##### Table of Contents

---

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549



---



FORM 10-Q



---



(Mark One)



|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------------



For the Quarterly period ended September 30, 2003



OR



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------



For the transition period from  to



000-50263

(Commission File Number)



---



ZHONE TECHNOLOGIES, INC.

(Exact name of registrant as specified in its
charter)



---



|Delaware                                                       |  | 94-3333763                             
|-------------------------------------------------------------- |  | ---------------------------------------
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification Number)
|                                                               | 
|7001 Oakport Street Oakland, California                        |  | 94621                                  
|(Address of principal executive offices)                       |  | (Zip code)                             



(510) 777-7000

(Registrants telephone number, including area code)



---



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



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



As of September 30, 2003, there were 15,744,078 shares of the Registrants Common Stock issued and outstanding.



---



---

##### Table of Contents

Zhone Technologies, Inc.

FORM 10-Q

Quarterly Period Ended September 30, 2003



Table of Contents



|Part I.  |  | Financial Information                                                                                                                                                                                                                                                                                                                                                                                                                                                             |  |                                                                                                                               
|-------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------------------------------------------------------------------------------------------------------
|Item 1.  |  | Financial Statements (Unaudited)                                                                                                                                                                                                                                                                                                                                                                                                                                                  |  |                                                                                                                               
|         |  | a)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |  | Condensed Consolidated Balance Sheets at September 30, 2003 and December 31, 2002* (1)                                        
|         |  | b)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |  | Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2003 and September 30, 2002*
|         |  | c)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |  | Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2003 and September 30, 2002*          
|         |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |  |                                                                                                                               
|         |  | * The Condensed Consolidated Balance Sheet at December 31, 2002(1)and the Condensed Consolidated Statement of Operations and Condensed Consolidated Statement of Cash Flows for the periods ended September 30, 2002 have been
restated as disclosed in the Companys Amendment No. 3 to its Form 10 for the year ended December 31, 2002 as filed on October 10, 2003 and the Amendment No. 1 to its Form 10-Q for the quarter ended June 30, 2003 as filed on October 10,
2003. |  |                                                                                                                               
|         |  | d)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |  | Notes to Condensed Consolidated Financial Statements                                                                          
|Item 2.  |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                                                                                                                                                                                                                                                                                                                                                                                             |  | 17                                                                                                                            
|Item 3.  |  | Quantitative and Qualitative Disclosures About Market Risk                                                                                                                                                                                                                                                                                                                                                                                                                        |  | 37                                                                                                                            
|Item 4.  |  | Controls and Procedures                                                                                                                                                                                                                                                                                                                                                                                                                                                           |  | 37                                                                                                                            
|         |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|Part II. |  | Other Information                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |  |                                                                                                                               
|Item 1.  |  | Legal Proceedings                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |  | 38                                                                                                                            
|Item 2.  |  | Changes in Securities and Use of Proceeds                                                                                                                                                                                                                                                                                                                                                                                                                                         |  | 38                                                                                                                            
|Item 3.  |  | Defaults Upon Senior Securities                                                                                                                                                                                                                                                                                                                                                                                                                                                   |  | 38                                                                                                                            
|Item 4.  |  | Submission of Matters to a Vote of Security Holders                                                                                                                                                                                                                                                                                                                                                                                                                               |  | 38                                                                                                                            
|Item 5.  |  | Other Information                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |  | 38                                                                                                                            
|Item 6.  |  | Exhibits and Reports on Form 8-K                                                                                                                                                                                                                                                                                                                                                                                                                                                  |  | 38                                                                                                                            
|         |  | Signature                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |  | 39                                                                                                                            

---

|(1) | Derived from the audited financial statements of Zhone Technologies, Inc. and subsidiaries, as restated.
|--- | --------------------------------------------------------------------------------------------------------



1



---

##### Table of Contents

PART I. FINANCIAL INFORMATION



Item 1. Financial Statements



ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES

Condensed Consolidated Balance Sheets

(In thousands, except per share data)



|                                                                                                                                                                                    |  | September 30,2003 |          |   | December 31,2002(1) |  
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------- | -------- | - | ------------------- | -
|                                                                                                                                                                                    |  | (unaudited)       |          |   |                     |  
|Assets                                                                                                                                                                              |  |                   |          |   |                     |  
|Current assets:                                                                                                                                                                     |  |                   |          |   |                     |  
|Cash and cash equivalents                                                                                                                                                           |  | $                 | 2,502    |   |                     | $
|Accounts receivable, net of allowances for sales returns and doubtful accounts of $3,738 and $7,969, respectively                                                                   |  |                   | 12,088   |   |                     |  
|Inventories                                                                                                                                                                         |  |                   | 24,974   |   |                     |  
|Prepaid expenses and other current assets                                                                                                                                           |  |                   | 1,921    |   |                     |  
|                                                                                                                                                                                    |  |                   |          |   |                     |  
|Total current assets                                                                                                                                                                |  |                   | 41,485   |   |                     |  
|Property and equipment, net                                                                                                                                                         |  |                   | 22,939   |   |                     |  
|Goodwill                                                                                                                                                                            |  |                   | 74,890   |   |                     |  
|Other acquisition-related intangible assets, net                                                                                                                                    |  |                   | 14,929   |   |                     |  
|Restricted cash                                                                                                                                                                     |  |                   | 6,681    |   |                     |  
|Other assets                                                                                                                                                                        |  |                   | 1,003    |   |                     |  
|                                                                                                                                                                                    |  |                   |          |   |                     |  
|Total assets                                                                                                                                                                        |  | $                 | 161,927  |   |                     | $
|                                                                                                                                                                                    |  |                   |          |   |                     |  
|Liabilities, Redeemable Convertible Preferred Stock, and Stockholders Equity                                                                                                       |  |                   |          |   |                     |  
|Current liabilities:                                                                                                                                                                |  |                   |          |   |                     |  
|Accounts payable                                                                                                                                                                    |  | $                 | 16,106   |   |                     | $
|Line of credit                                                                                                                                                                      |  |                   | 10,821   |   |                     |  
|Current portion of long-term debt                                                                                                                                                   |  |                   | 7,298    |   |                     |  
|Accrued and other liabilities                                                                                                                                                       |  |                   | 23,847   |   |                     |  
|                                                                                                                                                                                    |  |                   |          |   |                     |  
|Total current liabilities                                                                                                                                                           |  |                   | 58,072   |   |                     |  
|Long-term debt, less current portion                                                                                                                                                |  |                   | 32,288   |   |                     |  
|Other long-term liabilities                                                                                                                                                         |  |                   | 5,733    |   |                     |  
|                                                                                                                                                                                    |  |                   |          |   |                     |  
|Total liabilities                                                                                                                                                                   |  |                   | 96,093   |   |                     |  
|                                                                                                                                                                                    |  |                   |          |   |                     |  
|Commitments and contingencies (Note 10)                                                                                                                                             |  |                   |          |   |                     |  
|Series AA redeemable convertible preferred stock, $0.001 par value. (Note 5)                                                                                                        |  |                   |          |   |                     |  
|Authorized, issued, and outstanding 62,500 shares; redemption and liquidation value of $250,000 as of December 31,
2002                                                             |  |                   |         |   |                     |  
|Series B redeemable convertible preferred stock, $0.001 par value. (Note 5)                                                                                                         |  |                   |          |   |                     |  
|Authorized 17,000 shares; issued and outstanding 11,469 shares; redemption and liquidation value of $23,211 as of December 31,
2002                                                 |  |                   |         |   |                     |  
|                                                                                                                                                                                    |  |                   |          |   |                     |  
|                                                                                                                                                                                    |  |                   |         |   |                     |  
|Stockholders equity (deficit):                                                                                                                                                     |  |                   |          |   |                     |  
|Series AA convertible preferred stock, $0.001 par value. (Note 5)                                                                                                                   |  |                   |          |   |                     |  
|Authorized, issued, and outstanding 62,500 shares; liquidation value of $250,000 as of September 30, 2003                                                                           |  |                   | 157,985  |   |                     |  
|Series B convertible preferred stock, $0.001 par value. (Note 5)                                                                                                                    |  |                   |          |   |                     |  
|Authorized 51,000 shares; issued and outstanding 20,470 shares; liquidation value of $41,427 as of September 30,
2003                                                               |  |                   | 30,730   |   |                     |  
|Common stock, $0.001 par value. Authorized 135,000 and 110,000 shares; issued and outstanding 15,744 and 15,484 shares as of
September 30, 2003 and December 31, 2002, respectively |  |                   | 16       |   |                     |  
|Additional paid-in capital                                                                                                                                                          |  |                   | 472,055  |   |                     |  
|Notes receivable from stockholders                                                                                                                                                  |  |                   | (550     | ) |                     |  
|Deferred compensation                                                                                                                                                               |  |                   | (4,987   | ) |                     |  
|Other comprehensive loss                                                                                                                                                            |  |                   | (80      | ) |                     |  
|Accumulated deficit                                                                                                                                                                 |  |                   | (589,335 | ) |                     |  
|                                                                                                                                                                                    |  |                   |          |   |                     |  
|Total stockholders equity (deficit)                                                                                                                                                |  |                   | 65,834   |   |                     |  
|                                                                                                                                                                                    |  |                   |          |   |                     |  
|Total liabilities, redeemable convertible preferred stock, and stockholders equity                                                                                                 |  | $                 | 161,927  |   |                     | $
|                                                                                                                                                                                    |  |                   |          |   |                     |  

