**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

----

 

**FORM 10-Q**

 
| **ý****QUARTERLY REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                         |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **FOR THE QUARTERLY  PERIOD ENDED DECEMBER 31, 2003**                                                                                                                                                                                                                                                          |
|                                                                                                                                                                                                                                                                                                           |   |
| **o****TRANSITION REPORT  PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                             |
| **FOR THE TRANSITION  PERIOD  FROM                      TO                      ** |
|                                                                                                                                                                                                                                                                                                           |
| **Commission File Number   0-27427**                                                                                                                                                                                                                                                                      |

 

----

 

**ALTIGENCOMMUNICATIONS, INC.**

(Exact name of Registrant asspecified in its charter)

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

 

----

 

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2)has been subject to such filing requirements for the past90 days.     YES ý NO  o

 

Indicate by check mark whether the registrantis an accelerated filer.     YES o NO  ý

 

The number of shares of our common stockoutstanding as of February 11, 2004 was: **14,137,686 shares**

 

 

----

 

**Table of Contents**

 
| **PART I  FINANCIAL INFORMATION** |                                                                                                              |
|----------------------------------------|-------------------------------------------------------------------------------------------------------------------|
|                                   |                                                                                                              |   |
| Item  1.                               | Unaudited  Condensed Consolidated Financial Statements                                                            |   |
|                                   |                                                                                                              |   |
|                                   | Unaudited Condensed Consolidated Balance  Sheets as of  December 31, 2003 and September 30, 2003                  |   |
|                                   |                                                                                                              |   |
|                                   | Unaudited Condensed Consolidated Statements  of Operations for  the Three Months Ended December 31, 2003 and 2002 |   |
|                                   |                                                                                                              |   |
|                                   | Unaudited Condensed Consolidated Statements  of Cash Flows for  the Three Months Ended December 31, 2003 and 2002 |   |
|                                   |                                                                                                              |   |
|                                   | 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                                                                                  |   |
|                                   |                                                                                                              |   |
| **SIGNATURES**                         |                                                                                                              |
|                                   |                                                                                                              |
| **CERTIFICATION**                      |                                                                                                              |

 

2

----

 

**PART I.  FINANCIAL INFORMATION**

**Item 1.****                     UnauditedCondensed Consolidated Financial Statements**

 

**ALTIGEN COMMUNICATIONS, INC.  AND SUBSIDIARY**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(in thousands, except share and per shareamounts)**

 
|                                                                                                                                                                         |   | **December 31,  2003** |       | **September 30,  2003** |       |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------|------------|-------------------------|------------|
|                                                                                                                                                                         |   | **(unaudited)**        |       |                    |       |
|                                                                                                                                                                         |   |                   | ** ** |                    | ** ** |
| **ASSETS**                                                                                                                                                                   |   |                   | ** ** |                    | ** ** |
| Current assets:                                                                                                                                                              |   |                   |       |                    |       |
| Cash and cash equivalents                                                                                                                                                    |   | $                      | 6,111      |                    | $          | 8,548 |   |
| Short-term investments                                                                                                                                                       |   | 3,376                  |       | 1,598                   |       |
|                                                                                                                                                                         |   |                   |       |                    |       |
| Accounts receivable, net of allowances of $66 and  $60 at December 31, 2003 and September 30, 2003, respectively                                                             |   | 1,852                  |       | 1,521                   |       |
| Inventories                                                                                                                                                                  |   | 714                    |       | 910                     |       |
| Prepaid expenses and other current assets                                                                                                                                    |   | 214                    |       | 193                     |       |
| Total current assets                                                                                                                                                         |   | 12,267                 |       | 12,770                  |       |
| Property and equipment:                                                                                                                                                      |   |                   |       |                    |       |
| Furniture and equipment                                                                                                                                                      |   | 1,859                  |       | 1,853                   |       |
| Computer software                                                                                                                                                            |   | 942                    |       | 941                     |       |
|                                                                                                                                                                         |   | 2,801                  |       | 2,794                   |       |
| Less: Accumulated depreciation and amortization                                                                                                                              |   | (2,622                 | )          | (2,549                  | )          |
| Net property and equipment                                                                                                                                                   |   | 179                    |       | 245                     |       |
| Other non-current assets:                                                                                                                                                    |   |                   |       |                    |       |
| Long-term investment                                                                                                                                                         |   | 195                    |       | 195                     |       |
| Long-term deposit                                                                                                                                                            |   | 50                     |       | —                  |       |
| Total other non-current assets                                                                                                                                               |   | 245                    |       | 195                     |       |
| Total assets                                                                                                                                                                 |   | $                      | 12,691     |                    | $          | 13,210 |   |
|                                                                                                                                                                         |   |                   |       |                    |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                               |   |                   | ** ** |                    | ** ** |
| Current liabilities:                                                                                                                                                         |   |                   |       |                    |       |
| Accounts payable                                                                                                                                                             |   | $                      | 428        |                    | $          | 873 |   |
| Accrued liabilities:                                                                                                                                                         |   |                   |       |                    |       |
| Payroll and related benefits                                                                                                                                                 |   | 291                    |       | 276                     |       |
| Warranty (Note 3)                                                                                                                                                            |   | 670                    |       | 644                     |       |
| Marketing                                                                                                                                                                    |   | 231                    |       | 253                     |       |
| Other                                                                                                                                                                        |   | 450                    |       | 462                     |       |
| Deferred revenue                                                                                                                                                             |   | 268                    |       | 412                     |       |
| Total current liabilities                                                                                                                                                    |   | 2,338                  |       | 2,920                   |       |
|                                                                                                                                                                         |   |                   |       |                    |       |
| Stockholders’ equity:                                                                                                                                                   |   |                   |       |                    |       |
|                                                                                                                                                                         |   |                   |       |                    |       |
| Convertible preferred stock, $0.001 par value;  Authorized – 5,000,000  shares; None  outstanding at December 31, 2003 and September 30, 2003                      |   | —                 |       | —                  |       |
| Common stock, $0.001 par value; Authorized –  50,000,000 shares; Outstanding – 15,188,714 shares at December 31, 2003 and  15,054,442 shares at September 30, 2003 |   | 15                     |       | 15                      |       |
| Treasury stock at cost – 1,063,895  shares at December 31, 2003 and September  30, 2003                                                                            |   | (1,014                 | )          | (1,014                  | )          |
| Additional paid-in capital                                                                                                                                                   |   | 62,261                 |       | 62,152                  |       |
| Accumulated deficit                                                                                                                                                          |   | (50,909                | )          | (50,863                 | )          |
| Total stockholders’ equity                                                                                                                                              |   | 10,353                 |       | 10,290                  |       |
| Total liabilities and stockholders’ equity                                                                                                                              |   | $                      | 12,691     |                    | $          | 13,210 |   |

 

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

 

3

----

 

**ALTIGEN COMMUNICATIONS,INC. AND SUBSIDIARY**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(UNAUDITED)**

**(in thousands, exceptper share amounts)**

 
|                                                           |   | **Three  Months Ended December 31,** |   |
|----------------------------------------------------------------|--------|--------------------------------------|--------|
|                                                           |   | **2003**                             |   | **2002** |   |
|                                                           |   |                                 |   |   |   |
| Revenues, net                                                  |   | $                                    | 3,630  |   | $ | 2,890 |   |
| Cost of revenues                                               |   | 1,438                                |   | 1,330 |   |
|                                                           |   |                                 |   |   |   |
| Gross profit                                                   |   | 2,192                                |   | 1,560 |   |
| Operating expenses:                                            |   |                                 |   |   |   |
| Research and development                                       |   | 828                                  |   | 947 |   |
| Sales and marketing                                            |   | 1,013                                |   | 1,264 |   |
| General and administrative                                     |   | 422                                  |   | 446 |   |
| Deferred stock compensation (Note 4)                           |   | —                               |   | 13 |   |
|                                                           |   |                                 |   |   |   |
| Total operating expenses                                       |   | 2,263                                |   | 2,670 |   |
| Loss from operations                                           |   | (71                                  | )      | (1,110 | ) |
| Interest and other income, net                                 |   | 25                                   |   | 125 |   |
| Net loss                                                       |   | $                                    | (46    | ) | $ | (985 | ) |
| Basic and diluted net loss per share                           |   | $                                    | (0.00  | ) | $ | (0.07 | ) |
| Shares used in computing basic and diluted net loss  per share |   | 14,116                               |   | 13,521 |   |

 

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

 

4

----

 

