 2004                                   |   | 2003                                 |    
|                         |  |                                        |   |                                      |    
|AltiSys                  |  | 15                                     | % |                                      | 14 
|Ingram
            Micro |  | 14                                     | % |                                      | 28 
|Synnex                   |  | 47                                     | % |                                      | 49 
|Other                    |  | 24                                     | % |                                      | 9  
|                         |  |                                        |   |                                      |    
|                         |  | 100                                    | % |                                      | 100
|                         |  |                                        |   |                                      |    

14


---

Total revenues were $3.3
million and $6.9 million for the second quarter and the first six months of
fiscal 2004, an increase of 40% and 32% from total revenues of $2.4 million and
$5.2 million for the same periods in fiscal 2003, respectively. Revenue
generated in the Americas accounted for $3.0 million, or 90%, and $6.3
million, or 91%, for the second quarter and the first six months of fiscal 2004,
respectively, compared to $2.3 million, or 96%, and $5.0 million, or 95%, for
the second quarter and the first six months of fiscal 2003. Net product sales
related to our telephone systems for the second quarter of fiscal 2004 increased
by $621,000, or 29%, to $2.8 million from $2.2 million for the second
quarter of fiscal 2003. Net product sales related to our telephone systems for
the first six months of fiscal 2004 increased by $1.3 million, or 26%, to $6.1
million from $4.8 million for the first six months of fiscal 2003. This increase
was due to strong customer acceptance of our AltiServ Office line, AltiServ 1IP
and AltiServ 2IP, which has contributed to increased sales in each quarter since
the products were introduced in the second quarter of last fiscal year. Net
product sales related to phones for the second quarter of fiscal 2004 increased
by $317,000, or 183%, to $490,000 from $173,000 for the second quarter of fiscal
2003. Net product sales related to phones for the first six months of fiscal
2004 increased by $419,000, or 110%, to $800,000 from $381,000 for the first six
months of fiscal 2003. This increase was due to the introduction of the new
analog phone and increased in sales of our internet protocol phones.

Cost of revenues.
Cost of revenues were $1.3 million and $2.7 million for the second quarter and
the first six months of fiscal 2004, respectively, compared to $1.0 million and
$2.3 million for the same periods in fiscal 2003. This increase was due to an
increase in overall sales of products and the requisite increase in product
costs. Cost of revenues as a percentage of net revenues decreased from 43% and
45% for the second quarter and the first six months of fiscal 2003, to 38% and
39% for the same periods in fiscal 2004, respectively, which resulted in an
increase in product gross margin. For the three months ended March 31, 2004, the
decrease primarily was caused by lower warranty reserve due to the decline in
the product return rate and reversal of inventory allowance in the amount of
$64,000 related to the sale of products which were fully reserved against
obsolesces. Production overhead decreased by $77,000 from $328,000 for the first
six months of fiscal 2003 to $251,000 for the first six months of fiscal 2004.
This decrease primarily was caused by lower actual component costs and overhead
expenses. In addition, manufacturing and other related costs decreased by
$101,000 from $369,000 for the first six months of fiscal 2003 to $268,000 for
the first six months of fiscal 2004, resulting from lower warranty reserve due
to the decline in the product return rate, lower depreciation on equipment and
facilities charges associated with manufacturing activities. No additional
provision for excess or obsolete inventory was necessary in the three months
ended March 31, 2004.

Research and development
expenses. Research and development expenses consist principally of salaries
and related personnel expenses, consultant fees and prototype expenses related
to the design, development and testing of our products and enhancement of our
converged telephone system software. Research and development expenses decreased
to $819,000 for the second quarter of fiscal 2004 from $1.1 million for the same
period in fiscal 2003. This decrease was the result of a decrease in
headcount-related costs of $147,000 resulting from a reduction in our research
and development workforce, a decrease in office rent expense of $46,000 and a
decrease in service fees of $35,000. Research and development expenses as a
percentage of revenue decreased to 25% for the second quarter of fiscal 2004
from 45% for the same period in fiscal 2003. Research and development expenses
decreased to $1.7 million for the first six months of fiscal 2004 from $2.0
million for the same period in fiscal 2003. This decrease was the result of a
decrease in headcount-related costs of $295,000 resulting from a reduction in
our research and development workforce and a decrease in office rent expense of
$75,000. Research and development expenses as a percentage of revenue decreased
to 24% for the first six months of fiscal 2004 from 38% for the same period in
fiscal 2003. We expect research and development expenses to remain relatively
flat due to the uncertainty about customers spending patterns in the
current economic environment. Management continues to monitor research and
development expenses in line with revenue growth.

Sales and marketing
expenses. Sales and marketing expenses consist primarily of salaries,
commissions and related expenses for personnel engaged in marketing, sales and
customer support functions, as well as trade shows, advertising, and promotional
expenses. Sales and marketing expenses decreased to $1.0 million for the second
quarter of fiscal 2004 from $1.3 million for the same period in fiscal 2003.
This decrease was the result of a decrease in headcount-related costs of
$149,000 resulting from a reduction in our marketing workforce and a decrease in
advertising expense of $92,000. Sales and marketing expenses as a percentage of
revenue decreased to 31% for the second quarter of fiscal 2004 from 56% for the
same period in fiscal 2003. Sales and marketing expenses decreased to $2.1
million for the first six months of fiscal 2004 from $2.6 million for the same
period in fiscal 2003. This decrease was the result of a decrease in
headcount-related costs of $263,000 resulting from a reduction in our marketing
workforce and a decrease in advertising expense of $89,000 and a significant
cost reduction measures in the areas of service fees of approximately $102,000.
Sales and marketing expenses as a percentage of revenue decreased to 30% for the
first six months of fiscal 2004 from 49% for the same period in fiscal 2003. We
expect sales and marketing expenses to remain relatively flat due to the
uncertainty about customers spending patterns in the current economic
environment.