---

|(1) | Derived from the audited financial statements of Zhone Technologies, Inc. and subsidiaries, as restated.
|--- | --------------------------------------------------------------------------------------------------------



See accompanying notes to condensed consolidated financial statements.



2



---

##### Table of Contents

ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES



Unaudited Condensed Consolidated Statements of Operations



(In thousands, except per share data)



|                                                                                                                               |  | Three Months EndedSeptember 30, |        |   | Nine Months EndedSeptember 30, |  
|------------------------------------------------------------------------------------------------------------------------------ |  | ------------------------------- | ------ | - | ------------------------------ | -
|                                                                                                                               |  | 2003                            |        |   | 2002                           |  
|Net revenue                                                                                                                    |  | $                               | 22,240 |   |                                | $
|Cost of revenue                                                                                                                |  |                                 | 12,118 |   |                                |  
|Stock-based compensation                                                                                                       |  |                                 | 131    |   |                                |  
|                                                                                                                               |  |                                 |        |   |                                |  
|Gross profit                                                                                                                   |  |                                 | 9,991  |   |                                |  
|                                                                                                                               |  |                                 |        |   |                                |  
|Operating expenses:                                                                                                            |  |                                 |        |   |                                |  
|Research and product development (excluding non-cash stock-based compensation expense of $366, $2,622, $(344) and
$2,647)      |  |                                 | 5,513  |   |                                |  
|Sales and marketing (excluding non-cash stock-based compensation expense of $285, $72, $(373) and $77)                         |  |                                 | 4,513  |   |                                |  
|General and administrative (excluding non-cash stock-based compensation expense of $112, $4,426, $50, and $4,435)              |  |                                 | 1,228  |   |                                |  
|Purchased in-process research and development                                                                                  |  |                                 |       |   |                                |  
|Restructuring charges                                                                                                          |  |                                 |       |   |                                |  
|Litigation settlement                                                                                                          |  |                                 | 1,600  |   |                                |  
|Stock-based compensation                                                                                                       |  |                                 | 763    |   |                                |  
|Amortization and impairment of intangible assets                                                                               |  |                                 | 2,053  |   |                                |  
|                                                                                                                               |  |                                 |        |   |                                |  
|Total operating expenses                                                                                                       |  |                                 | 15,670 |   |                                |  
|                                                                                                                               |  |                                 |        |   |                                |  
|Operating loss                                                                                                                 |  |                                 | (5,679 | ) |                                |  
|Interest expense and other income (expense), net                                                                               |  |                                 |        |   |                                |  
|Interest expense                                                                                                               |  |                                 | (936   | ) |                                |  
|Other income (expense), net                                                                                                    |  |                                 | 57     |   |                                |  
|                                                                                                                               |  |                                 |        |   |                                |  
|Interest expense and other income (expense), net                                                                               |  |                                 | (879   | ) |                                |  
|                                                                                                                               |  |                                 |        |   |                                |  
|Loss before income taxes                                                                                                       |  |                                 | (6,558 | ) |                                |  
|Income tax (benefit) provision                                                                                                 |  |                                 | (3,064 | ) |                                |  
|                                                                                                                               |  |                                 |        |   |                                |  
|Net loss                                                                                                                       |  |                                 | (3,494 | ) |                                |  
|Accretion on preferred stock                                                                                                   |  |                                 |       |   |                                |  
|                                                                                                                               |  |                                 |        |   |                                |  
|Net loss applicable to holders of common stock                                                                                 |  | $                               | (3,494 | ) |                                | $
|                                                                                                                               |  |                                 |        |   |                                |  
|Basic and diluted net loss per share applicable to holders of common stock                                                     |  | $                               | (0.23  | ) |                                | $
|Weighted average shares outstanding used to compute basic and diluted net loss per share applicable to holders of common
stock |  |                                 | 15,210 |   |                                |  



All per share amounts have been
retroactively adjusted to reflect the one-for-ten reverse split of common stock (See Note 1(l)).



See accompanying notes to condensed consolidated financial statements.



3



---

##### Table of Contents

ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES



Unaudited Condensed Consolidated Statements of Cash Flows



(In thousands)



|                                                                              |  | Nine months endedSeptember 30, |        
|----------------------------------------------------------------------------- |  | ------------------------------ | -------
|                                                                              |  | 2003                           |        
|Cash flows from operating activities:                                         |  |                                |        
|Net loss                                                                      |  | $                              | (10,753
|Adjustments to reconcile net loss to net cash used in operating activities:   |  |                                |        
|Depreciation and amortization                                                 |  |                                | 6,925  
|Stock-based compensation                                                      |  |                                | (822   
|Purchased in-process research and development                                 |  |                                |       
|Loss on disposal of equipment                                                 |  |                                |       
|Deferred income taxes                                                         |  |                                | (3,205 
|Changes in operating assets and liabilities, net of effect of acquisitions:   |  |                                |        
|Accounts receivable                                                           |  |                                | 5,207  
|Inventories                                                                   |  |                                | (3,725 
|Prepaid expenses and other current assets                                     |  |                                | (374   
|Other assets                                                                  |  |                                | (71    
|Accounts payable                                                              |  |                                | 2,738  
|Accrued liabilities and other                                                 |  |                                | (10,696
|                                                                              |  |                                |        
|Net cash used in operating activities                                         |  |                                | (14,776
|                                                                              |  |                                |        
|Cash flows from investing activities:                                         |  |                                |        
|Acquisition of subsidiaries, net of cash acquired                             |  |                                |       
|Purchases of property and equipment                                           |  |                                | (462   
|Proceeds from sale of property and equipment                                  |  |                                |       
|Purchases of short term investment                                            |  |                                |       
|Proceeds from sale of short term investment                                   |  |                                |       
|                                                                              |  |                                |        
|Net cash provided by (used in) investing activities                           |  |                                | (462   
|                                                                              |  |                                |        
|Cash flows from financing activities:                                         |  |                                |        
|Net borrowings (payments) under line of credit facilities                     |  |                                | 6,207  
|Net proceeds from issuance of Series A redeemable convertible preferred stock |  |                                |       
|Net proceeds from issuance of Series B redeemable convertible preferred stock |  |                                |       
|Proceeds from issuance of common stock and warrants, net of repurchases       |  |                                | 49     
|Repayment of debt                                                             |  |                                | (3,196 
|Proceeds of loans from officers/employees                                     |  |                                | 4,079  
|                                                                              |  |                                |        
|Net cash provided by (used in) financing activities                           |  |                                | 7,139  
|                                                                              |  |                                |        
|Effect of exchange rate changes on cash                                       |  |                                | (13    
|                                                                              |  |                                |        
|Net decrease in cash and cash equivalents                                     |  |                                | (8,112 
|Cash and cash equivalents at beginning of period                              |  |                                | 10,614 
|                                                                              |  |                                |        
|Cash and cash equivalents at end of period                                    |  | $                              | 2,502  
|                                                                              |  |                                |        
|Supplemental disclosures of cash flow information:                            |  |                                |        
|Cash paid during period for:                                                  |  |                                |        
|Taxes                                                                         |  | $                              | (169   
|Interest                                                                      |  |                                | (2,940 
|Non-cash investing and financing activities:                                  |  |                                |        
|Series B redeemable convertible preferred stock issued for acquisition        |  |                                | 10,125 



See
accompanying notes to condensed consolidated financial statements.