**ALTIGEN COMMUNICATIONS,INC. AND SUBSIDIARY**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(UNAUDITED)**

**(inthousands)**

 
|                                                                         |   | **Three  Months Ended December 31,** |   |
|------------------------------------------------------------------------------|--------|--------------------------------------|--------|
|                                                                         |   | **2003**                             |   | **2002** |   |
|                                                                         |   |                                 |   |   |   |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                        |   |                                 |   |   |   |
| Net loss                                                                     |   | $                                    | (46    | ) | $ | (985 | ) |
| Adjustments to reconcile net loss to net cash used  in operating activities: |   |                                 |   |   |   |
| Depreciation and amortization                                                |   | 73                                   |   | 127 |   |
| Amortization of deferred stock compensation                                  |   | —                               |   | 13 |   |
| Changes in operating assets and liabilities                                  |   |                                 |   |   |   |
| Accounts receivable                                                          |   | (331                                 | )      | 126 |   |
| Inventories                                                                  |   | 196                                  |   | 157 |   |
| Prepaid expenses and other current assets                                    |   | (21                                  | )      | (313 | ) |
| Accounts payable                                                             |   | (445                                 | )      | 109 |   |
| Accrued liabilities                                                          |   | 7                                    |   | (185 | ) |
| Deferred revenue                                                             |   | (144                                 | )      | 136 |   |
| Net cash used in operating activities                                        |   | (711                                 | )      | (815 | ) |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                        |   |                                 |   |   |   |
| Purchases of short-term investments                                          |   | (3,369                               | )      | (6,446 | ) |
| Proceeds from sale and maturities of short-term  investments                 |   | 1,591                                |   | 4,950 |   |
| Increase in deposit                                                          |   | (50                                  | )      | — |   |
| Purchases of property and equipment                                          |   | (7                                   | )      | (12 | ) |
| Net cash used in investing activities                                        |   | (1,835                               | )      | (1,508 | ) |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                        |   |                                 |   |   |   |
| Proceeds from issuances of common stock                                      |   | 109                                  |   | 28 |   |
| Collection of promissory note from  officer/stockholder                      |   | —                               |   | 343 |   |
| Net cash provided by financing activities                                    |   | 109                                  |   | 371 |   |
| NET DECREASE IN CASH AND CASH EQUIVALENTS                                    |   | (2,437                               | )      | (1,952 | ) |
| CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD                               |   | 8,548                                |   | 7,210 |   |
| CASH AND CASH EQUIVALENTS, END OF PERIOD                                     |   | $                                    | 6,111  |   | $ | 5,258 |   |
|                                                                         |   |                                 |   |   |   |
| NONCASH INVESTING ACTIVITIES:                                                |   |                                 |   |   |   |
| Unrealized gain on short term investments                                    |   | $                                    | — |   | $ | 1 |   |

 

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

 

5

----

 

**NOTESTO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**1. SUMMARY OF SIGNIFICANT ACCOUNTINGPOLICIES**

 

**BASISOF PRESENTATION**

 

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

 

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

 

These financial statementsshould be read in conjunction with our audited consolidated financialstatements for the fiscal year ended September 30, 2003, included in theCompany’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 notnecessarily indicative of the results of operations for any other interimperiod or for a full fiscal year.

 

**CASH ANDCASH EQUIVALENTS AND SHORT-TERM INVESTMENTS**

 

We consider all highly liquid investments with an original maturity ofthree months or less from the date of purchase to be cash equivalents.Short-term investments are in highly liquid financial instruments with originalmaturities greater than three months but less than one year and are classifiedas “available-for-sale” investments. Investments are reported at their fairvalue, with unrealized gains and losses excluded from earnings and reported asa separate component of stockholders’ equity. As of December 31, 2003, our cash and cash equivalents consisted ofcommercial paper and cash deposited in checking and money market accounts. Forthe three-months ended December 31, 2003 and December 31, 2002, we did not makeany cash payments for interest or income taxes.

 

**INVENTORIES**

 

Inventories (which includecosts associated with components assembled by third-party assemblymanufacturers, as well as internal labor and allocable overhead) are stated atthe lower of cost (first-in, first-out method) or market. Provisions, whenrequired, are made to reduce excess and obsolete inventories to their estimatednet realizable values. We regularly monitor inventory quantities on hand andrecord a provision for excess and obsolete inventories based primarily on ourestimated forecast of product demand and production requirements for the nextsix months. The components of inventories include (in thousands):

 
|             |   | **December 31,  2003** |   | **September 30,  2003** | ** ** |
|------------------|--------|------------------------|--------|-------------------------|------------|
|             |   |                   |   |                    |       |
| Raw materials    |   | $                      | 60     |                    | $          | 35 |   |
| Work-in-progress |   | 141                    |   | 184                     |       |
| Finished goods   |   | 513                    |   | 691                     |       |
|             |   | $                      | 714    |                    | $          | 910 |   |

 

**LONG-TERMINVESTMENT**

 

As of December 31, 2003, we held an investment of common stock in aprivate Chinese telecommunication company valued at approximately $195,000accounted for using the cost method. Our interest in the company is approximately 2%,  which interest does not allow us to exercisesignificant influence.

 

Weperform periodic reviews of our investments for impairment. Our investments areconsidered impaired when a review of the investees’ operations and otherindicators of impairment indicate that the carrying value of the investment isnot 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-downswere recorded during the three-months ended December 31, 2003 and December 31,2002.

 

6

----

 

**REVENUERECOGNITION**

 

We account for the recognition of revenues in accordance with Statementof Position (“SOP”) 97-2, “Software Revenue Recognition”. Revenues consist ofsales to end-users, including resellers, and to distributors. Revenues fromsales to end-users are recognized upon shipment, when risk of loss has passedto the customer, collection of the receivable is reasonably assured, persuasiveevidence of an arrangement exists, and the price is fixed and determinable. Weprovide for estimated sales returns and allowances and warranty costs relatedto such sales at the time of shipment. Net revenues consist of product revenuesreduced by estimated sales returns and allowances. Sales to distributors aremade under terms allowing certain rights of return and protection againstsubsequent price declines on our products held by its distributors. Upontermination, any unsold products may be returned by the distributor for a fullrefund. These agreements may be canceled by either party based on specifiednotice. As a result of the above provisions, we defer recognition ofdistributor revenues until such distributors resell our products to theircustomers. The amounts deferred as a result of this policy are reflected as“deferred revenue” in the accompanying consolidated balance sheets. The relatedcost of revenue is also deferred and reported in the consolidated balancesheets as inventory.

 

Software components generally are not sold separately from our hardwarecomponents. Software revenues consist of license revenues that are recognizedupon the delivery of application products. We provide limited post-contractcustomer support (PCS), consisting primarily of technical support and “bug”fixes. In accordance with SOP 97-2, revenue earned on software arrangementsinvolving multiple elements is allocated to each element based upon therelative fair values of the elements. Although we provide PCS, the revenueallocated to this element is recognized together with the initial licensing feeon delivery of the software because: (1) the PCS fee is included with theinitial licensing fee; (2) the PCS included with the initial license feeis for one year or less; (3) the estimated cost of providing PCS duringthe arrangement is insignificant; and (4) unspecifiedupgrades/enhancements offered for minimal or no cost during PCS arrangementshistorically have been and are expected to continue to be minimal andinfrequent. All estimated costs of providing the services, including upgradesand enhancements are accrued for at the time of delivery.

 

**STOCK–BASED COMPENSATION**

 

We account for stock-based compensation in accordance with theprovisions of APB No. 25, “Accounting for Stock Issued to Employees”, and comply with thedisclosure provisions of SFAS No. 123 as amended by SFAS No. 148,“Accounting for Stock-Based Compensation—Transition and Disclosures.” Deferredcompensation recognized under APB No. 25 is amortized to expense using thegraded vesting method. We account for stock options issued to non-employees inaccordance with the provisions of SFAS No. 123 and EITF No. 96-18under the fair value based method.