General and administrative
  expenses. General and administrative expenses consist of salaries and related
  expenses for executive, finance and administrative personnel, facilities, bad
  debt, legal, and other general corporate expenses. General and administrative
  expenses remained relatively unchanged at $459,000 and $881,000 for the second
  quarter and the first six months of fiscal 2004, compared to $467,000 and $913,000
  for the same periods in fiscal 2003, respectively. General and administrative
  expenses as a percentage of revenue decreased to 14% and 13% for the second
  quarter and the first six months of fiscal 2004, compared to 20% and 17% for
  the same periods in fiscal 2003, respectively, due to primarily to increased
  revenues. We expect to maintain general and administrative expenses at the current
  level.

15


---

Amortization of deferred
stock compensation. We had no amortization of deferred stock compensation in
the second quarter and the first six months of fiscal 2004. Amortization of
deferred stock compensation was $14,000 and $27,000 for the second quarter and
the first six months of fiscal 2003, respectively. Deferred stock compensation
expense reflects the amortization of stock compensation charges resulting from
granting stock options at exercise prices below the deemed fair value of our
common stock on the dates the options were granted. We amortized these deferred
amounts using the straight-line method over the vesting period of the related
stock options. All outstanding deferred stock compensation was amortized in
fiscal year 2003.

Interest and other
income, net. Net interest and other income decreased to $22,000 and $47,000
for the second quarter and the first sixmonths of fiscal 2004, respectively,
from $48,000 and $173,000 for the same periods in fiscal 2003. The decrease
primarily was due to the recognition of interest received from full repayment of
an outstanding promissory note held by our Chief Executive Officer, Gilbert Hu
in fiscal 2003. We expect net interest and other income to continue to decrease
as a result of further decreases in cash available to invest and relatively flat
or lower interest rates.

## Liquidity and
Capital Resources

Since inception, we
primarily have financed our operations through the sale of equity securities. As
of March 31, 2004, we had cash, cash equivalents, and short-term investments
totaling $9.4 million, which consisted of cash and cash equivalents of
$6.6 million and $2.8 million of short-term investments.

Changes in Cash Flows

During the first six months
of fiscal 2004, net cash used in operating activities was $0.9 million, which is
$1.2 million lower than the cash used in operating activities during the
same period in fiscal 2003.

Net accounts receivable
increased to $1.9 million at March 31, 2004 from $1.5 million at
September 30, 2003. The increase in net accounts receivable primarily was
due to higher sales of $1.7 million generated in the last month of the quarter.

Inventories decreased to
$0.8 million at March 31, 2004 from $0.9 million at September 30,
2003 and our inventory turn rate increased to 6.9 times at March 31, 2004 from
5.4 times at September 30, 2003. Inventory turn rate is annualized and
represents the number of times inventory is replenished during the year. The
increase in the inventory turn rate is the result of lower inventory levels and
our ability to efficiently manage our inventory to meet customer demands.
Inventory management will continue to be an area of focus as we balance the need
to maintain strategic inventory levels to help ensure competitive lead times
with the risk of inventory obsolescence due to rapidly changing technology and
customer requirements.

Accounts payable decreased
to $0.5 million at March 31, 2004 from $0.9 million at September 30,
2003. This decrease primarily was due to less inventory purchases in the recent
quarter.

Accrued payroll-related
liabilities increased to $304,000 at March 31, 2004 from $276,000 at
September 30, 2003. This increase primarily was due to an increase in sales
commission related to an increase in revenues.

Other liabilities decreased
to $417,000 at March 31, 2004 from $462,000 at September 30, 2003. This
decrease primarily was due to a decrease in accounting service fees and other
related operational costs.

During the first six months
of fiscal 2004, net cash used in investing activities was a $50,000 long-term
deposit for our new office lease and purchases of short-term investments of
$11.8 million. On October 1, 2003, we entered into a lease for
approximately 32,000 square feet to serve as our new headquarters for corporate
administration, research and development, manufacturing, and sales and marketing
facility in Fremont, California. The lease commenced on December 22, 2003
and expires on February 21, 2009. During the first six months of fiscal
2004, we received proceeds from the sale and maturities of short-term
investments of $10.6 million.

During the first six-months
  of fiscal 2004, net cash provided by financing activities was $175,000 of proceeds
  from the exercise of employee stock options and employee stock purchase plan
  rights.

Liquidity and Capital Resources

We intend to invest our
cash in excess of current operating requirements in short-term, interest bearing
investment-grade securities.

Our cash needs depend on
numerous factors, including market acceptance of and demand for our products,
our ability to develop and introduce new products and enhancements to existing
products, the prices at which we can sell our products, the resources we devote
to developing, marketing, selling and supporting our products, the timing and
expense associated with expanding our distribution channels, increases in
manufacturing costs and the prices of the components we purchase, as well as
other factors. If we need and are unable to raise additional capital or if sales
from our new products or enhancements are lower than expected, we will be
required to make additional reductions in operating expenses and capital
expenditures to ensure that we will have adequate cash reserves to fund
operations.