4



---

##### Table of Contents

ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES



Notes to Condensed Consolidated Financial Statements



|(1) | Organization and Summary of Significant Accounting Policies
|--- | -----------------------------------------------------------



| | (a) | Description of Business
| | --- | -----------------------



Zhone Technologies, Inc. (the Company) is a network equipment vendor. The Company has developed an integrated hardware and software architecture designed
to simplify the way network service providers deliver communication services to their subscribers. The Companys products enable service providers to use their existing networks to deliver voice, video, data, and entertainment services to their
customers. The Company was incorporated under the laws of the state of Delaware in June 1999. The Company began operations in September 1999 and is headquartered in Oakland, California.



| | (b) | Liquidity and Capital Resources
| | --- | -------------------------------



The Company has incurred recurring losses from operations and has an accumulated deficit of $589.3 million as of September 30, 2003. The Company has
financed operations through private sales of capital stock and borrowings under various debt arrangements. In November 1999, the Company issued 125.0 million shares of Series A redeemable convertible preferred stock to investors in exchange for a
maximum capital commitment of $500.0 million. Although the Company has incurred substantial losses and negative cash flows from operations since inception, management anticipates that these losses will decrease as the Companys products gain
market acceptance. In July 2002, the Company completed a restructuring of its equity capitalization, resulting in a reduction of the redemption and liquidation value on Series AA redeemable convertible preferred stock of $250.0 million. In April
2003, the terms of the redeemable convertible preferred stock were changed to eliminate the redemption feature.



In December 2002, the Company established a line of credit agreement with a financial institution for a maximum commitment of $25.0 million. Amounts
advanced under the credit facility are subject to underlying eligible accounts receivable. In February 2003, the Company entered into a secured note and warrant purchase agreement with certain of its original investors for a maximum commitment of up
to $25.0 million pursuant to the issuance of promissory notes. In total, the Company has a maximum commitment of $50.0 million on these credit facilities. As of September 30, 2003, total borrowings were $10.8 million from the line of credit with a
financial institution.



In July 2003, the Company entered into
a definitive merger agreement with Tellium, Inc. Under the terms of the agreement, as a result of the proposed merger, the Companys current stockholders will own approximately 60% of the combined companys outstanding shares on a fully
converted basis and 40% will be held by Telliums stockholders. This merger could require substantial cash payments related to the integration and rationalization of the acquired business.



On July 29, 2003, the Company borrowed $2.0 million for working capital
purposes from Mory Ejabat, Chairman and Chief Executive Officer of Zhone, and Jeanette Symons, Chief Technology Officer and Vice President, Engineering of Zhone. On August 7, 2003, the Company borrowed $2.0 million for working capital purposes from
Jeanette Symons, Chief Technology Officer and Vice President, Engineering of Zhone. The remaining current debt will be funded through cash flow from operations. To the extent that sufficient cash from operations is not generated, the Company would
seek additional equity or debt financing. If the Company is unsuccessful in obtaining additional equity or debt financing, management plans to reduce expenditures. Management believes that it has sufficient available cash equity and debt resources
to provide for its working capital needs through at least September 30, 2004.



| | (c) | Basis of Presentation
| | --- | ---------------------



The condensed consolidated financial statements are unaudited and reflect all adjustments (consisting only of normal recurring adjustments) that, in the
opinion of management, are necessary for a fair presentation of the results for the interim periods presented. The results of operations for the current interim period are not necessarily indicative of results to be expected for the current year or
any other period. Certain amounts in 2002 have been reclassified to conform to the 2003 presentation.



These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto
included in the Zhone Technologies, Inc. Form 10, as amended, for the year ended December 31, 2002.



5



---

##### Table of Contents

ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES



Notes to Condensed Consolidated Financial Statements



| | (d) | Restatement
| | --- | -----------



In October 2003, in response to an inquiry from the Securities and Exchange Commission, or SEC, the Company restated its consolidated financial statements
and related disclosures for the year ended December 31, 2002 and for the six months ended June 30, 2003. Zhones condensed consolidated financial statements as of and for the year ended December 31, 2002 and as of and for the three and six
month periods ended June 30, 2003 have been restated as discussed in the Companys Amendment No. 3 to its Form 10 filed on October 10, 2003 and the Amendment No. 1 to its Quarterly Report on Form 10-Q for the quarter ended June 30, 2003 filed
on October 10, 2003. The restatement reflected increased non-cash stock-based compensation expense resulting from a change in the estimated fair value of the Companys common stock from $0.10 per share to $1.50 per share. The Company also
adjusted its Series AA redeemable preferred stock to reflect a decrease in the estimated fair value from $170.7 million to $126.5 million, or $2.73 per share to $2.02 per share as of July 1, 2002. The accompanying condensed consolidated balance
sheet as of December 31, 2002 represents restated balances. The accompanying statements of operations for the three and nine months ended September 30, 2002 and statement of cash flows for the nine months ended September 30, 2002 include restated
results.



| | (e) | Use of Estimates
| | --- | ----------------



The preparation of the condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of
America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported
amounts of revenue and expenses during the reporting period. Actual results could differ materially from those estimates.



| | (f) | Revenue Recognition
| | --- | -------------------



The Company recognizes revenue when the earnings process is complete. The Company recognizes product revenue upon shipment of product under contractual
terms which transfer title upon shipment, under normal credit terms, or under sales-type leases, net of estimated sales returns and allowances at the time of shipment. Revenue is deferred if there are significant post-delivery obligations, if
collection is not considered probable at the time of sale, or if the fee is not fixed or determinable. When significant post-delivery obligations exist, revenue is deferred until such obligations are fulfilled. The Companys arrangements
generally do not have any significant post delivery obligations. The Company offers products and services such as support, education and training, hardware upgrades and extended warranty coverage. The Company has established the fair value of these
products and services based on sales prices when they are sold separately. Any discounts provided on these additional products and services are identical to the discount provided on the original sale of product. When collectibility is not probable,
revenue is recognized when cash is collected. Revenue from education services and support services is recognized over the contract term or as the service is performed. The Company makes certain sales to product distributors. These customers are
given certain privileges to return a portion of inventory. The Company recognizes revenue on sales to distributors that have contractual return rights when the products have been sold by the distributors. Revenue from sale of software products is
recognized provided that a purchase order has been received, the software has been shipped, collection of the resulting receivable is deemed probable, and the fee is fixed or determinable. To date, revenue from software transactions and sales-type
leases has not been significant. The Company accrues for warranty costs, sales returns, and other allowances at the time of shipment based on historical experience and expected future costs.



| | (g) | Allowances for Sales Returns and Doubtful Accounts
| | --- | --------------------------------------------------



The Company has an allowance for sales returns for estimated future product returns related to current period product revenue. The Company bases its
allowance on periodic assessment of historical trends in product return rates and current approved returned products. If the actual future returns were to deviate from the historical data on which the reserve had been established, the Companys
revenue could be adversely affected.