 

We adopted the disclosure-only provisions of SFAS No. 123, andaccordingly, no expense has been recognized for options granted to employeesunder the various equity incentive plans. We amortize deferred stock-basedcompensation over the vesting periods of the applicable stock purchase rightsand stock options, generally four years. Had compensation expense beendetermined based on the fair value at the grant date for awards, consistentwith the provisions of SFAS No. 123, the Company’s pro forma net loss andnet loss per share would be as follows (in thousands, except per share data):

 
|                                                                                                 |   | **Three  Months Ended  December 31,** |   |
|------------------------------------------------------------------------------------------------------|--------|---------------------------------------|--------|
|                                                                                                 |   | **2003**                              |   | **2002** |   |
|                                                                                                 |   |                                  |   |   |   |
| Reported net loss                                                                                    |   | $                                     | (46    | ) | $ | (985 | ) |
| Add: Total stock-based employee  compensation expense included in reported net loss under APB No. 25 |   | —                                |   | 13 |   |
| Deduct: Total stock-based compensation  determined under fair value based method for all awards      |   | (246                                  | )      | (597 | ) |
| Pro forma net loss under SFAS  No 123                                                                |   | $                                     | (292   | ) | $ | (1,569 | ) |
| Basic and diluted – as reported                                                                 |   | $                                     | (0.00  | ) | $ | (0.07 | ) |
| Basic and diluted – pro forma                                                                   |   | $                                     | (0.02  | ) | $ | (0.12 | ) |

 

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

 

7

----

 
|                     |   | **Employee Stock Option Plans  for Three Months  Ended December 31,** |   | **Employee Stock Purchase Plan  for Three Months  Ended December 31,** |   |
|--------------------------|--------|-----------------------------------------------------------------------|--------|------------------------------------------------------------------------|--------|
|                     |   | **2003**                                                              |   | **2002**                                                               |   | **2003** |   | **2002** |   |
| Expected Life (in years) |   | 5                                                                     |   | 5                                                                      |   | 0.5 |   | 0.5 |   |
| Risk-free interest rate  |   | 3.4                                                                   | %      | 3.1                                                                    | %      | 1.1 | % | 2.1 | % |
| Volatility               |   | 113                                                                   | %      | 111                                                                    | %      | 113 | % | 111 | % |
| Expected dividend        |   | 0.0                                                                   | %      | 0.0                                                                    | %      | 0.0 | % | 0.0 | % |

 

TheBlack-Scholes option pricing model was developed for use in estimating the fairvalue of traded options that have no vesting restrictions and are fullytransferable. In addition, option pricing models require the input of highlysubjective assumptions, including the expected stock price volatility. We useprojected volatility rates, which are based upon historical volatility ratessince our initial public offering, trended into future years. Because ouremployee stock options have characteristics significantly different from thoseof traded options and because changes in the subjective input assumptions canmaterially affect the fair value estimate, in management’s opinion, theexisting models do not necessarily provide a reliable single measure of thefair value of our options.

 

**COMPUTATIONOF BASIC AND DILUTED NET LOSS PER SHARE**

 

Historicalnet loss per share has been calculated under SFAS No. 128, “Earnings perShare.” SFAS No. 128 requires companies to compute earnings per shareunder two methods (basic and diluted). Basic net loss per share is calculatedby dividing net loss by the weighted average shares of common stock outstandingduring the period. Basic and diluted net loss per share numbers are identical aspotential common shares resulting from the exercise of stock options areantidilutive.

 

For the three-months endedDecember 31, 2003 and December 31, 2002, 2,600,422 shares and 2,492,594 sharesof common stock options with a weighted average exercise price of $4.75 and$4.38, respectively, were excluded from the diluted net income per sharecomputation.

 

**COMPREHENSIVEINCOME**

 

Comprehensiveloss for the Company consists of net loss plus the effect of foreign currencytranslation adjustments and other unrealized gains and losses, which werematerial for each of the three-months ended December 31, 2003 and December 31,2002. Accordingly, comprehensive loss closely approximates actual net loss. Ourother comprehensive income is immaterial for all periods presented.

 

**SEGMENTREPORTING**

 

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

 

Net revenue by geographicregion based on customer location for the three-months ended December 31, 2003and December 31, 2002 were as follows:

 
|          |   | **Three  Months Ended  December 31** |   |
|---------------|--------|--------------------------------------|--------|
|          |   | **2003**                             |   | **2002** |   |
| Americas      |   | 92                                   | %      | 95 | % |
| International |   | 8                                    | %      | 5 | % |
|          |   | 100                                  | %      | 100 | % |

 

Net revenue by certain customersthat individually account for more than 10% of revenue for the three-monthsended December 31, 2003 and December 31, 2002 were as follows:

 

8

----

 
|         |   | **Three  Months Ended  December 31** |   |
|--------------|--------|--------------------------------------|--------|
|         |   | **2003**                             |   | **2002** |   |
| AltiSys      |   | 17                                   | %      | 22 | % |
| Ingram Micro |   | 18                                   | %      | 22 | % |
| Synnex       |   | 48                                   | %      | 42 | % |

 

All significantlong-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”) reacheda consensus on EITF No. 00-21, “Revenue Arrangements with MultipleDeliverables.” This pronouncement addresses certain aspects of the accountingby a vendor for arrangements under which it will perform multiple revenue-generating activities. The guidance in this pronouncement was effective forrevenue arrangements entered into in fiscal periods beginning afterJune 15, 2003. The adoption of EITF 00-21 did not have an effect on ourconsolidated financial statements.

 

In January 2003, the FASB issued Interpretation No. 46,“Consolidation of Variable Interest Entities.” FIN No. 46 requires an investorwith a majority of the variable interests in a variable interest entity toconsolidate the entity and also requires majority and significant variableinterest investors to provide certain disclosures. A variable interest entityis an entity in which the equity investors do not have a controlling interestor the equity investment at risk is insufficient to finance the entity’sactivities without receiving additional subordinated financial support from theother parties. We do not expect to identify any variable interest entities thatmust be consolidated.

 

In April 2003, the FASB issued SFAS No. 149, “Amendment ofSFAS No. 133 on Derivative Instruments and Hedging Activities.” SFASNo. 149 amends and clarifies accounting for derivative instruments, includingcertain derivative instruments embedded in other contracts, and for hedgingactivities under SFAS No. 133. SFAS No. 149 was effective forcontracts entered into or modified after June 30, 2003 and did not have animpact on our consolidated financial statements.

 

In May 2003, the FASB issued SFAS No. 150, “Accounting forCertain Financial Instruments with Characteristics of both Liabilities andEquity.” The Statement improves the accounting for certain financialinstruments that, under previous guidance, issuers could account for as equityby requiring that such instruments be classified as liabilities in statementsof financial position. Adoption of SFAS No. 150 did not have an effect onour consolidated financial statements.

 

**3.WARRANTY**

 

We provide a one year warrantyfor hardware products starting upon shipment to end-users. We historically haveexperienced minimal warranty costs. Factors that affect our warranty liabilityinclude the number of installed units, historical experience and management’s judgmentregarding anticipated rates of warranty claims and cost per claim. We assessthe adequacy of our recorded warranty liability every quarter and makeadjustments to the liability if necessary.

 

Changes in our warrantyliability for the three-months ended December 31, 2003 and December 31, 2002,are as follows (in thousands):

 
|                                                 |   | **Three  Months Ended  December 31** |   |
|------------------------------------------------------|--------|--------------------------------------|--------|
|                                                 |   | **2003**                             |   | **2002** |   |
| Beginning balance                                    |   | $                                    | 644    |   | $ | 590 |   |
| Provisions for warranty liability                    |   | 60                                   |   | 117 |   |
| Warranty cost including labor, components  and scrap |   | (34                                  | )      | (82 | ) |
| Ending balance                                       |   | $                                    | 670    |   | $ | 625 |   |

 

**4.  DEFERRED STOCK COMPENSATION**

 

In connection with the issuance of certain stock options to employeesin fiscal years 1999 and 1998, we recorded deferred stock compensation in theaggregate amount of approximately $3,892,000, which represents the differencebetween the deemed fair value of our

 

9

----

 

common stock and the exercise price of stock options at the date ofgrant. We had fully amortized the deferred stock compensation in fiscal year2003.