16


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Additional financing, if
required, may not be available on acceptable terms, or at all. We also may
require additional capital to acquire or invest in complementary businesses or
products, or obtain the right to use complementary technologies. If we need and
cannot raise funds on acceptable terms, we may not be able to further develop or
enhance our products, take advantage of future opportunities, or respond to
competitive pressures or unanticipated requirements, which could seriously harm
our business. Even if additional financing is available, we may be required to
obtain the consent of our stockholders, which we may or may not be able to
obtain. In addition, the issuance of equity or equity-related securities will
dilute the ownership interest of our stockholders and the issuance of debt
securities could increase our risk or perceived risk.

We do not have any material
commitments for capital expenditures as of March 31, 2004. We have commitments
under our noncancellable operating lease in the amount of $1.3 million as
of March 31, 2004. The following table represents our future commitments as of
March 31, 2004:

|                                       |  |       |       |                                                    | Payments
          Due by Period |                      
|-------------------------------------- |  | ----- | ----- | -------------------------------------------------- | -------------------------------- | ---------------------
|                                       |  |       |       |                                                    |                                 
|                                       |  | Total |       | Less
            than
          1
            Year |                                  | 1
          - 3 Years
|                                       |  |       |       |                                                    |                                  |                      
|Office
            lease obligation    |  | $     | 1,279 |                                                    | $                                | 148                  
|Operating
            lease obligation |  |       | 7     |                                                    |                                  | 4                    
|                                       |  |       |       |                                                    |                                  |                      
|Total                                  |  | $     | 1,286 |                                                    | $                                | 152                  
|                                       |  |       |       |                                                    |                                  |                      

We believe we have
sufficient cash reserves to allow us to continue operations for more than a year
assuming our quarterly cash burn rate does not increase over that period, which
we currently do not expect to occur.

## Recent
Accounting Pronouncements

In December 2002, the
Emerging Issues Task Force (EITF) reached a consensus on EITF
No. 00-21, Revenue Arrangements with Multiple Deliverables.
This pronouncement addresses certain aspects of the accounting by a vendor for
arrangements under which it will perform multiple revenue- generating
activities. The guidance in this pronouncement was effective for revenue
arrangements entered into in fiscal periods beginning after June 15, 2003.
The adoption of EITF 00-21 did not have an effect on our consolidated financial
statements.

The Financial Accounting
Standards Board (FASB) issued Interpretation No. 46 (FIN
46), Consolidation of Variable Interest Entities, in January
2003, and a revised interpretation of FIN 46 (FIN 46-R) in December
2003. FIN 46 requires certain variable interest entities (VIEs) to
be consolidated by the primary beneficiary of the entity if the equity investors
in the entity do not have the characteristics of a controlling financial
interest or do not have sufficient equity at risk for the entity to finance its
activities without additional subordinated financial support from other parties.
The adoption of FIN 46 did not have an impact on the Companys financial
position. For all arrangements entered into after January 31, 2003, the Company
is required to continue to apply FIN 46 through April 30, 2004, after that date
the Company is required to adopt the provisions of FIN 46-R for those
arrangements on May 1, 2004. For arrangements entered into prior to February 1,
2003, the Company is required to adopt the provisions of FIN 46-R on May 1,
2004. The Company does not expect the adoption of FIN 46-R to have an impact on
the financial position, results of operations or cash flows of the Company.

In April 2003, the
FASB issued SFAS No. 149, Amendment of SFAS No. 133 on
Derivative Instruments and Hedging Activities. SFAS No. 149 amends
and clarifies accounting for derivative instruments, including certain
derivative instruments embedded in other contracts, and for hedging activities
under SFAS No. 133. SFAS No. 149 was effective for contracts entered
into or modified after June 30, 2003 and did not have an impact on our
consolidated financial statements.

In May 2003, the FASB
issued SFAS No. 150, Accounting for Certain Financial Instruments with
Characteristics of both Liabilities and Equity, which requires that
certain financial instruments be presented as liabilities that were previously
presented as equity or as temporary equity. Such instruments include mandatory
redeemable preferred and common stock, and certain options and warrants. SFAS
No. 150 is effective for financial instruments entered into or modified after
May 31, 2003 and was effective at the beginning of the first interim period
beginning after June 15, 2003. In November 2003, the FASB issued FASB Staff
Position (FSP) No. 150-3, Effective Date, Disclosures, and
Transition for Mandatorily Redeemable Financial Instruments of Certain Nonpublic
Entities and Certain Mandatorily Redeemable Noncontrolling Interests under SFAS
No. 150, which defers the effective date for various provisions of SFAS No. 150.
As of March 31, 2004, we had no financial instruments within the scope of this
pronouncement.

17


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## CERTAIN
FACTORS AFFECTING BUSINESS, OPERATING RESULTS, AND FINANCIAL CONDITION

We have a history of
losses and expect to incur future losses, which may prevent us from becoming
profitable.

We have experienced
operating losses since our inception. As of March 31, 2004, we had an
accumulated deficit of $51.2 million. We expect to incur operating losses
for the foreseeable future, and these losses may be substantial. We do not
expect to increase expenditures for product development, general and
administrative expenses, and sales and marketing expenses; however, if we cannot
increase revenues significantly, we will not achieve either profitability or
positive operating cash flows. Even if we do achieve profitability and positive
operating cash flows, we may not be able to sustain or increase profitability or
positive operating cash flows on a quarterly or annual basis.