The Company has an
allowance for doubtful accounts for estimated losses resulting from the inability of customers to make payments. The Company bases its allowance on periodic assessment of its customers liquidity and financial condition through analysis of
information obtained from credit rating agencies, financial statement reviews, and historical collection trends. Additional allowances may be required if the liquidity or financial condition of its customers were to deteriorate.



6



---

##### Table of Contents

ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES



Notes to Condensed Consolidated Financial Statements



| | (h) | Inventories
| | --- | -----------



Inventories are stated at the lower of cost or market, with cost being determined using the first-in, first-out (FIFO) method. In assessing the net
realizable value of inventories, the Company is required to make judgments as to future demand requirements and compare these with the current or committed inventory levels. Once inventory has been written down to its estimated net realizable value,
its carrying value cannot be increased due to subsequent changes in demand forecasts. To the extent that a severe decline in forecasted demand occurs, or the Company experiences a higher incidence of inventory obsolescence due to rapidly changing
technology and customer requirements, the Company may incur significant charges for excess inventory.



| | (i) | Concentration of Risk
| | --- | ---------------------



The Companys customers include competitive and incumbent local exchange carriers, competitive access providers, Internet service providers, wireless
carriers, and resellers serving these markets. The Company performs ongoing credit evaluations of its customers and generally does not require collateral. Allowances are maintained for potential doubtful accounts. For the three months ended
September 30, 2003, sales to Motorola and Qwest represented 16% and 14% of net revenue, respectively, as compared to 10% of net revenue to Motorola for the same period last year. For the nine months ended September 30, 2003, sales to Motorola and
Qwest represented 18% and 12% of net revenue, respectively, as compared to 10% of net revenue to Motorola for the same period last year. As of September 30, 2003, the Company had accounts receivable balances from three customers individually
representing 20%, 11% and 10% of accounts receivable, respectively.



| | (j) | Accounting for Stock-Based Compensation
| | --- | ---------------------------------------



The Company has elected to account for employee stock options using the intrinsic-value method in accordance with Accounting Principles Board Opinion No.
25 (APB 25) and related interpretations. Under this method, compensation expense is recorded on the date of grant only if the current fair value exceeds the exercise price. SFAS No. 123, Accounting for Stock-Based Compensation, established
accounting and disclosure requirements using a fair-value-based method of accounting for stock-based employee compensation plans. As allowed by SFAS No. 123, the Company has elected to continue to apply the intrinsic-value-based method of accounting
described above, and has adopted the disclosure requirements of SFAS No. 123, as amended.



For the three and nine month periods ended September 30, 2003 and 2002, the fair value of the Companys stock-based awards to employees was estimated using the following weighted average assumptions: expected
option life of 4 years; dividend yield of 0%; risk-free interest rate of 4.45% and 3.87%, respectively; and volatility of 80% and 0%, respectively. Prior to the proposed merger agreement with Tellium, Inc., the Company used the minimum value option
pricing model for privately-held companies which does not consider the impact of stock price volatility.



The following table illustrates the effect on net loss and net loss per share if the fair-value-based method had been applied to all outstanding and
unvested awards in each period (in thousands, except per share data):



|                                                                                                           |  | Three months endedSeptember 30, |        |   | Nine months endedSeptember 30, |  
|---------------------------------------------------------------------------------------------------------- |  | ------------------------------- | ------ | - | ------------------------------ | -
|                                                                                                           |  | 2003                            |        |   | 2002                           |  
|Net loss, as reported                                                                                      |  | $                               | (3,494 | ) |                                | $
|                                                                                                           |  |                                 |        |   |                                |  
|Add: Stock-based compensation expense included in reported net loss                                        |  |                                 | 894    |   |                                |  
|Deduct: Total stock-based compensation benefit (expense) determined under fair value method for all awards |  |                                 | (1,502 | ) |                                |  
|                                                                                                           |  |                                 |        |   |                                |  
|Pro forma net loss                                                                                         |  | $                               | (4,102 | ) |                                | $
|                                                                                                           |  |                                 |        |   |                                |  
|Loss per share applicable to holders of common stock:                                                      |  |                                 |        |   |                                |  
|As reported  basic and diluted                                                                            |  | $                               | (0.23  | ) |                                | $
|                                                                                                           |  |                                 |        |   |                                |  
|Pro forma  basic and diluted                                                                              |  | $                               | (0.27  | ) |                                | $
|                                                                                                           |  |                                 |        |   |                                |  



7



---

##### Table of Contents

ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES



Notes to Condensed Consolidated Financial Statements



| | (k) | Recent Accounting Pronouncements
| | --- | --------------------------------



In November 2002, the Emerging Issues Task Force (EITF) reached a consensus regarding Issue 00-21 (EITF 00-21), Revenue
Arrangements with Multiple Deliverables. The consensus addresses not only when and how an arrangement involving multiple deliverables should be divided into separate elements of accounting but also how the arrangements consideration
should be allocated among separate units. The applicable provisions of EITF 00-21 were applied to the Companys revenue transactions beginning in the quarter ended September 30, 2003. The adoption of EITF 00-21 did not have a material impact on
the Companys consolidated financial statements.



In
January 2003, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities. FIN 46 requires that if an entity has a controlling
financial interest in a variable interest entity, the assets, liabilities and results of activities of the variable interest entity should be included in the consolidated financial statements of the entity. FIN 46 requires that its provisions are
effective immediately for all arrangements entered into after January 31, 2003. The Company does not have any financial interests in variable interest entities created after January 31, 2003. For those arrangements entered into prior to January 31,
2003, the provisions of FIN 46 are required to be adopted by the Company in the quarter ended December 31, 2003. The adoption of FIN 46 is not expected to have a material impact on the Companys consolidated financial statements.



In May 2003, the FASB issued Statement of Financial Accounting Standards No.
150 (SFAS No. 150), Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. This statement establishes standards for how an issuer classifies and measures in its statement of
financial position certain financial instruments with characteristics of both liabilities and equity. In accordance with the standard, financial instruments that embody obligations for the issuer are required to be classified as liabilities. This
Statement is effective for financial instruments entered into or modified after May 31, 2003. The adoption of SFAS No. 150 did not have a material impact on the Companys consolidated financial statements.



| | (l) | Reverse Stock Split
| | --- | -------------------



On July 1, 2002 the Company effectuated a reverse stock split of its common stock at a ratio of one-for-ten (the Reverse Split), causing each outstanding
share of common stock to convert automatically into one-tenth of a share of common stock. Stockholders equity (deficit) has been retroactively adjusted to reflect the Reverse Split for all periods presented by reclassifying the excess par
value resulting from the reduced number of shares from common stock to paid-in capital. All references to common share and per common share amounts for all periods presented have been retroactively adjusted to reflect this reverse split.



8



---

##### Table of Contents

ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES



Notes to Condensed Consolidated Financial Statements



|(2) | Business Combinations
|--- | ---------------------



Vpacket Communications, Inc.



In July 2002, the Company acquired Vpacket Communications, Inc. (Vpacket), in exchange for total consideration of $19.2 million consisting of $15.5
million in stock and $3.7 million in assumed liabilities. The Company issued approximately 9.7 million shares of Series B redeemable convertible preferred stock. The purchase consideration was allocated based on the fair values as follows (in
thousands):



|Cash acquired                 |  | $ | 21,926 |  
|----------------------------- |  | - | ------ | -
|Other net liabilities assumed |  |   | (2,752 | )
|                              |  |   |        |  
|Total purchase consideration  |  | $ | 19,174 |  
|                              |  |   |        |  



Vpacket developed and
marketed a voice/data router and a network management system that allowed service providers to deliver converged voice and data services while leveraging their existing data network infrastructure. The Vpacket acquisition was complementary to the
Zhone portfolio of products because it extended the Companys products, customers and engineering expertise in the area of Internet Protocol (IP) voice.



Accrued liabilities related to this acquisition totaled $3.7 million. These included compensation-related liabilities of $0.6 million, facility costs
of $2.6 million and direct transaction costs of $0.5 million. As of September 30, 2003, accrued liabilities related to this acquisition were $1.0 million primarily related to facility costs.