 

The amortization of deferred stock compensationrelates to the following items in the accompanying unaudited condensed consolidated statementsof operations (in thousands):

 
|                     |   | **Three  Months Ended  December 31** |   |
|--------------------------|--------|--------------------------------------|--------|
|                     |   | **2003**                             |   | **2002** |   |
|                     |   |                                 |   |   |   |
| Research and development |   | $                                    | — |   | $ | 5 |   |
| Sales and marketing      |   | —                               |   | 1 |   |
| General and admistrative |   | —                               |   | 7 |   |
|                     |   | $                                    | — |   | $ | 13 |   |

 

**5.  COMMITMENTS AND CONTINGENCIES**

 

*Commitments*

 

We lease our facilities under various operating lease agreements expiringon various dates through January 2009. Rent expense for all operatingleases totaled approximately $162,000 and $202,000, for three-months endedDecember 31, 2003 and December 31, 2002, respectively. Minimum future leasepayments under all noncancellable operating leases as of December 31, 2003 areas follows (in thousands):

 
| Fiscal Year       |   |   |   |
|-------------------|--------|--------|--------|
| 2004              |   | 148    |   |
| 2005              |   | 248    |   |
| 2006              |   | 256    |   |
| 2007              |   | 264    |   |
| 2008              |   | 271    |   |
| Due after 5 years |   | 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 inparticular, 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 suitagainst us in the United States District Court for the Northern District ofCalifornia, alleging infringement of Vertical Networks’ United States PatentsNos. 6,266,341; 6,289,025; 6,292,482; 6,389,009; and 6,396,849. OnOctober 28, 2002, Vertical Networks amended its Complaint to addallegations of infringement of Patents Nos. 5,617,418 and 5,687,174. VerticalNetworks filed a Second Amended Complaint on November 20, 2002 to identifyour products and/or activities that allegedly infringe the sevenpatents-in-suit. Vertical Networks seeks a judgment of patent infringement andan award of damages, including treble damages for alleged willful infringement,and attorneys’ fees and costs. We filed an Answer and Counterclaims forDeclaratory Relief on December 9, 2002. On December 26, 2002,Vertical Networks filed its Answer to our Counterclaims. Vertical Networksserved its Preliminary Infringement Contentions on us on April 9, 2003 andwe served its Preliminary Invalidity Contentions on June 3, 2003, andJuly 14, 2003. To date, the parties have exchanged some discovery, but nodepositions have been taken, and no motions are currently pending. OnOctober 7, 2003, the parties filed a stipulation to stay this action,pending the outcome of the reissue of some of the subject patents before theUnited States Patent and Trademark Office. We believe we have strong defensesand arguments in this dispute and intend to vigorously litigate our position.Management’s view is that any loss from this litigation is not probable orestimable.

 

10

----

 

**Item 2. Management’s Discussion and Analysisof Financial Condition and Results of Operations**

 

#### **FORWARD-LOOKING INFORMATION**

 

This report contains certainforward-looking statements (within the meaning of Section 27A of theSecurities Act of 1933, as amended, and Section 21E of the SecuritiesExchange Act of 1934, as amended) and information relating to us that are basedon the beliefs of our management as well as assumptions made by and informationcurrently available to our management. Additional forward looking statementsmay be identified by the words “anticipate”, “believe”, “expect”, “intend”,“plan” and similar expressions, as they relate to us or our management.

 

The forward-looking statementscontained in this report reflect our judgment as of the date of this reportwith respect to future events, the outcome of which is subject to certain risksthat may have a significant impact on our business, operating results orfinancial condition. Investors are cautioned that these forward-lookingstatements are inherently uncertain. Should one or more of these risks oruncertainties 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-lookingstatements are reasonable, we cannot guarantee future results, levels ofactivity, performance or achievements. Our stockholders should carefully reviewthe cautionary statements contained in this Form 10-Q, including the“Certain Factors Affecting Business, Operating Results and Financial Condition”below.

 

#### **OVERVIEW**

 

Weprovide converged Internet protocol phone systems for small and medium sizedbusinesses. We were incorporated in California in May 1994 and beganoperations in July 1994. We first recognized revenues from product salesof our Quantum board and AltiWare software in July 1996. We generated netrevenues of $3.6 million and $2.9 million for the three-months ended December31, 2003 and 2002, respectively. As of December 31, 2003, we had an accumulateddeficit of $50.9 million.

 

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

 

Our cost of revenues consists of component and material costs, directlabor costs, provisions for excess and obsolete inventory, warranty costs andoverhead related to the manufacturing of our products. We have experiencedoperating losses and negative cash flows from operations in each period sinceour inception. Several factors that have affected, and will continue to affect,our revenue growth include the state of the economy, the market acceptance ofour products, our ability to add new resellers and our ability to design,develop, and release new products. We engage a third-party assembler, which, inthe three-months ended December 31, 2003, was principally All Quality Servicesin San Jose, to insert the hardware components into the printed circuit board.We selected our manufacturing partner with the goals of ensuring a reliablesupply of high-quality finished products and lowering per unit product costs asa result of manufacturing economies of scale. We cannot assure that we willmaintain the volumes required to realize these economies of scale or when or ifsuch cost reductions will occur. The failure to obtain such cost reductions, ormaintain such inductions if they occur, could materially adversely affect ourgross margins and operating results.

 

Wecontinue to focus on developing enhancements to our current products to providegreater functionality and increased capabilities, based on our market research,customer feedback and our competitors’ product offerings. We also continue tofocus on creating new product offerings. In particular, we are focusing ondeveloping products that allow us to enhance our position in our target marketsegment and to enter new geographical markets. Additionally, we intend tocontinue to focus on selling our products to small to medium-sized businessesand branch offices of larger corporations, which are offices with less than 500employees, with particular emphasis in the Internet protocol phone systemssegment of the telecommunications market. Also, we plan to continue to recruitadditional resellers and distributors that focus on selling phone systems toour target customers. There can be no assurance ,however, that we will besuccessful in developing any new products or enhancements to existing products,entering new geographical or product markets or expanding our network ofresellers. We believe that the adoption rate for this new technology is muchfaster with smaller businesses because they do not have significant investmenton their books for traditional phone systems. We believe that small-to-mediumsized businesses are looking for call center type administration to increasethe productivity and efficiency of their contacts with customers. Assuming thecontinued market trends, successful product enhancements, the introduction of thecall center products, the beginning of sales activities in the United Kingdomand Norway, continuing growth in the Chinese marketplace, and the status quo ofthe North American economy, we expect to see continued revenue growth for thenext quarter at a rate equal to that experienced during the past quarter.

 

11

----

 

**CRITICALACCOUNTING POLICIES**

 

*Revenue recognition.*  Revenues consist of sales to end-users,including to resellers, and to distributors. Revenues from sales to end-usersare recognized upon shipment, when risk of loss has passed to the customer,collection of the receivable is reasonably assured, persuasive evidence of anarrangement exists, and the price is fixed and determinable. We provide for estimatedsales returns and allowances and warranty costs related to such sales at thetime of shipment. Net revenues consist of product revenues reduced by estimatedsales returns and allowances. Sales to distributors are made under termsallowing certain rights of return and protection against subsequent pricedeclines on our products held by its distributors. Upon termination, any unsoldproducts may be returned by the distributor for a full refund. These agreementsmay be canceled by either party based on specified notice. As a result of theabove provisions, we defer recognition of distributor revenues until suchdistributors resell our products to their customers. The amounts deferred as aresult of this policy are reflected as “deferred revenue” in the accompanyingconsolidated balance sheets. The related cost of revenues is also deferred andreported in the consolidated balance sheets as inventory. Our total deferredrevenue was $268,000 as of December 31, 2003.

 

*Allowance for Doubtful Accounts.*  The allowance for doubtful accounts is basedon our assessment of the collectibility of specific customer accounts and theaging of the accounts receivable. If there were a deterioration of a majorcustomer’s creditworthiness, or actual defaults were higher than our historicalexperience, we could be required to increase our allowance and our earningscould be adversely affected. Our allowance for doubtful accounts was $66,000 ofDecember 31, 2003.

 

*Inventory.*  Inventory is stated at the lower of cost(first-in, first-out method) or market. Our inventory balance was$0.7 million as of December 31, 2003. We regularly review value ofinventory in detail, with consideration given to future customer demand for ourproducts, obsolescence from rapidly changing technology, and other factors. Ifactual market conditions are less favorable than those projected by management,and our estimates prove to be inaccurate, we could be required to increase ourinventory provision and our gross margins could be adversely affected. Ourinventory allowance was $2.8 million as of December 31, 2003.

 

*Warranty.*  We accrue for warranty costs based onestimated product return rates and the expected material and labor costs toprovide warranty services. If actual return rates and repair and replacementcosts differ significantly from our estimates, our gross margin could beadversely affected. The liability for product warranties was $670,000 as ofDecember 31, 2003.