The current economic
downturn may continue to adversely affect our revenues, gross margins and
expenses.

Our annual revenue and
operating results have and may continue to fluctuate due to the effects of
general economic conditions in the United States and globally and specific
market conditions in the telecommunications industry. We are uncertain about the
extent, severity, and length of the economic downturn. If the economic
conditions in the United States and globally do not improve, or if the global
economic slowdown worsens, we may continue to experience material negative
effects on our business, operating results, and financial condition.

We have a limited
operating history, which makes it difficult to evaluate our business and our
future prospects.

We shipped our first
products in July 1996. As a result of our limited operating history, we
have limited financial data that you can use to evaluate our business. You must
consider our prospects in light of the risks, expenses and challenges we might
encounter because we are at an early stage of development in a new and rapidly
evolving market. To address these risks and achieve profitability and increased
sales levels, we must:

  Establish and increase market acceptance of our technology, products and systems;




  Expand our network of distributors, dealers and companies that buy our products in bulk, customize them for particular applications or customers, and resell them under their own names;




  Introduce products and systems incorporating our technology and enhancements to our product applications on a timely basis;




  Respond effectively to competitive pressures; and




  Successfully market and support our products and systems.


We may not successfully
meet any of these challenges, and our failure to do so will seriously harm our
business and results of operations. In addition, because of our limited
operating history, we have limited insight into trends that may emerge and harm
our business.

Our operating results
vary, making future operating results difficult to predict.

Our quarterly and annual operating
results have varied significantly in the past and likely will vary significantly
in the future. A number of factors, many of which are beyond our control, may
cause our operating results to vary, including:



  Our sales cycle, which may vary substantially from customer to customer;




  Unfavorable changes in the prices and delivery of the components we purchase;




  The size and timing of orders for our products, which may vary depending on the season, and the contractual terms of the orders;




  The size and timing of our expenses, including operating expenses and expenses of developing new products and product enhancements;


18


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  Deferrals of customer orders in anticipation of new products, services or product enhancements introduced by us or by our competitors; and




  Our ability to attain and maintain production volumes and quality levels for our products.


Our future projected
budgets and commitments are based in part on our expectations of future sales.
If our sales do not meet expectations, it will be difficult for us to reduce our
expenses quickly and, consequently, our operating results may suffer.

Our dealers often require
immediate shipment and installation of our products. As a result, we have
historically operated with limited backlog, and our sales and operating results
in any quarter primarily depend on orders booked and shipped during that
quarter.

Any of the above factors
could harm our business, financial condition and results of operations. We
believe that period-to-period comparisons of our results of operations are not
meaningful, and you should not rely upon them as indicators of our future
performance.

Our market is highly
competitive and we may not have the resources to adequately compete.

The market for our
integrated, multifunction telecommunications systems is new, rapidly evolving
and highly competitive. We expect competition to intensify in the future as
existing competitors develop new products and new competitors enter the market.
We believe that a critical component to success in this market is the ability to
establish and maintain strong partner and customer relationships with a wide
variety of domestic and international providers. If we fail to establish or
maintain these relationships, we will be at a serious competitive disadvantage.

We face competition from
companies providing traditional private telephone systems. Our principal
competitors that produce these telephone systems are Avaya Communications, NEC
and Nortel Networks. We also compete against providers of multifunction
telecommunications systems, including Artisoft, Inc., Shoreline
Communications, Inc., 3Com Corporation, and Cisco Systems, Inc., as
well as any number of future competitors. Many of our competitors are
substantially larger than we are and have significantly greater name
recognition, financial resources, sales and marketing teams, technical and
customer support, manufacturing capabilities and other resources. These
competitors also may have more established distribution channels and stronger
relationships with service providers. These competitors may be able to respond
more rapidly to new or emerging technologies and changes in customer
requirements or to devote greater resources to the development, promotion and
sale of their products. These competitors may enter our existing or future
markets with products that may be less expensive, provide higher performance or
additional features or be introduced earlier than our phone systems. We also
expect that other companies may enter our market with better products and
technologies. If any technology that is competing with ours is more reliable,
faster, less expensive or has other advantages over our technology, then the
demand for our products and services could decrease and harm our business.

We expect our competitors
to continue to improve the performance of their current products and introduce
new products or new technologies. If our competitors successfully introduce new
products or enhance their existing products, our sales or market acceptance of
our products and services could be reduced, price competition could decreased or
make our products could become obsolete. To be competitive, therefore, we must
continue to invest significant resources in research and development, sales and
marketing and customer support. We may not have sufficient resources to make
these investments or to make the technological advances necessary to be
competitive, which in turn will cause our business to suffer.

Losing any of our key
distributors would harm our business. We also need to establish and maintain
relationships with additional distributors and original equipment manufacturers.

Sales through our four key
distributors, Altisys, Ingram Micro Inc., Graybar and Synnex, accounted for
83% and 84% of our net revenues in the second quarter and the first six months
of fiscal year 2004, respectively. Our business and operating results will
suffer if any one of these distributors does not continue distributing our
products, fails to distribute the volume of our products that it currently
distributes or fails to expand our customer base. We also need to establish and
maintain relationships with additional distributors and original equipment
manufacturers. We may not be able to establish, or successfully manage,
relationships with additional distribution partners. In addition, our agreements
with distributors typically provide for termination by either party upon written
notice to the other party. For example, our agreement with Ingram Micro provides
for termination, with or without cause, by either party upon 30 days
written notice to the other party, or upon insolvency or bankruptcy. Generally,
these agreements are non-exclusive and distributors sell products that compete
with ours. If we fail to establish or maintain relationships with distributors
and original equipment manufacturers, our ability to increase or maintain our
sales and our customer base will be substantially harmed.