NEC eLuminant Technologies



On February 14, 2003, the Company acquired NEC eLuminant Technologies, Inc.
(eLuminant), a subsidiary of NEC USA, Inc., in exchange for total consideration of approximately $13.6 million consisting of $10.1 million in stock, $3.2 million in assumed liabilities and $0.3 million in acquisition costs. The results of
eLuminants operations have been included in the consolidated financial statements since that date. The Company issued approximately 9.0 million shares of Series B redeemable convertible preferred stock. The value of the preferred stock issued
was determined based on the results of a third party appraisal. The purchase consideration was allocated based on the fair values of the assets acquired as follows (in thousands):



|Receivables and inventory    |  | $ | 4,652 
|---------------------------- |  | - | ------
|Intangible assets            |  |   | 4,840 
|Goodwill                     |  |   | 4,083 
|                             |  |   |       
|Total purchase consideration |  | $ | 13,575
|                             |  |   |       



Details of the
acquisition-related intangible assets are as follows:



|                     |  | September 30, 2003
|-------------------- |  | ------------------
|                     |  | GrossAmount       
|                     |  | (in thousands)    
|Developed technology |  | $                 
|Customer list        |  |                   
|Patents/tradenames   |  |                   
|                     |  |                   
|Total                |  | $                 
|                     |  |                   



eLuminant developed a
family of multiplexers and digital loop carrier products. The primary reasons for the acquisition of eLuminant were to gain access to its product portfolio, strengthen the Companys customer base and increase the Companys workforce with
experienced personnel. As of September 30, 2003, assumed liabilities related to this acquisition were $1.7 million.



The following unaudited pro forma financial information for the three and nine months ended September 30, 2003 and 2002 presents the consolidated
operations of the Company as if the acquisition had been made on January 1, 2002. Under the provisions of SFAS No. 142, goodwill acquired in transactions completed after June 30, 2001 is not amortized. As the



9



---

##### Table of Contents

ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES



Notes to Condensed Consolidated Financial Statements



acquisition of eLuminant occurred subsequent to that date, these pro forma results do not reflect any
goodwill amortization expense. The unaudited pro forma financial information is provided for informational purposes only, should not be construed to be indicative of the Companys consolidated results of operations had the acquisition of
eLuminant been consummated on this earlier date, and is not intended to project the Companys results of operations for any future period.



|                                                       |  | Three months endedSeptember 30,       |        |   | Nine months endedSeptember 30, |  
|------------------------------------------------------ |  | ------------------------------------- | ------ | - | ------------------------------ | -
|                                                       |  | 2003                                  |        |   | 2002                           |  
|                                                       |  | (in thousands, except per share data) |       
|Net revenue                                            |  | $                                     | 22,240 |   |                                | $
|Net loss                                               |  |                                       | (3,494 | ) |                                |  
|Net loss per share-basic and diluted                   |  | $                                     | (0.23  | ) |                                | $
|Number of shares used in computation-basic and diluted |  |                                       | 15,210 |   |                                |  



|(3) | Long-lived Assets, Goodwill and Other Acquisition-Related Intangible Assets
|--- | ---------------------------------------------------------------------------



As of January 1, 2001, the Company adopted SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 requires
that goodwill no longer be amortized, but should be tested for impairment at least annually. The Company completed its transitional and annual goodwill impairment test as of January 2002 and November 2002, respectively. As the Company has determined
that it operates in a single segment with one operating unit, the fair value of its reporting unit was performed at the Company level using a combination of the income, or discounted cash flows, approach and the market approach, which utilizes
comparable companies data. As of September 30, 2003 and December 31, 2002, the Company had goodwill with a carrying value of approximately $74.9 million and $70.8 million, respectively.



In accordance with SFAS No. 144, the Company reviews long-lived assets,
including intangible assets other than goodwill, for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable based on expected undiscounted cash flows attributable to that asset. The
amount of any impairment is measured as the difference between the carrying value and the fair value of the impaired asset.



The Company estimated the fair value of its long-lived assets based on a combination of the market, income and replacement cost approaches. In the
application of the impairment testing, the Company was required to make estimates of future operating trends and resulting cash flows and judgments on discount rates and other variables. Actual future results and other assumed variables could differ
from these estimates.



In the second quarter of 2002, the
Company discontinued its wireless product line which included the analog wireless design previously acquired from Optaphone Networks. As a result, the Company recorded a non-cash impairment charge of $0.7 million because the estimated undiscounted
future cash flows of these assets was less than the carrying value of the purchased intangibles related to Optaphone Networks.



Details of the Companys acquisition-related intangible assets are as follows:



|                     |  | September 30, 2003
|-------------------- |  | ------------------
|                     |  | GrossAmount       
|                     |  | (in thousands)    
|Developed technology |  | $                 
|Core technology      |  |                   
|Others               |  |                   
|                     |  |                   
|Total                |  | $                 
|                     |  |                   



|                     |  | December 31, 2002
|-------------------- |  | -----------------
|                     |  | GrossAmount      
|                     |  | (in thousands)   
|Developed technology |  | $                
|Core technology      |  |                  
|Others               |  |                  
|                     |  |                  
|Total                |  | $                
|                     |  |                  



10



---

##### Table of Contents

ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES



Notes to Condensed Consolidated Financial Statements



Amortization expense of acquisition-related intangible assets was $2.1 million and $4.2 million for
the three months ended September 30, 2003 and 2002, respectively, and $5.9 million and $12.2 million for the nine months ended September 30, 2003 and 2002, respectively.



Estimated amortization expense for the fiscal years ending December 31, is as follows (in thousands):



|2003  |  | $ | 7,950 
|----- |  | - | ------
|2004  |  | $ | 8,200 
|2005  |  | $ | 4,400 
|2006  |  | $ | 270   
|      |  |   |       
|Total |  | $ | 20,820
|      |  |   |       



11



---

##### Table of Contents

ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES



Notes to Condensed Consolidated Financial Statements



The changes in the carrying amount of goodwill are as follows (in thousands):



|                  |  | Three months endedSeptember 30, |        | Nine months endedSeptember 30, |     
|----------------- |  | ------------------------------- | ------ | ------------------------------ | ----
|                  |  | 2003                            |        |                                | 2002
|Beginning balance |  | $                               | 74,911 |                                |     
|Goodwill acquired |  |                                 |       |                                |     
|Impairment losses |  |                                 |       |                                |     
|Adjustments       |  |                                 | (21    | )                              |     
|                  |  |                                 |        |                                |     
|Ending balance    |  | $                               | 74,890 |                                |     
|                  |  |                                 |        |                                |     



|(4) | Inventories
|--- | -----------



Inventories as of September 30, 2003 and December 31, 2002 are as follows (in thousands):



|                |  | September 30,2003 |        | December 31,2002
|--------------- |  | ----------------- | ------ | ----------------
|Inventories:    |  |                   |        |                 
|Raw materials   |  | $                 | 17,991 |                 
|Work in process |  |                   | 5,764  |                 
|Finished goods  |  |                   | 1,219  |                 
|                |  |                   |        |                 
|                |  | $                 | 24,974 |                 
|                |  |                   |        |                 



|(5) | Redeemable Convertible Preferred Stock
|--- | --------------------------------------



Prior to April 17, 2003, the Series AA and Series B redeemable convertible preferred stock contained a redemption feature, such that holders of the
redeemable convertible preferred stock could require the Company to redeem the preferred stock at, or any time after, November 1, 2004, 2005, and 2006, in three annual installments, that number of shares of redeemable convertible preferred stock
equal to not less than 33.3%, 66.7%, and 100%, respectively. On April 17, 2003, the terms of the redeemable convertible preferred stock were changed to eliminate the redemption feature. Upon the elimination of the redemption feature, the convertible
preferred stock has been reclassified to stockholders equity.