 

12

----

 

**Results of Operations**

 

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

 
|                                        |   | **Three Months Ended  December 31** |   |
|---------------------------------------------|--------|-------------------------------------|--------|
|                                        |   | **2003**                            |   | **2002** |   |
| Consolidated Statements of Operations Data: |   |                                |   |   |   |
| Revenues, net                               |   | 100.0                               | %      | 100.0 | % |
| Cost of revenues                            |   | 39.6                                |   | 46.0 |   |
| Gross profit                                |   | 60.4                                |   | 54.0 |   |
| Operating expenses:                         |   |                                |   |   |   |
| Research and development                    |   | 22.8                                |   | 32.8 |   |
| Sales and marketing                         |   | 27.9                                |   | 43.7 |   |
| General and administrative                  |   | 11.6                                |   | 15.4 |   |
| Deferred stock compensation                 |   | —                              |   | 0.5 |   |
| Total operating expenses                    |   | 62.3                                |   | 92.4 |   |
|                                        |   |                                |   |   |   |
| Loss from operations                        |   | (1.9                                | )      | (38.4 | ) |
| Interest and other income, net              |   | 0.7                                 |   | 4.3 |   |
|                                        |   |                                |   |   |   |
| Net loss                                    |   | (1.2                                | )%     | (34.1 | )% |

 

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

 

Net Revenue by Products:

 
|                     |   | **Three Months Ended  December 31** |   |
|--------------------------|--------|-------------------------------------|--------|
|                     |   | **2003**                            |   | **2002** |   |
| Telephone systems        |   | 91                                  | %      | 92 | % |
| Internet protocol phones |   | 8                                   | %      | 7 | % |
| Product support          |   | 1                                   | %      | 1 | % |

 

Net Revenue by Geographic Area:

 
|          |   | **Three Months Ended  December 31** |   |
|---------------|--------|-------------------------------------|--------|
|          |   | **2003**                            |   | **2002** |   |
| Americas      |   | 92                                  | %      | 95 | % |
| International |   | 8                                   | %      | 5 | % |

 

Net Revenue by Customers:

 
|         |   | **Three Months Ended  December 31** |   |
|--------------|--------|-------------------------------------|--------|
|         |   | **2003**                            |   | **2002** |   |
| AltiSys      |   | 17                                  | %      | 22 | % |
| Ingram Micro |   | 18                                  | %      | 22 | % |
| Synnex       |   | 48                                  | %      | 42 | % |

 

13

----

 

Revenuegenerated in the Americas accounted for $3.3 million ,or 92%, for thethree-months ended December 31, 2003 and $2.7 million ,or 95%, for thethree-months ended December 31, 2002. Net revenues for the three-months endedDecember 31, 2003 increased 26% to $3.6 million from $2.9 million for thethree-months ended December 31, 2002. Net product sales related to telephonesystems for the three-months ended December 31, 2003 increased by $650,000 ,or23%, to $3.3 million from $2.7 million for the three-months ended December31, 2002. This increase was due to the introduction of our new line of AltiServOffice, AltiServ 1IP and AltiServ 2IP, which offer our customers an all voiceover Internet protocol phone system.

 

**Cost of revenues.**  Cost of revenues for the three-months endedDecember 31, 2003 has increased $0.1 million ,or 8%, to $1.4 millionfrom approximately $1.3 million for the three-months ended December 31,2002 due to an increase in overall sales of products and the requisite increasein product costs. Cost of revenues as a percentage of net revenues decreasedfrom 46% for the three-months ended December 31, 2002 to 40% for thethree-months ended December 31, 2003, which resulted in an increase in productgross margin and an increase in net revenues. Production overhead decreased by$61,000 from $149,000 for the three-months ended December 31, 2002 to $88,000for the three-months ended December 31, 2003. This decrease primarily wascaused by lower actual component costs and overhead expenses. In addition,manufacturing and other related costs decreased by $104,000 from $218,000 forthe three-months ended December 31, 2002 to $114,000 for three-months endedDecember 31, 2003, resulting from lower warranty reserve due to the decline inthe product return rate, lower depreciation on equipment and facilities chargesassociated with manufacturing activities. No additional provision for excess orobsolete inventory was necessary in the three-months ended December 31, 2003.

 

**Research and development expenses.**  Research and development expenses consistprincipally of salaries and related personnel expenses, consultant fees andprototype expenses related to the design, development and testing of ourproducts and enhancement of our converged telephone system software. Researchand development expenses decreased slightly by approximately $0.1 million,or 12%, from $0.9 million for the three-months ended December 31, 2002 to$0.8 million for the three-months ended December 31, 2003. Research anddevelopment expenses as a percentage of revenue decreased from 33% for thethree-months ended December 31, 2002 to 23% for the three-months ended December31, 2003. The slight decrease in research and development expenses was theresult of a decrease in headcount-related costs of $147,000 resulting from areduction in our research and development workforce. We expect research anddevelopment expenses to remain relatively flat due to the uncertainty aboutcustomers’ spending patterns in the current economic environment. Managementcontinues to monitor research and development expenses in line with revenuegrowth.

 

**Sales and marketing expenses.**  Sales and marketing expenses consistprimarily of salaries, commissions and related expenses for personnel engagedin marketing, sales and customer support functions, as well as trade shows,advertising, and promotional expenses. Sales and marketing expenses decreasedby approximately $0.3 million ,or 20%, from $1.3 million for thethree-months ended December 31,2002 to $1.0 million for the three-monthsended December 31, 2003. Sales and marketing expenses as a percentage ofrevenue decreased from 44% for the three-months ended December 31, 2002 to 28%for the three-months ended December 31, 2003. The decrease in absolute dollarsprimarily was a result of a decrease in headcount-related costs ofapproximately $133,000 due to a workforce reduction in the marketing group anda significant cost reduction measures in the areas of service fee ofapproximately $98,000. We expect sales and marketing expenses to remainrelatively flat due to the uncertainty about customers’ spending patterns inthe current economic environment.

 

**General and administrative expenses.**  General and administrative expenses consistof salaries and related expenses for executive, finance and administrativepersonnel, facilities, bad debt, legal, and other general corporate expenses.General and administrative expenses remained relatively unchanged at $0.4million for the three-months ended December 31, 2003 and December 31, 2002,respectively. General and administrative expenses as a percentage of revenuedecreased from 15% for the three-months ended December 31, 2002 to 12% for thethree-months ended December 31, 2003. We expect to maintain general and administrative expenses at the currentlevel.

 

**Amortization of deferred stock compensation.**  Amortization of deferred stock compensationwas $13,000 for the three-months ended December 31, 2002. Deferred stockcompensation expense reflects the amortization of stock compensation chargesresulting from granting stock options at exercise prices below the deemed fairvalue of our common stock on the dates the options were granted. We amortizethese deferred amounts using the straight-line method over the vesting periodof the related stock options. All remaining deferred stock compensation wasamortized in fiscal year 2003.

 

**Interest and other income, net.**  Net interest and other income decreased to$25,000 for the three-months ended December 31, 2003 from $125,000 for thethree-months ended December 31, 2002. The decrease primarily was due to therecognition of interest received from an outstanding promissory note held byour Chief Executive Officer, Gilbert Hu, which was fully repaid in December 27,2002. We expect net interest and other income to continue to decrease as aresult of further decreases in cash available to invest and relatively flat orlower interest rates.

 

14

----

 

**Liquidity and Capital Resources**

 

Since inception, we primarily have financed our operations through thesale of equity securities. As of December 31, 2003, we had cash, cashequivalents, and short-term investments totaling $9.5 million, whichconsisted of cash and cash equivalents of $6.1 million and $3.4 millionof short-term investment.

 

*Changes in Cash Flows*

 

During the quarter ended December 31, 2003, net cash used in operatingactivities were $0.7 million, which is $0.1 million lower than the cashused in operating activities during the same period of fiscal 2003.

 

Netaccounts receivable increased to $1.9 million at December 31, 2003 from$1.5 million at September 30, 2003. The increase in net accountsreceivable primarily was due to higher sales of  $1.6 million generated in the last month of the quarter.

 

Inventories decreased to $0.7 million at December 31, 2003 from$0.9 million at September 30, 2003 and our inventory turn rateincreased to 8.1 times at December 31, 2003 from 5.4 times atSeptember 30, 2003. Inventory turn rate is annualized and represents thenumber of times inventory is replenished during the year. The increase in theinventory turn rate is the result of lower inventory levels and our ability toefficiently manage our inventory to meet customer demands. Inventory managementwill continue to be an area of focus as we balance the need to maintainstrategic inventory levels to help ensure competitive lead times with the riskof inventory obsolescence due to rapidly changing technology and customerrequirements.

 

Accounts payable decreased to $0.4 million at December 31, 2003from $0.9 million at September 30, 2003. This decrease primarily was dueto inventory purchases in the last month of the prior quarter for which paymentwas made in the quarter ended December 31, 2003.

 

Accrued payroll-related liabilities increased to $291,000 atDecember 31, 2003 from $276,000 at September 30, 2003, as a result ofan increase in incentive compensation.

 

Other liabilities decreased to $450,000 at December 31, 2003 from$462,000 at September 30, 2003, as a result of the decrease in accountingservice fee and related operational costs.