19


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We sell our products
through dealers and distributors, which limits our ability to control the timing
of our sales, and which makes it more difficult to predict our revenues.

We do not recognize revenue
from the sale of our products to our distributors until these products are sold
to either resellers or end-users. We have little control over the timing of
product sales to dealers and end users. Our lack of control over the revenue
that we recognize from our distributors sales to resellers and end-users
limits our ability to predict revenue for any given period. Our future projected
budgets and commitments are based in part on our expectations of future sales.
If our sales do not meet expectations, it will be difficult for us to reduce our
expenses quickly, and consequently our operating results may suffer.

We rely on sole-sourced
components and third party technology and products; if these components are not
available, our business may suffer.

We purchase technology from
third parties that is incorporated into many of our products, including
virtually all of our hardware products. We order sole-sourced components using
purchase orders and do not have supply contracts for them. One sole-sourced
component, a TI DSP chip, is particularly important to our business because it
is included in virtually all of our hardware products. If we were unable to
purchase an adequate supply of these sole-sourced components on a timely basis,
we would be required to develop alternative products, which could entail
qualifying an alternative source or redesigning our products based on different
components. Our inability to obtain these sole-sourced components, especially
the TI DSP chip, could significantly delay shipment of our products, which could
have a negative effect on our business, financial condition and results of
operations.

We rely on resellers to
promote, sell, install and support our products, and their failure to do so may
substantially reduce our sales and thus seriously harm our business.

We rely on resellers who
can provide high quality sales and support services. As with our distributors,
we compete with other telecommunications systems providers for our
resellers business as our resellers generally market competing products.
If a reseller promotes a competitors products to the detriment of our
products or otherwise fails to market our products and services effectively, we
could lose market share. In addition, the loss of a key reseller or the failure
of resellers to provide adequate customer service could cause our business to
suffer. If we do not properly train our resellers to sell, install and service
our products, our business will suffer.

Software or hardware
errors may seriously harm our business and damage our reputation, causing loss
of customers and revenues.

Users expect telephone
systems to provide a high level of reliability. Our products are inherently
complex and may have undetected software or hardware errors. We have detected
and may continue to detect errors and product defects in our installed base of
products, new product releases and product upgrades. End-users may install,
maintain and use our products improperly or for purposes for which they were not
designed. These problems may degrade or terminate the operation of our products,
which could cause end-users to lose telephone service, cause us to incur
significant warranty and repair costs, damage our reputation and cause
significant customer relations problems. Any significant delay in the commercial
introduction of our products due to errors or defects, any design modifications
required to correct these errors or defects or any negative effect on customer
satisfaction as a result of errors or defects could seriously harm our business,
financial condition and results of operations.

Any claims brought because
of problems with our products or services could seriously harm our business,
financial condition and results of operations. We currently offer a one-year
hardware guarantee to end-users. If our products fail within the first year, we
face replacement costs. Our insurance policies may not provide sufficient or any
coverage should a claim be asserted. In addition, our introduction of products
and systems with reliability, quality or compatibility problems could result in
reduced revenues, uncollectible accounts receivable, delays in collecting
accounts receivable, warranties and additional costs. Our customers, end-users
or employees could find errors in our products and systems after we have begun
to sell them, resulting in product redevelopment costs and loss of, or delay in,
their acceptance by the markets in which we compete. Further, we may experience
significant product returns in the future. Any of these events could have a
material adverse effect on our business, financial condition and results of
operations.

We may face infringement
issues that could harm our business by requiring us to license technology on
unfavorable terms or temporarily or permanently cease sales of key products.

We may become parties to
litigation in the normal course of our business. Litigation in general, and
intellectual property and securities litigation in particular, can be expensive
and disruptive to normal business operations. Moreover, the results of complex
litigation are difficult to predict.

20


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On September 6, 2002, Vertical Networks, Inc. filed suit against us in the United States District Court for the Northern District
of California, alleging infringement of Vertical Networks' United States Patents Nos. 6,266,341; 6,289,025; 6,292,482; 6,389,009;
and 6,396,849. On October 28, 2002, Vertical Networks amended its Complaint to add allegations of infringement of Patents Nos.
5,617,418 and 5,687,174. Vertical Networks filed a Second Amended Complaint on November 20, 2002 to identify our products and/or
activities that allegedly infringe the seven patents-in-suit. Vertical Networks seeks a judgment of patent infringement and an
award of damages, including treble damages for alleged willful infringement, and attorneys' fees and costs. We filed an Answer and
Counterclaims for Declaratory Relief on December 9, 2002. On December 26, 2002, Vertical Networks filed its Answer to our
Counterclaims. Vertical Networks served its Preliminary Infringement Contentions on us on April 9, 2003 and we served its
Preliminary Invalidity Contentions on June 3, 2003, and July 14, 2003. To date, the parties have exchanged some discovery, but no
depositions have been taken, and no motions are currently pending. On October 7, 2003, the parties filed a stipulation to stay
this action, pending the outcome of the reissue of some of the subject patents before the United States Patent and Trademark
Office. We believe we have strong defenses and arguments in this dispute and intend to vigorously litigate our position. Thus,
management's view is that any loss from this litigation is not probable or estimable.