Prior to April 17, 2003, the Company was accreting the redeemable convertible preferred stock to its stated redemption price. The Company accreted, by charging paid in capital, $12.7 million on all outstanding Series AA and Series B
redeemable convertible preferred stock in 2003, which has been reflected as an increase in the carrying value of the preferred stock. Upon the elimination of the redemption feature for the Series AA and Series B preferred shares, the Company will no
longer accrete the convertible preferred stock. The accretion of the redemption value of the redeemable convertible preferred stock for the three and nine months ended September 30, 2003 was zero and $12.7 million, respectively, as compared to $10.2
million and $12.0 million for the same periods in 2002.



|(6) | Net Loss Per Share
|--- | ------------------



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



|                                                                           |  | Three months endedSeptember 30, |        |   | Nine months endedSeptember 30, |  
|-------------------------------------------------------------------------- |  | ------------------------------- | ------ | - | ------------------------------ | -
|                                                                           |  | 2003                            |        |   | 2002                           |  
|Numerator:                                                                 |  |                                 |        |   |                                |  
|Net loss                                                                   |  | $                               | (3,494 | ) |                                | $
|Accretion on preferred stock                                               |  |                                 |       |   |                                |  
|                                                                           |  |                                 |        |   |                                |  
|Net loss applicable to holders of common stock                             |  | $                               | (3,494 | ) |                                | $
|                                                                           |  |                                 |        |   |                                |  
|Denominator:                                                               |  |                                 |        |   |                                |  
|Weighted average common stock outstanding                                  |  |                                 | 15,662 |   |                                |  
|Adjustment for common stock issued subject to repurchase                   |  |                                 | (452   | ) |                                |  
|                                                                           |  |                                 |        |   |                                |  
|Denominator for basic and diluted calculation                              |  |                                 | 15,210 |   |                                |  
|                                                                           |  |                                 |        |   |                                |  
|Basic and diluted net loss per share applicable to holders of common stock |  | $                               | (0.23  | ) |                                | $



12



---

##### Table of Contents

ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES



Notes to Condensed Consolidated Financial Statements



The following table sets forth potential common stock that is not included in the diluted net loss
per share calculation above because their effect would be antidilutive for the periods indicated (in thousands, except exercise price data):



|                                                           |  | Three MonthsEndedSeptember 30, 2003 |  | WeightedAverageExerciseprice |       | Nine MonthsEndedSeptember 30, 2003 |        | WeightedAverageExerciseprice
|---------------------------------------------------------- |  | ----------------------------------- |  | ---------------------------- | ----- | ---------------------------------- | ------ | ----------------------------
|Convertible Preferred stock                                |  | 82,970                              |  | $                            | 6.38  |                                    | 82,970 |                             
|Weighted average common stock issued subject to repurchase |  | 452                                 |  |                              | .83   |                                    | 1,001  |                             
|Warrants                                                   |  | 171                                 |  |                              | 12.97 |                                    | 171    |                             
|Outstanding stock options granted                          |  | 3,522                               |  |                              | .83   |                                    | 3,522  |                             
|                                                           |  |                                     |  |                              |       |                                    |        |                             
|                                                           |  | 87,115                              |  |                              |       |                                    | 87,664 |                             
|                                                           |  |                                     |  |                              |       |                                    |        |                             



|                                                           |  | Three MonthsEndedSeptember 30, 2002 |  | WeightedAverageExerciseprice |       | Nine MonthsEndedSeptember 30, 2002 |        | WeightedAverageExerciseprice
|---------------------------------------------------------- |  | ----------------------------------- |  | ---------------------------- | ----- | ---------------------------------- | ------ | ----------------------------
|Convertible Preferred stock                                |  | 73,865                              |  | $                            | 7.02  |                                    | 73,865 |                             
|Weighted average common stock issued subject to repurchase |  | 2,764                               |  |                              | 1.45  |                                    | 1,269  |                             
|Warrants                                                   |  | 28                                  |  |                              | 70.13 |                                    | 28     |                             
|Outstanding stock options granted                          |  | 4,021                               |  |                              | 3.92  |                                    | 4,021  |                             
|                                                           |  |                                     |  |                              |       |                                    |        |                             
|                                                           |  | 80,678                              |  |                              |       |                                    | 79,183 |                             
|                                                           |  |                                     |  |                              |       |                                    |        |                             



As of September 30,
2003 and 2002, common stock issued subject to repurchase at the end of each period was 449,423 and 2,948,561, respectively.



|(7) | Comprehensive Loss
|--- | ------------------



The components of comprehensive loss, net of tax, for the three and nine months ended September 30, 2003 and 2002 were as follows (in thousands):



|                                         |  | Three Months EndedSeptember 30, |        |   | Nine Months EndedSeptember 30, |  
|---------------------------------------- |  | ------------------------------- | ------ | - | ------------------------------ | -
|                                         |  | 2003                            |        |   | 2002                           |  
|Net loss                                 |  | $                               | (3,494 | ) |                                | $
|Other comprehensive loss:                |  |                                 |        |   |                                |  
|Change in unrealized loss on investments |  |                                 |       |   |                                |  
|Foreign currency translation adjustments |  |                                 | (38    | ) |                                |  
|                                         |  |                                 |        |   |                                |  
|Total other comprehensive loss           |  |                                 | (38    | ) |                                |  
|                                         |  |                                 |        |   |                                |  
|Total comprehensive loss                 |  | $                               | (3,532 | ) |                                | $
|                                         |  |                                 |        |   |                                |  



The foreign currency
translation adjustments are not adjusted for income taxes as they relate to indefinite investments in non-U.S. subsidiaries.



|(8) | Income Taxes
|--- | ------------



In April 2002, Premisys Communications, a wholly-owned subsidiary, received a $3.1 million income tax refund related to the net operating loss carryback
of its post-acquisition loss sustained during the tax year ended December 31, 2001. At the time, the Company did not recognize the income tax benefit associated with this refund claim because of substantial uncertainty regarding whether the benefit
could be sustained upon audit. In August 2003, Premisys Communications received notification from the Internal Revenue Service that it had concluded an audit of the federal income tax return for the tax year ended December 31, 2001 and accepted the
refund claim resulting from the net operating loss carryback generated in that year. Accordingly, an income tax benefit of $3.1 million was recognized during the three months ended September 30, 2003.



13



---

##### Table of Contents

ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES



Notes to Condensed Consolidated Financial Statements



|(9) | Related-Party Transactions
|--- | --------------------------



In 2002, the Company cancelled $1.9 million in notes receivable from certain employees of the Company due to repurchase of the related options to purchase
shares of the Companys common stock.



In 2002, the
Company loaned $0.6 million to its founders under promissory notes for the purchase of its common stock. The notes accrue interest at a rate of 5.50% compounded annually and expire on July 11, 2006, on which date all unpaid interest and principal is
due on demand.



In July 2002, the Company issued 62.5 million
shares of Series AA redeemable convertible preferred stock in exchange for 125.0 million shares of Series A redeemable convertible preferred stock.



On July 1, 2002, the Company acquired Vpacket Communications, Inc. in exchange for total consideration of $19.2 million. Robert K. Dahl, one of our
directors, was also a member of the board of directors of Vpacket. C. Richard Kramlich, one of our directors, is affiliated with New Enterprise Associates VIII, Limited Partnership and/or its affiliates, which was a significant stockholder of
Vpacket. Jim Timmins, who joined our board following the acquisition, was a member of the board of directors of Vpacket and is also affiliated with NIF Ventures, which was a stockholder in Vpacket.



On July 29, 2003, the Company borrowed $2.0 million from Mory Ejabat,
Chairman and Chief Executive Officer of Zhone, and Jeanette Symons, Chief Technology Officer and Vice President, Engineering of Zhone. This loan will bear interest at 12% per year and will mature on the date which is the earlier of December 31,
2003, the closing of the Companys proposed merger with Tellium, Inc. or upon an event of liquidation or default.