 

In the quarter ended December 31, 2003, net cash used in investingactivities was a $50,000 long-term deposit for our new office lease. OnOctober 1, 2003, we entered into a lease for approximately 32,000 squarefeet to serve as our new headquarters for corporate administration, researchand development, manufacturing, and sales and marketing facility in Fremont,California. The lease commences on December 22, 2003 and expires on February 19,2009.

 

In the quarter ended December 31, 2003, net cash provided by financingactivities was  $109,000 of proceedsfrom the exercise of employee stock options and employee stock purchase plan.

 

*Liquidity and Capital Resources*

 

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

 

Our cash needs depend on numerous factors, including market acceptanceof and demand for our products, our ability to develop and introduce newproducts and enhancements to existing products, the prices at which we can sellour products, the resources we devote to developing, marketing, selling andsupporting our products, the timing and expense associated with expanding ourdistribution channels, increases in manufacturing costs and the prices of thecomponents we purchase, as well as other factors. If we need and are unable toraise additional capital or if sales from our new products or enhancements arelower than expected, we will be required to make additional reductions inoperating expenses and capital expenditures to ensure that we will haveadequate cash reserves to fund operations.

 

Additional financing, if required, may not be available on acceptableterms, or at all. We also may require additional capital to acquire or investin complementary businesses or products, or obtain the right to usecomplementary technologies. If we need and cannot raise funds on acceptableterms, we may not be able to further develop or enhance our products, takeadvantage of future opportunities, or respond to competitive pressures orunanticipated requirements, which could seriously harm our business. Even ifadditional financing is available, we may be required to obtain the consent ofour stockholders, which we may or may not be able to obtain. In addition, theissuance of equity or equity-related securities will dilute the ownershipinterest of our stockholders and the issuance of debt securities could increaseour risk or perceived risk.

 

We do not have any material commitments for capital expenditures as ofDecember  31, 2003. We have commitments under our noncancellable operatinglease in the amount of $1.3 million as of December 31, 2003. We believe wehave sufficient cash reserves to

 

15

----

 

allow us to continue operations for more than a year assuming ourquarterly cash burn rate does not increase over that period, which we currentlydo not expect to occur.

 

**Recent Accounting Pronouncements**

 

In December 2002, the Emerging Issues Task Force (“EITF”) reacheda consensus on EITF No. 00-21, “Revenue Arrangements with MultipleDeliverables.” This pronouncement addresses certain aspects of the accountingby a vendor for arrangements under which it will perform multiple revenue-generating activities. The guidance in this pronouncement was effective forrevenue arrangements entered into in fiscal periods beginning afterJune 15, 2003. The adoption of EITF 00-21 did not have an effect on ourconsolidated financial statements.

 

In January 2003, the FASB issued Interpretation No. 46,“Consolidation of Variable Interest Entities.” FIN No. 46 requires aninvestor with a majority of the variable interests in a variable interestentity to consolidate the entity and also requires majority and significantvariable interest investors to provide certain disclosures. A variable interestentity is an entity in which the equity investors do not have a controllinginterest or the equity investment at risk is insufficient to finance theentity’s activities without receiving additional subordinated financial supportfrom the other parties. We do not expect to identify any variable interestentities that must be consolidated.

 

In April 2003, the FASB issued SFAS No. 149, “Amendment ofSFAS No. 133 on Derivative Instruments and Hedging Activities.” SFASNo. 149 amends and clarifies accounting for derivative instruments,including certain derivative instruments embedded in other contracts, and forhedging activities under SFAS No. 133. SFAS No. 149 was effective forcontracts entered into or modified after June 30, 2003 and did not have animpact on our consolidated financial statements.

 

In May 2003, the FASB issued SFAS No. 150, “Accounting forCertain Financial Instruments with Characteristics of both Liabilities andEquity.” The Statement improves the accounting for certain financialinstruments that, under previous guidance, issuers could account for as equityby requiring that such instruments be classified as liabilities in statementsof financial position. Adoption of SFAS No. 150 did not have an effect onour consolidated financial statements.

 

16

----

 

**CERTAIN FACTORS AFFECTING BUSINESS, OPERATINGRESULTS, AND FINANCIAL CONDITION**

 

*Risks Related to AltiGen*

 

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

 

We have experienced operating losses since our inception. As ofDecember 31, 2003, we had an accumulated deficit of $50.9 million. Weexpect to incur operating losses for the foreseeable future, and these lossesmay be substantial. We do not expect to increase expenditures for productdevelopment, general and administrative expenses, and sales and marketingexpenses; however, if we cannot increase revenues significantly, we will notachieve either profitability or positive operating cash flows. Even if we doachieve profitability and positive operating cash flows, we may not be able tosustain or increase profitability or positive operating cash flows on aquarterly or annual basis.

 

*The current economic downturn may continue toadversely affect our revenues, gross margins and expenses.*

 

Our annual revenue and operating results have and may continue tofluctuate due to the effects of general economic conditions in the UnitedStates and globally and specific market conditions in the telecommunicationsindustry. We are uncertain about the extent, severity, and length of theeconomic downturn. If the economic conditions in the United States and globallydo not improve, or if we experience a worsening in the global economicslowdown, we may continue to experience material negative effects on ourbusiness, operating results, and financial condition.

 

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

 

We shipped our first products in July 1996. As a result of ourlimited operating history, we have limited financial data that you can use toevaluate 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 ofdevelopment in a new and rapidly evolving market. To address these risks andachieve profitability and increased sales levels, we must:

 

•                                          Establishand increase market acceptance of our technology, products and systems;

 

•                                          Expandour network of distributors, dealers and companies that buy our products inbulk, customize them for particular applications or customers, and resell themunder their own names;

 

•                                          Introduceproducts and systems incorporating our technology and enhancements to ourproduct applications on a timely basis;

 

•                                          Respondeffectively to competitive pressures; and

 

•                                          Successfullymarket and support our products and systems.

 

We may not successfully meet any of these challenges, and our failureto do so will seriously harm our business and results of operations. Inaddition, because of our limited operating history, we have limited insightinto trends that may emerge and harm our business.

 

*Our operating results vary, making futureoperating results difficult to predict.*

 

Our quarterly and annual operating results have varied significantly inthe 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:

 

•                                          Oursales cycle, which may vary substantially from customer to customer;

 

•                                          Unfavorablechanges in the prices and delivery of the components we purchase;

 

•                                          Thesize and timing of orders for our products, which may vary depending on theseason, and the contractual terms of the orders;

 

•                                          Thesize and timing of our expenses, including operating expenses and expenses ofdeveloping new products and product enhancements;

 

17

----

 

•                                          Deferralsof customer orders in anticipation of new products, services or productenhancements introduced by us or by our competitors; and

 

•                                          Ourability to attain and maintain production volumes and quality levels for ourproducts.

 

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

 

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

 

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

 

*Our market is highly competitive and we maynot have the resources to adequately compete.*

 

The market for our integrated, multifunction telecommunications systemsis new, rapidly evolving and highly competitive. We expect competition tointensify in the future as existing competitors develop new products and newcompetitors enter the market. We believe that a critical component to successin this market is the ability to establish and maintain strong partner andcustomer relationships with a wide variety of domestic and internationalproviders. If we fail to establish or maintain these relationships, we will beat a serious competitive disadvantage.

 

We face competition from companies providing traditional privatetelephone systems. Our principal competitors that produce these telephonesystems are Avaya Communications, NEC and Nortel Networks. We also competeagainst providers of multifunction telecommunications systems, includingArtisoft, Inc., Shoreline Communications, Inc., 3Com Corporation, andCisco Systems, Inc., as well as any number of future competitors. Many ofour competitors are substantially larger than we are and have significantlygreater name recognition, financial, sales and marketing, technical, customersupport, manufacturing and other resources. These competitors also may havemore established distribution channels and stronger relationships with serviceproviders. These competitors may be able to respond more rapidly to new oremerging technologies and changes in customer requirements or to devote greaterresources to the development, promotion and sale of their products. Thesecompetitors may enter our existing or future markets with products that may beless expensive, provide higher performance or additional features or beintroduced earlier than our phone systems. We also expect that other companiesmay enter our market with better products and technologies. If any technologythat is competing with ours is more reliable, faster, less expensive or hasother advantages over our technology, then the demand for our products andservices could decrease and harm our business.

 

We expect our competitors to continue to improve the performance oftheir current products and introduce new products or new technologies. If ourcompetitors successfully introduce new products or enhance their existingproducts, our sales or market acceptance of our products and services could bereduced, price competition could decreased or make our products could become obsolete.To be competitive, therefore, we must continue to invest significant resourcesin research and development, sales and marketing and customer support. We maynot have sufficient resources to make these investments or to make thetechnological advances necessary to be competitive, which in turn will causeour business to suffer.