More generally, litigation
related to these types of claims may require us to acquire licenses under
third-party patents that may not be available on acceptable terms, if at all. We
believe that an increasing portion of our revenues in the future will come from
sales of software applications for our hardware products. The software market
traditionally has experienced widespread unauthorized reproduction of products
in violation of developers intellectual property rights. This activity is
difficult to detect, and legal proceedings to enforce developers
intellectual property rights are often burdensome and involve a high degree of
uncertainty and substantial costs.

Any failure by us to
protect our intellectual property could harm our business and competitive
position.

Our success depends, to a
certain extent, upon our proprietary technology. We currently rely on a
combination of patent, trade secret, copyright and trademark law, together with
non-disclosure and invention assignment agreements, to establish and protect the
proprietary rights in the technology used in our products.

Although we have filed
patent applications, we are not certain that our patent applications will result
in the issuance of patents, or that any patents issued will provide commercially
significant protection of our technology. In addition, other individuals or
companies may independently develop substantially equivalent proprietary
information not covered by patents to which we own rights, may obtain access to
our know-how or may claim to have issued patents that prevent the sale of one or
more of our products. Also, it may be possible for third parties to obtain and
use our proprietary information without our authorization. Further, the laws of
some countries, such as those in Japan, one of our target markets, may not
adequately protect our intellectual property or such protection may be
uncertain. Our success also depends on trade secrets that cannot be patented and
are difficult to protect. If we fail to protect our proprietary information
effectively, or if third parties use our proprietary technology without
authorization, our competitive position and business will suffer.

Our products may not
meet the legal standards required for their sale in some countries; if we cannot
sell our products in these countries, our results of operations may be seriously
harmed.

The United States and other
countries in which we intend to sell our products have standards for safety and
other certifications that must be met for our products to be legally sold in
those countries. We have tried to design our products to meet the requirements
of the countries where we sell or plan to sell them. We also have obtained or
are trying to obtain the certifications that we believe are required to sell our
products in these countries. We cannot, however, guarantee that our products
meet all of these standards or that we will be able to obtain any certifications
required. In addition, there is, and will likely continue to be, an increasing
number of laws and regulations pertaining to the products we offer and may offer
in the future. These laws or regulations may include, for example, more
stringent safety standards, requirements for additional or more burdensome
certifications or more stringent consumer protection laws.

If our products do not meet
a countrys standards or we do not receive the certifications required by a
countrys laws or regulations, then we may not be able to sell our products
in that country. This inability to sell our products may seriously harm our
results of operation by reducing our sales or requiring us to invest significant
resources to conform our products to these standards.

Our market is subject to
changing preferences; failure to keep up with these changes would result in our
losing market share, thus seriously harming our business, financial condition
and results of operations.

Our customers and end-users
expect frequent product introductions and have changing requirements for new
products and features. In order to be competitive, therefore, we need to develop
and market new products and product enhancements that respond to these changing
requirements on a timely and cost-effective basis. Our failure to do so promptly
and cost effectively would seriously harm our business, financial condition and
results of operations. Also, introducing new products could require us to
write-off existing inventory as obsolete, which could harm our results of
operations.

If we are unable to
raise additional capital when needed, we may be unable to develop or enhance our
products and services.

21


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We may seek additional
funding in the future. If we cannot raise funds on acceptable terms, we may be
unable to develop or enhance our products and services, take advantage of future
opportunities or respond to competitive pressures or unanticipated requirements.
We also may be required to reduce operating costs through lay-offs or reduce our
sales and marketing or research and development efforts. If we issue equity
securities, stockholders may experience additional dilution or the new equity
securities may have rights, preferences or privileges senior to those of our
common stock.

If we do not manage our growth effectively, our business will suffer.

We may not be successful in
managing our future growth. We have expanded our operations rapidly since our
inception. In order to manage this expansion and grow in the future, we will
need to expand or enhance our management, manufacturing, research and
development and sales and marketing capabilities. We may not be able to hire the
management, staff or other personnel required to do so.

We may not be able to
install adequate control systems in an efficient and timely manner, and our
current or planned operational systems, procedures and controls may not be
adequate to support our future operations. Difficulties in installing and
implementing new systems, procedures and controls may significantly burden our
management and our internal resources. Delays in the implementation of new
systems or operational disruptions when we transition to new systems would
impair our ability to accurately forecast sales demand, manage our product
inventory and record and report financial and management information on a timely
and accurate basis.

Lead times for materials
and components used in the assembly of our products vary significantly, and
depend on factors such as the supplier, contract terms and demand for a
component at a given time. If orders do not match forecasts, we may have excess
or inadequate inventory of certain materials and components, which may seriously
harm our business, financial condition and results of operations.

Our planned expansion in
international markets will involve new risks that our previous domestic
operations have not prepared us to address; our failure to address these risks
could harm our business, financial condition and results of operations.

For the second quarter and
the first six months of fiscal year 2004, approximately 10% and 9% of our net
revenues, respectively, came from customers outside of the United States. We
intend to expand our international sales and marketing efforts. Our efforts are
subject to a variety of risks associated with conducting business
internationally, any of which could seriously harm our business, financial
condition and results of operations. These risks include:

  tariffs, duties, price controls or other restrictions on foreign currencies or trade barriers, such as import or export licensing imposed by foreign countries, especially on technology;




  potential adverse tax consequences, including restrictions on repatriation of earnings;




  fluctuations in foreign currency exchange rates, which could make our products relatively more expensive in foreign markets; and




  conflicting regulatory requirements in different countries that may require us to invest significant resources customizing our products for each country.