On August 7, 2003, the Company borrowed $2.0 million from Jeanette Symons, Chief Technology Officer and Vice President, Engineering of Zhone. This loan
will bear interest at 12% per year and will mature on the date which is the earlier of December 31, 2003, the closing of the Companys proposed merger with Tellium, Inc. or upon an event of liquidation or default.



|(10) | Commitments and Contingencies
|---- | -----------------------------



In November 2002, the FASB issued FASB Interpretation No. 45 (FIN 45), Guarantors Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of Indebtedness of Othersan interpretation of FASB Statements No. 5, 57 and 107 and rescission of FIN 34. FIN 45 requires that disclosures be made by a guarantor in its interim and annual financial
statements about its obligations under certain guarantees that it has issued and clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the
guarantee. FIN 45 does not apply to certain guarantee contracts, such as residual value guarantees provided by lessees in capital leases, guarantees that are accounted for as derivatives, guarantees that represent contingent consideration in a
business combination, guarantees issued between either parents and their subsidiaries or corporations under common control, a parents guarantee of a subsidiarys debt to a third party, and a subsidiarys guarantee of the debt owed to
a third party by either its parent or another subsidiary of that parent. This interpretation is effective on a prospective basis for guarantees issued or modified after December 31, 2002 and for financial statements of interim or annual periods
ending after December 15, 2002. This interpretation did not have a material impact on the Companys financial position or results of operations.



Leases



The Company has entered into operating leases for certain office space and equipment, some of which contain renewal options. The Company has options to
purchase the leased assets at the end of the lease terms. However, the payments for the equipment operating leases are immaterial in relation to the Companys condensed consolidated financial statements.



Future minimum lease payments under all noncancelable operating leases with
terms in excess of one year are as follows (in thousands):



|                             |  | Operating leases
|---------------------------- |  | ----------------
|Year ending December 31:     |  |                 
|2003                         |  | $               
|2004                         |  |                 
|2005                         |  |                 
|2006                         |  |                 
|2007                         |  |                 
|Thereafter                   |  |                 
|                             |  |                 
|Total minimum lease payments |  | $               
|                             |  |                 



14



---

##### Table of Contents

ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES



Notes to Condensed Consolidated Financial Statements



Warranties & Other Commitments



The Company accrues for warranty costs based on historical trends for the
expected material and labor costs to provide warranty services. Warranty periods are generally one year from the date of shipment.



The following table reconciles changes in the Companys accrued warranties and related costs for the nine months ended September 30, 2003 and 2002,
respectively (in thousands):



|                                             |  | Nine Months EndedSeptember 30, |       
|-------------------------------------------- |  | ------------------------------ | ------
|                                             |  | 2003                           |       
|Beginning accrued warranty and related costs |  | $                              | 6,040 
|Cost of warranty claims                      |  |                                | (1,980
|Accruals for product warranties              |  |                                | 1,850 
|                                             |  |                                |       
|Ending accrued warranty and related costs    |  | $                              | 5,910 
|                                             |  |                                |       



The Company depends
on sole source and limited source suppliers for several key components and contract manufacturing. If the Company was unable to obtain these components on a timely basis, the Company would be unable to meet its customers product delivery
requirements which could adversely impact operating results.



The Company has agreements with various contract manufacturers which include inventory repurchase commitments on excess material based on the Companys reduced forecasts. The Company has recorded a liability of $4.4 million and $6.1
million related to these arrangements as of September 30, 2003 and December 31, 2002, respectively.



Letters of Credit



The Company has letters of credit to ensure its performance of product warranties or payment to third parties in accordance with specified terms and
conditions, which amounted to $0.5 million as of September 30, 2003 and $0.3 million as of December 31, 2002.



Legal Proceedings



On October 16, 2003, the Company agreed with HeliOss Communications, Inc. to dismiss HeliOss claims filed against it on March 27, 2003 in the
Superior Court of the State of California, County of Alameda, in an action entitled HeliOss Communications, Inc. v. Zhone Technologies, Inc., case no. RG 03088921 and the Companys cross-complaint against HeliOss, in consideration of a $1.6
million payment from Zhone to HeliOss. Under the terms of the settlement, if this payment is not made by the Company on or before November 26, 2003, the Company must pay HeliOss $400,000 plus an additional $100,000 per month over the following 16
months.



|(11) | Segment Information
|---- | -------------------



Zhone designs, develops and markets telecommunications hardware and software products for network service providers. The Company derives substantially all
of its revenues from the sales of the Zhone product family. The Companys chief operating decision maker is the Companys chief executive officer, or CEO. The CEO reviews financial information presented on a consolidated basis accompanied
by disaggregated information about revenues by geographic region for purposes of making operating decisions and assessing financial performance. The Company has determined that it has operated within one discrete reportable business segment since
inception. The Company is required to disclose certain information about geographic concentrations and major customers.



15



---

##### Table of Contents

ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES



Notes to Condensed Consolidated Financial Statements



|              |  | Three Months endedSeptember 30, |        | Nine months endedSeptember 30,
|------------- |  | ------------------------------- | ------ | ------------------------------
|              |  | 2003                            |        | 2002                          
|              |  | (in thousands)                 
|Revenue:      |  |                                 |        |                               
|North America |  | $                               | 20,411 |                               
|International |  |                                 | 1,829  |                               
|              |  |                                 |        |                               
|Total revenue |  | $                               | 22,240 |                               
|              |  |                                 |        |                               



|                           |  | Three Months endedSeptember 30, |        | Nine months endedSeptember 30,
|-------------------------- |  | ------------------------------- | ------ | ------------------------------
|                           |  | 2003                            |        | 2002                          
|                           |  | (in thousands)                 
|Revenue by Product Family: |  |                                 |        |                               
|SLMS                       |  | $                               | 7,033  |                               
|MUX                        |  |                                 | 10,070 |                               
|DLC                        |  |                                 | 5,137  |                               
|                           |  |                                 |        |                               
|Total revenue              |  | $                               | 22,240 |                               
|                           |  |                                 |        |                               



|                                        |  | Three Months endedSeptember 30, |   |  | Nine months endedSeptember 30, |  
|--------------------------------------- |  | ------------------------------- | - |  | ------------------------------ | -
|                                        |  | 2003                            |   |  | 2002                           |  
|Major customers, percentage of revenue: |  |                                 |   |  |                                |  
|Motorola                                |  | 16                              | % |  | 10                             | %
|Qwest                                   |  | 14                              | % |  |                               |  



|(12) | Restructuring Charges
|---- | ---------------------



During 2002, the Company recorded charges in connection with its restructuring programs. The related reserves were based on various estimates, including
those pertaining to severance and related charges, facilities and lease cancellations and equipment write-offs. The Company assessed the reserve requirements to complete each individual plan under its restructuring programs at the end of each
reporting period, and recorded any adjustments as necessary. As a result of these restructuring programs, the Company recorded restructuring charges of $4.5 million during the nine months ended September 30, 2002. As of September 30, 2003, there
were no liabilities associated with the Companys restructuring programs.



|(13) | Subsequent Events
|---- | -----------------



On October 14, 2003, the Company terminated the master purchase agreement, or MPA, with CIT Vendor Leasing Fund, or CIT. The MPA provided for the
establishment of reserves to offset potential credit losses suffered by CIT. In January 2001, the Company borrowed $12.5 million under a secured loan facility from CIT. The Company received $10.0 million in proceeds from the borrowing and the
remaining $2.5 million was contributed to the loss reserve and was recorded as sales and marketing expense in 2001. Under the termination of the MPA with CIT, the Company was able to recover the $2.5 million loss reserve which was used to pay off
the remaining $2.4 million loan balance with CIT.



On October
20, 2003, the Company converted $6.0 million of restricted cash held as security for obligations under a loan agreement with Fremont Investment and Loan to a letter of credit issued by Silicon Valley Bank. This conversion provides Zhone with cash to
paydown the credit facility with Silicon Valley Bank.