 

*Losing any of our key distributors would harmour business. We also need to establish and maintain relationships withadditional distributors and original equipment manufacturers.*

 

Sales through our three key distributors, Altisys, IngramMicro Inc. and Synnex, accounted for 83% of our net revenues in the firstquarter of fiscal year 2004. On June 12, 2003, we signed a newdistribution agreement with Graybar Electric Company, a leader in thedistribution of high-quality electrical telecommunications and networkingproducts and an expert provider of related supply chain management andlogistics services. No material purchases by Graybar; however, have been madeas of December 31, 2003. Our business and operating results will suffer if anyone of these distributors does not continue distributing our products, fails todistribute the volume of our products that it currently distributes or fails toexpand our customer base. We also need to establish and maintain relationshipswith additional distributors and original equipment manufacturers. We may notbe able to establish, or successfully manage, relationships with additionaldistribution partners. In addition, our agreements with distributors typicallyprovide for termination by either party upon written notice to the other party.For example, our agreement with Ingram Micro provides for termination, with orwithout cause, by either party upon 30 days’ written notice to the other party,or upon insolvency or bankruptcy. Generally, these agreements are non-exclusiveand distributors sell products that compete with ours. If we fail to establishor maintain relationships with distributors and original equipmentmanufacturers, our ability to increase or maintain our sales and our customerbase will be substantially harmed.

 

18

----

 

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

 

We do not recognize revenue from the sale of our products to ourdistributors until these products are sold to either resellers or end-users. Wehave 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 anygiven period. Our future projected budgets and commitments are based in part onour expectations of future sales. If our sales do not meet expectations, itwill be difficult for us to reduce our expenses quickly, and consequently ouroperating results may suffer.

 

*We rely on sole-sourced components andthird-party technology and products; if these components are not available, ourbusiness may suffer.*

 

We purchase technology from third-parties that is incorporated intomany of our products, including virtually all of our hardware products. Weorder sole-sourced components using purchase orders and do not have supplycontracts for them. One sole-sourced component, a TI DSP chip, is particularlyimportant to our business because it is included in virtually all of ourhardware products. If we were unable to purchase an adequate supply of thesesole-sourced components on a timely basis, we would be required to developalternative products, which could entail qualifying an alternative source orredesigning our products based on different components. Our inability to obtainthese sole-sourced components, especially the TI DSP chip, could significantlydelay shipment of our products, which could have a negative effect on ourbusiness, 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 substantiallyreduce our sales and thus seriously harm our business.*

 

We rely on resellers who can provide high quality sales and supportservices. As with our distributors, we compete with other telecommunicationssystems providers for our resellers’ business as our resellers generally marketcompeting products. If a reseller promotes a competitor’s products to thedetriment of our products or otherwise fails to market our products andservices effectively, we could lose market share. In addition, the loss of akey reseller or the failure of resellers to provide adequate customer servicecould cause our business to suffer. If we do not properly train our resellersto sell, install and service our products, our business will suffer.

 

*Software or hardware errors may seriouslyharm our business and damage our reputation, causing loss of customers andrevenues.*

 

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

 

Any claims brought because of problems with our products or servicescould seriously harm our business, financial condition and results ofoperations. We currently offer a one-year hardware guarantee to end-users. Ifour products fail within the first year, we face replacement costs. Ourinsurance policies may not provide sufficient or any coverage should a claim beasserted. In addition, our introduction of products and systems withreliability, quality or compatibility problems could result in reducedrevenues, uncollectible accounts receivable, delays in collecting accountsreceivable, warranties and additional costs. Our customers, end-users oremployees could find errors in our products and systems after we have begun tosell them, resulting in product redevelopment costs and loss of, or delay in,their acceptance by the markets in which we compete. Further, we may experiencesignificant product returns in the future. Any of these events could have amaterial adverse effect on our business, financial condition and results ofoperations.

 

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

 

We may become parties to litigation in the normal course of ourbusiness. Litigation in general, and intellectual property and securitieslitigation in particular, can be expensive and disruptive to normal businessoperations. Moreover, the results of complex litigation are difficult topredict.

 

On September 6, 2002, Vertical Networks, Inc. filed suitagainst us in the United States District Court for the Northern District ofCalifornia, alleging infringement of Vertical Networks’ United States PatentsNos. 6,266,341; 6,289,025; 6,292,482; 6,389,009; and

 

19

----

 

6,396,849. On October 28, 2002, Vertical Networks amended itsComplaint to add allegations of infringement of Patents Nos. 5,617,418 and5,687,174. Vertical Networks filed a Second Amended Complaint onNovember 20, 2002 to identify our products and/or activities thatallegedly infringe the seven patents-in-suit. Vertical Networks seeks ajudgment of patent infringement and an award of damages, including trebledamages for alleged willful infringement, and attorneys’ fees and costs. Wefiled an Answer and Counterclaims for Declaratory Relief on December 9,2002. On December 26, 2002, Vertical Networks filed its Answer to ourCounterclaims. Vertical Networks served its Preliminary InfringementContentions on us on April 9, 2003 and we served its PreliminaryInvalidity 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 partiesfiled a stipulation to stay this action, pending the outcome of the reissue ofsome of the subject patents before the United States Patent and TrademarkOffice. We believe we have strong defenses and arguments in this dispute andintend to vigorously litigate our position. Thus, management’s view is that anyloss from this litigation is not probable or estimable.

 

More generally, litigation related to these types of claims may requireus to acquire licenses under third-party patents that may not be available onacceptable terms, if at all. We believe that an increasing portion of ourrevenues in the future will come from sales of software applications for ourhardware products. The software market traditionally has experienced widespreadunauthorized reproduction of products in violation of developers’ intellectualproperty rights. This activity is difficult to detect, and legal proceedings toenforce developers’ intellectual property rights are often burdensome andinvolve a high degree of uncertainty and substantial costs.

 

*Any failure by us to protect our intellectualproperty could harm our business and competitive position.*

 

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

 

Although we have filed patent applications, we are not certain that ourpatent applications will result in the issuance of patents, or that any patentsissued will provide commercially significant protection of our technology. Inaddition, other individuals or companies may independently developsubstantially equivalent proprietary information not covered by patents towhich we own rights, may obtain access to our know-how or may claim to haveissued patents that prevent the sale of one or more of our products. Also, itmay be possible for third parties to obtain and use our proprietary informationwithout our authorization. Further, the laws of some countries, such as thosein Japan, one of our target markets, may not adequately protect ourintellectual property or such protection may be uncertain. Our success alsodepends on trade secrets that cannot be patented and are difficult to protect.If we fail to protect our proprietary information effectively, or if thirdparties use our proprietary technology without authorization, our competitiveposition and business will suffer.

 

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

 

The United States and other countries in which we intend to sell ourproducts have standards for safety and other certifications that must be metfor our products to be legally sold in those countries. We have tried to designour products to meet the requirements of the countries where we sell or plan tosell them. We also have obtained or are trying to obtain the certificationsthat we believe are required to sell our products in these countries. Wecannot, however, guarantee that our products meet all of these standards orthat we will be able to obtain any certifications required. In addition, thereis, and will likely continue to be, an increasing number of laws andregulations pertaining to the products we offer and may offer in the future.These laws or regulations may include, for example, more stringent safetystandards, requirements for additional or more burdensome certifications ormore stringent consumer protection laws.

 

If our products do not meet a country’s standards or we do not receivethe certifications required by a country’s laws or regulations, then we may notbe able to sell our products in that country. This inability to sell ourproducts may seriously harm our results of operation by reducing our sales orrequiring us to invest significant resources to conform our products to thesestandards.

 

*Our market is subject to changingpreferences; failure to keep up with these changes would result in our losingmarket share, thus seriously harming our business, financial condition andresults of operations.*

 

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

 

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

 

20

----

 

We may seek additional funding in the future. If we cannot raise fundson acceptable terms, we may be unable to develop or enhance our products andservices, take advantage of future opportunities or respond to competitivepressures or unanticipated requirements. We also may be required to reduceoperating costs through lay-offs or reduce our sales and marketing or researchand development efforts. If we issue equity securities, stockholders mayexperience 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 haveexpanded our operations rapidly since our inception. In order to manage thisexpansion and grow in the future, we will need to expand or enhance ourmanagement, manufacturing, research and development and sales and marketingcapabilities. We may not be able to hire the management, staff or otherpersonnel required to do so.

 

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

 

Lead times for materials and components used in the assembly of ourproducts vary significantly, and depend on factors such as the supplier,contract terms and demand for a component at a given time. If orders do notmatch forecasts, we may have excess or inadequate inventory of certainmaterials and components, which may seriously harm our business, financialcondition and results of operations.