We depend on attracting
and retaining qualified personnel to maintain and expand our business; our
failure to promptly attract and retain qualified personnel may seriously harm
our business, financial condition and results of operations.

We depend, in large part,
on our ability to attract and retain highly skilled personnel, particularly
engineers and sales and marketing personnel. We need highly trained technical
personnel to design and support our server-based telecommunications systems. In
addition, we need highly trained sales and marketing personnel to expand our
marketing and sales operations in order to increase market awareness of our
products and generate increased revenues. Competition for highly trained
personnel is intense, especially in the San Francisco Bay Area where most of our
operations are located. We cannot be certain that we will be successful in our
recruitment and retention efforts. If we fail to attract or retain qualified
personnel or suffer from delays in hiring required personnel, our business,
financial condition and results of operations may be seriously harmed.

Our facility is
vulnerable to damage from earthquakes and other natural disasters and other
business interruptions; any such damage could seriously or completely impair our
business.

We perform final assembly,
software installation and testing of our products at our facility in Fremont,
California. Our facility is located on or near known earthquake fault zones and
may be subject to rolling electrical blackouts and is vulnerable to damage or
interruption

22


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from fire, floods,
earthquakes, power loss, telecommunications failures and similar events. If such
a disaster or interruption occurs, our ability to perform final assembly,
software installation and testing of our products at our facility would be
seriously, if not completely, impaired. If we were unable to obtain an
alternative place or way to perform these functions, our business, financial
condition and results of operations would suffer. The insurance we maintain may
not be adequate to cover our losses against fires, floods, earthquakes and
general business interruptions.

Our strategy to
outsource assembly and test functions in the future could delay delivery of
products, decrease quality or increase costs.

Based on volume or customer
requirements, we may begin outsourcing some assembly and test functions. In
addition, we may determine that we need to establish assembly and test
operations overseas to better serve our international customers. Establishing
overseas assembly and test operations may be more difficult or take longer than
we anticipate. This outsourcing strategy involves certain risks, including the
potential lack of adequate capacity and reduced control over delivery schedules,
manufacturing yield, quality and costs. In the event that any significant
subcontractor were to become unable or unwilling to continue to manufacture or
test our products in the required volumes, we would have to identify and qualify
acceptable replacements. Finding replacements could take time and we cannot be
sure that additional sources would be available to us on a timely basis. Any
delay or increase in costs in the assembly and testing of products by
third-party subcontractors could seriously harm our business, financial
condition and results of operations.

Risks Related to the Industry

Integrated,
multifunction telecommunications systems may not achieve widespread acceptance.

The market for integrated,
multifunction telecommunications systems is relatively new and rapidly evolving.
Businesses have invested substantial resources in the existing
telecommunications infrastructure, including traditional private telephone
systems, and may be unwilling to replace these systems in the near term or at
all. Businesses also may be reluctant to adopt integrated, multifunction
telecommunications systems because of their concern about the current
limitations of data networks, including the Internet. For example, end users
sometimes experience delays in receiving calls and reduced voice quality during
calls when routing calls over data networks. Moreover, businesses that begin to
route calls over the same networks that currently carry only their data also may
experience these problems if the networks do not have sufficient capacity to
carry all of these communications at the same time.

Future regulation or
legislation could harm our business or increase our cost of doing business.

In April 1998, the Federal
Communications Commission submitted a report to Congress stating that it may
regulate certain Internet services if it determines that such Internet services
are functionally equivalent to conventional telecommunications services. The
increasing growth of the voice over data network market and the popularity of
supporting products and services, heighten the risk that national governments
will seek to regulate the transmission of voice communications over networks
such as the Internet. In addition, large telecommunications companies may devote
substantial lobbying efforts to influence the regulation of this market so as to
benefit their interests, which may be contrary to our interests. These
regulations may include, for example, assessing access or settlement charges,
imposing tariffs or imposing regulations based on encryption concerns or the
characteristics and quality of products and services. Future laws, legal
decisions or regulations, as well as changes in interpretations of existing laws
and regulations, could require us to expend significant resources to comply with
them. In addition, these future events or changes may create uncertainty in our
market that could reduce demand for our products.

Evolving standards may
delay our product introductions, increase our product development costs or cause
end users to defer or cancel plans to purchase our products, any of which could
adversely affect our business.

The standards in our market
are still evolving. These standards are designed to ensure that integrated,
multifunction telecommunications products from different manufacturers can
operate together. Some of these standards are proposed by other participants in
our market, including some of our competitors, and include proprietary
technology. In recent years, these standards have changed, and new standards
have been proposed, in response to developments in our market. Our failure to
conform our products to existing or future standards may limit their acceptance
by market participants. We may not anticipate which standards will achieve the
broadest acceptance in our market in the future, and we may take a significant
amount of time and expense to adapt our products to these standards. We also may
have to pay additional royalties to developers of proprietary technologies that
become standards in our market. These delays and expenses may seriously harm our
results of operations. In addition, customers and users may defer or cancel
plans to purchase our products due to concerns about the ability of our products
to conform to existing standards or to adapt to new or changed standards, and
this could seriously harm our results of operations.

23


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## Item 3.
Quantitative and Qualitative Disclosures About Market Risk.