 

*Our planned expansion in internationalmarkets will involve new risks that our previous domestic operations have notprepared us to address; our failure to address these risks could harm ourbusiness, financial condition and results of operations.*

 

For the first quarter of fiscal year 2004, approximately 8% of our netrevenues came from customers outside of the United States. We intend to expandour international sales and marketing efforts. Our efforts are subject to avariety of risks associated with conducting business internationally, any ofwhich could seriously harm our business, financial condition and results ofoperations. These risks include:

 

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

 

•                                          potentialadverse tax consequences, including restrictions on repatriation of earnings;

 

•                                          fluctuationsin foreign currency exchange rates, which could make our products relativelymore expensive in foreign markets; and

 

•                                          conflictingregulatory requirements in different countries that may require us to investsignificant resources customizing our products for each country.

 

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

 

We depend, in large part, on our ability to attract and retain highlyskilled personnel, particularly engineers and sales and marketing personnel. Weneed highly trained technical personnel to design and support our server-basedtelecommunications systems. In addition, we need highly trained sales andmarketing personnel to expand our marketing and sales operations in order toincrease market awareness of our products and generate increased revenues.Competition for highly trained personnel is intense, especially in the SanFrancisco Bay Area where most of our operations are located. We cannot becertain that we will be successful in our recruitment and retention efforts. Ifwe fail to attract or retain qualified personnel or suffer from delays inhiring required personnel, our business, financial condition and results ofoperations may be seriously harmed.

 

*Our facility is vulnerable to damage fromearthquakes and other natural disasters and other business interruptions; anysuch damage could seriously or completely impair our business.*

 

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

 

21

----

 

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

 

*Our strategy to outsource assembly and testfunctions in the future could delay delivery of products, decrease quality orincrease costs.*

 

Based on volume or customer requirements, we may begin outsourcing someassembly and test functions. In addition, we may determine that we need toestablish assembly and test operations overseas to better serve ourinternational customers. Establishing overseas assembly and test operations maybe more difficult or take longer than we anticipate. This outsourcing strategyinvolves certain risks, including the potential lack of adequate capacity andreduced control over delivery schedules, manufacturing yield, quality andcosts. In the event that any significant subcontractor were to become unable orunwilling to continue to manufacture or test our products in the requiredvolumes, we would have to identify and qualify acceptable replacements. Findingreplacements could take time and we cannot be sure that additional sourceswould be available to us on a timely basis. Any delay or increase in costs inthe assembly and testing of products by third-party subcontractors couldseriously harm our business, financial condition and results of operations.

 

*Risks Related to the Industry*

 

*Integrated, multifunction telecommunicationssystems may not achieve widespread acceptance.*

 

The market for integrated, multifunction telecommunications systems isrelatively new and rapidly evolving. Businesses have invested substantialresources in the existing telecommunications infrastructure, includingtraditional private telephone systems, and may be unwilling to replace thesesystems in the near term or at all. Businesses also may be reluctant to adoptintegrated, multifunction telecommunications systems because of their concernabout the current limitations of data networks, including the Internet. Forexample, end users sometimes experience delays in receiving calls and reducedvoice quality during calls when routing calls over data networks. Moreover,businesses that begin to route calls over the same networks that currentlycarry only their data also may experience these problems if the networks do nothave sufficient capacity to carry all of these communications at the same time.

 

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

 

In April 1998, the Federal Communications Commission submitted areport to Congress stating that it may regulate certain Internet services if itdetermines that such Internet services are functionally equivalent toconventional telecommunications services. The increasing growth of the voiceover data network market and the popularity of supporting products andservices, heighten the risk that national governments will seek to regulate thetransmission of voice communications over networks such as the Internet. Inaddition, large telecommunications companies may devote substantial lobbyingefforts to influence the regulation of this market so as to benefit theirinterests, which may be contrary to our interests. These regulations mayinclude, for example, assessing access or settlement charges, imposing tariffsor imposing regulations based on encryption concerns or the characteristics andquality of products and services. Future laws, legal decisions or regulations,as well as changes in interpretations of existing laws and regulations, couldrequire us to expend significant resources to comply with them. In addition,these future events or changes may create uncertainty in our market that could reducedemand for our products.

 

*Evolving standards may delay our productintroductions, increase our product development costs or cause end users todefer or cancel plans to purchase our products, any of which could adverselyaffect our business.*

 

The standards in our market are still evolving. These standards aredesigned to ensure that integrated, multifunction telecommunications productsfrom different manufacturers can operate together. Some of these standards areproposed by other participants in our market, including some of ourcompetitors, and include proprietary technology. In recent years, thesestandards have changed, and new standards have been proposed, in response todevelopments in our market. Our failure to conform our products to existing or futurestandards may limit their acceptance by market participants. We may notanticipate which standards will achieve the broadest acceptance in our marketin the future, and we may take a significant amount of time and expense toadapt our products to these standards. We also may have to pay additionalroyalties to developers of proprietary technologies that become standards inour market. These delays and expenses may seriously harm our results ofoperations. In addition, customers and users may defer or cancel plans topurchase our products due to concerns about the ability of our products toconform to existing standards or to adapt to new or changed standards, and thiscould seriously harm our results of operations.

 

22

----

 

**Item 3. Quantitative and QualitativeDisclosures About Market Risk.**

 

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

 

**Item4. Controls and Procedures**

 

*(a)**                               Evaluationof disclosure controls and procedures*. Our management evaluated, with theparticipation of our Chief Executive Officer and our Chief Financial Officer,the effectiveness of our disclosure controls and procedures (as defined inRules 13a-14(c) and 15d-14(c) of the Securities Exchange Act of 1934) asof 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 FinancialOfficer have concluded that our disclosure controls and procedures are adequateand effective to ensure that information we are required to disclose in reportsthat we file or submit under the Securities Exchange Act of 1934 is recorded,processed, summarized and reported within the time periods specified inSecurities and Exchange Commission rules and forms.

 

*(b)**                               Changesin internal control*. There was no change in our internal controls thatoccurred during the period covered by this Quarterly Report on Form 10-Qthat could significantly affect these controls subsequent to the date of theirevaluation, including any corrective actions with regard to significantdeficiencies and material weaknesses.

 

23

----

 

**PART II OTHER INFORMATION**

 

**Item 1.  LegalProceedings**

 

We may become parties to litigation in the normal course of ourbusiness. Litigation in general, and intellectual property and securitieslitigation in particular, can be expensive and disruptive to normal businessoperations. Moreover, the results of complex litigation are difficult topredict.

 

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

 

**Item 2. Changesin Securities and Use of Proceeds**

 

During the three months ended December 31, 2003, we issued 45,213 shares of common stock pursuantto the exercise of stock options at an exercise price ranging from $0.83 to$2.13 per share. All of these stock options were granted under our 1994 and1999 Stock Option Plans. For the same period, 89,059 shares of theCompany’s common stock were purchased by and distributed to employees at aprice ranging from $0.47 to $1.21 per share, pursuant to the Company’s 1999Employee Stock Purchase Plan. The issuance of these shares was exempt fromregistration requirements pursuant to rule 701 promulgated under the SecuritiesAct of 1933, as amended.

 

**Item3. Defaults Upon Senior Securities**

 

None

 

**Item 4.Submission of Matters to a Vote of Security Holders**

 

None

 

**Item5  Other Information**

 

None

 

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

 

(a)          Exhibits:

 
| **Number** |   | **Exhibit Description**                                                                                                                             |
|------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------|
|       |   |                                                                                                                                                |
| 31.1       |   | Certification  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                            |
|       |   |                                                                                                                                                |
| 31.2       |   | Certification Pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002                                                                            |
|       |   |                                                                                                                                                |
| 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 |

 

(b)         Reports on Form 8-K:

 

We filed a report on Form 8-K with the Securities and ExchangeCommission on November 11, 2003 furnishing our press release, dated November11, 2003, announcing our financial results for our fiscal year ended September30, 2003.

 

24

----

 

**SIGNATURES**

 

Pursuant tothe requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized, in the city of Fremont, State ofCalifornia, on the17th day of February, 2004.

 

 
|   | ALTIGEN  COMMUNICATIONS, INC.                 |
|--------|-----------------------------------------------|
|   |                                          |
|   |                                          |
|   | By:                                           | /s/ Philip  M. McDermott |   |
|   | Philip M.  McDermott,                         |
|   | Chief  Financial Officer                      |
|   | (Principal  Financial and Accounting Officer) |

 

25

----