Market Risk. Our
interest income is sensitive to changes in the general level of U.S. interest
rates, particularly since the majority of our investments are in cash
equivalents and short-term instruments. Due to the short-term nature of our cash
equivalents and investments, we have concluded that a change in interest rates
does not pose a material market risk to us.

## Item 4.
Controls and Procedures

(a)  Evaluation of disclosure controls and procedures . Our management evaluated, with the participation of our Chief Executive Officer and our Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures are adequate and effective to ensure that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commiss

ion rules and forms.




(b)  Changes in internal control over financial reporting . There was no change in our internal control over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.


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## PART II OTHER
INFORMATION

## Item 1. Legal Proceedings

We may become parties to
litigation in the normal course of our business. Litigation in general, and
intellectual property and securities litigation in particular, can be expensive
and disruptive to normal business operations. Moreover, the results of complex
litigation are difficult to predict.

On September 6, 2002,
Vertical Networks, Inc. filed suit against us in the United States District
Court for the Northern District of California, alleging infringement of Vertical
Networks United States Patents Nos. 6,266,341; 6,289,025; 6,292,482;
6,389,009; and 6,396,849. On October 28, 2002, Vertical Networks amended
its Complaint to add allegations of infringement of Patents Nos. 5,617,418 and
5,687,174. Vertical Networks filed a Second Amended Complaint on
November 20, 2002 to identify our products and/or activities that allegedly
infringe the seven patents-in-suit. Vertical Networks seeks a judgment of patent
infringement and an award of damages, including treble damages for alleged
willful infringement, and attorneys fees and costs. We filed an Answer and
Counterclaims for Declaratory Relief on December 9, 2002. On
December 26, 2002, Vertical Networks filed its Answer to our Counterclaims.
Vertical Networks served its Preliminary Infringement Contentions on us on
April 9, 2003 and we served its Preliminary Invalidity Contentions on
June 3, 2003, and July 14, 2003. To date, the parties have exchanged
some discovery, but no depositions have been taken, and no motions are currently
pending. On October 7, 2003, the parties filed a stipulation to stay this
action, pending the outcome of the reissue of some of the subject patents before
the United States Patent and Trademark Office. We believe we have strong
defenses and arguments in this dispute and intend to vigorously litigate our
position. Thus, managements view is that any loss from this litigation is
not probable or estimable.

## Item 2.
Changes in Securities and Use of Proceeds

During the three months
ended March 31, 2004, we issued 85,262 shares of common stock pursuant to the
exercise of stock options at an exercise price ranging from $0.58 to $2.13 per
share. All of these stock options were granted under our 1994 and 1999 Stock
Option Plans. The issuance of these shares was exempt from registration
requirements pursuant to rule 701 promulgated under the Securities Act of 1933,
as amended.

## Item 3.
Defaults Upon Senior Securities

None

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

On February 12, 2004, we
held our annual meeting of stockholders to seek their approval as to the
following matters:

  The reelection of Richard Black and Wen-Huang (Simon) Chang as Class II Directors.


As to the reelection:


  Mr. Black received 11,738,866 votes for reelection and 48,640 shares withheld.


  Mr. Chang received 11,720,621 votes for reelection and 66,885 shares withheld.


  The ratification of the appointment of Deloitte & Touche, LLP as our independent auditors.


As to the ratification of the appointment of Deloitte & Touche, LLP:


  11,722,016 shares voted for the appointment, 46,140 shares voted against the appointment and 19,350 shares abstained from voting.


In addition, the terms of
the following directors continued after the date of the meeting: Kenneth Tai,
Tacheng Chester Wang, and Gilbert Hu.

There were 14,124,819
shares issued, outstanding and eligible to vote at the meeting.

Effective as of March 1,
2004, Mr. Chang resigned from the Board of Directors in order to pursue other
opportunities.

25


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## Item 5 Other
Information

## Item 6.
Exhibits and Reports on Form 8-K

|(a) | Exhibits                                                                                                                                                                                                                                                                                   
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    |                                                                                                                                                                                                                                                                                            
|    | Please refer to the Exhibit Index of this
      report on Form 10-Q.                                                                                                                                                                                                                       
|    |                                                                                                                                                                                                                                                                                            
|(b) | Reports on Form 8-K                                                                                                                                                                                                                                                                        
|    |                                                                                                                                                                                                                                                                                            
|    | We filed a current report on Form 8-K
      with the Securities and Exchange Commission reporting under Items 7 and
      12, on January 29, 2004 furnishing our press release, dated January 29,
      2004, announcing financial results for the first quarter of fiscal year
      2004.

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# SIGNATURE

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

|                   | ALTIGEN COMMUNICATIONS, INC.                
|------------------ | --------------------------------------------
|                   |                                             
|                   |                                             
|Date: May 14, 2004 | By:                                         
|                   |                                             
|                   | Philip M. McDermott,                        
|                   | Chief Financial Officer                     
|                   | (Principal Financial and Accounting Officer)

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EXHIBIT INDEX





|Exhibit
Number |  | Description                                                                                                                                       
|-------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------
|               |  |                                                                                                                                                   
|               |  |                                                                                                                                                   
|3.2            |  | Second Amended and Restated Bylaws of Registrant                                                                                                  
|               |  |                                                                                                                                                   
|31.1           |  | Certification of Principal Executive Officer.                                                                                                     
|               |  |                                                                                                                                                   
|31.2           |  | Certification of Principal Financial Officer.                                                                                                     
|               |  |                                                                                                                                                   
|32.1           |  | Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
|               |  |                                                                                                                                                   
|32.2           |  | Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.




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