16



---

##### Table of Contents

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



The following discussion and analysis should be read in conjunction with our condensed consolidated financial statements and related notes included elsewhere in this
report. In addition to historical information, this report contains forward-looking statements. These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those reflected
in these forward-looking statements. We use words such as anticipate, believe, could, estimate, expect, intend, may, should, will,
would and similar expressions to identify forward-looking statements. Factors that might cause such a difference include, but are not limited to, our ability to obtain additional capital to fund our existing and future operations, the
rate of product purchases by current and prospective customers, general economic conditions, conditions specific to the telecommunications and related industries, new product introductions and enhancements by us and our competitors, competition,
manufacturing and sourcing risks. Readers are cautioned that these forward-looking statements are only predictions and are subject to risks, uncertainties, and assumptions that are difficult to predict. Therefore, actual results may differ
materially and adversely from those expressed in any forward-looking statements. Readers are referred to risks and uncertainties identified below, under Risk Factors and elsewhere herein. We undertake no obligation to revise or update
publicly any forward-looking statements for any reason.



Restatement



In October 2003, in response to an inquiry from the SEC, we restated our
consolidated financial statements and related disclosures for the year ended December 31, 2002 and for the quarter ended June 30, 2003. All information, discussions and comparisons in this Form 10-Q reflect the restatement. The restatement reflected
increased non-cash stock-based compensation expense resulting from a change in the estimated fair value of our common stock from $0.10 per share to $1.50 per share. We also adjusted the Series AA redeemable preferred stock to reflect a decrease in
the estimated fair value from $170.7 million to $126.5 million, or $2.73 per share to $2.02 per share as of July 1, 2002.



OVERVIEW



We were founded to offer network service providers a simplified, comprehensive architectural approach to delivering services over their access networks.



We have developed hardware and software that simplify the way network service providers deliver communication services to their subscribers.
Our Single Line Multi-Service Architecture, or SLMS, is a simplified network architecture that provides broadband and narrowband services over a scalable next-generation local-loop infrastructure. SLMS is designed to extend the speed, reliability and cost-efficiencies
currently achieved in the core of the communications network to business and consumer subscribers. Our products enable service providers to use their existing networks to deliver voice, data, video, and entertainment services to their customers. We
have designed our products to interoperate with different types of wiring and equipment already deployed in service providers networks.



Our Zhone Management System, or ZMS, provides the software tools necessary to manage all of the products, services and subscribers in a SLMS network. ZMS is a single management tool that
enables network service providers to allow instant delivery and upgrade of network services. In addition, ZMS is capable of interfacing with and managing other vendors equipment already deployed in service providers networks.



We currently have products in three categories: the SLMS product family; the digital loop
carrier, or DLC, product family and the multiplexer, or MUX, product family.



We have assembled the employee base, technological breadth and market presence to provide a simple yet comprehensive solution to the problem of delivering communications services to subscribers.



The global telecommunications market has deteriorated significantly over the last two to
three years. Most service providers have reduced their capital spending significantly during this period and many others have ceased operations. Additional capital spending reductions have continued during 2003 due to the general economic slowdown,
network overcapacity, customer bankruptcies, network build-out delays and limited capital availability. In response to the challenging environment, we have taken the actions that we believe are necessary for our future success. In particular, we
have significantly reduced our operating costs through workforce reductions and careful cost controls. We have also taken significant write-downs of intangible assets and property and equipment. As we look forward, we intend to continue to focus on
cost controls while also continuing to invest in research and development activities and strategic acquisitions. We do not expect any significant reductions in our overall workforce for at least through the period ending December 2003.



17



---

##### Table of Contents

Recent Events



On February 4, 2003, we commenced a voluntary offer to eligible employees to exchange certain outstanding stock options to purchase shares of common stock, including all
stock options issued during the six-month period ended February 4, 2003, for our promise to grant new stock options. On August 8, 2003, we granted 447,761 options to purchase common stock at an exercise price of $1.40 per share. The options granted
are immediately exercisable and vest over a 4-year period.



In February 2003,
we entered into a secured note and warrant purchase agreement with certain purchasers that provides that we may borrow up to $30.0 million from such purchasers, of which $25.0 million has been committed to, pursuant to the issuance of promissory
notes. Each promissory note will bear interest at five percent per year and will mature on the date which is the earlier of one year from the date of issuance, the closing of an equity financing with an aggregate gross offering price of at least
$10.0 million, or upon an event of liquidation or default.



On February 14,
2003, we acquired NEC eLuminant Technologies, Inc., a subsidiary of NEC USA, Inc., in exchange for total consideration of approximately $13.6 million, consisting of $10.1 million in stock, $3.2 million in assumed liabilities and $0.3 million in
acquisition costs. eLuminant developed a family of multiplexers and digital loop carrier products.



On July 27, 2003, we entered into a definitive merger agreement with Tellium, Inc. Under the terms of the agreement, as a result of the proposed merger, our existing stockholders will own approximately 60% of the
combined companys outstanding shares on a fully converted basis and 40% will be held by Telliums stockholders. This transaction is subject to the approval of both companies security holders as well as other customary closing
conditions. This transaction is expected to close in November 2003.



On July
29, 2003, we borrowed an aggregate of $2.0 million from Mory Ejabat, Chairman and Chief Executive Officer, and Jeanette Symons, Chief Technology Officer and Vice President, Engineering of Zhone. This loan will bear interest at 12% per year and will
mature on the date which is the earlier of December 31, 2003, the closing of our proposed merger with Tellium, Inc. or upon an event of liquidation or default.



On August 7, 2003, we borrowed $2.0 million from Jeanette Symons, Chief Technology Officer and Vice President, Engineering of Zhone. This loan will bear interest at
12% per year and will mature on the date which is the earlier of December 31, 2003, the closing of our proposed merger with Tellium, Inc. or upon an event of liquidation or default.



On October 16, 2003, we agreed with HeliOss Communications, Inc. to settle a breach of contract dispute in consideration of a $1.6 million
payment from Zhone to HeliOss. If this payment is not made by us on or before November 26, 2003, we must pay HeliOss $400,000 plus an additional $100,000 per month over the following 16 months.



Acquisitions



As of September 30, 2003, we had completed eight acquisitions of complementary companies, products or technologies to supplement our
internal growth. To date, we have generated a significant amount of our revenue from sales of products obtained through acquisitions.



We are likely to acquire additional businesses, products and technologies in the future. If we do complete future acquisitions, we could incur substantial debt, assume
additional liabilities, incur amortization expenses related to intangible assets or incur large write-offs related to impairment of goodwill and long-lived assets. In addition, acquisitions can have a significant impact on our short term results of
operations, materially impacting revenues or expenses and making period to period comparisons of our results of operations less meaningful.



18



---

##### Table of Contents

CRITICAL ACCOUNTING POLICIES AND ESTIMATES



Managements discussion and analysis of its financial condition and results of operations is based upon our condensed consolidated
financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and judgments that affect
the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. The policies discussed below are considered by management to be critical because changes in such estimates can materially
affect the amount of our reported net income or loss. For all of these policies, management cautions that actual results may differ materially from these estimates under different assumptions or conditions.



Revenue Recognition



We recognize revenue when the earnings process is complete. We recognize product revenue upon shipment of product under contractual terms
which transfer title upon shipment, under normal credit terms, or under sales-type leases, net of estimated sales returns and allowances at the time of shipment. Revenue is deferred if there are significant post-delivery obligations, if collection
is not considered probable at the time of sale, or if the fee is not fixed or determinable. When significant post-delivery obligations exist, revenue is deferred until such obligations are fulfilled. Our arrangements generally do not have any
significant post delivery obligations. We offer products and services such as support, education and training, hardware upgrades and extended warranty coverage. We have established the fair value of these products and services based on sales prices
when they are sold separately. Any discounts provided on these additional products and services are identical to the discount provided on the original sale of product. When collectibility is not probable, revenue is recognized when cash is
collected. Revenue from education services and support services is recognized over the contract term or as the service is performed. We make certain sales to product distributors. These customers are given certain privileges to return a portion of
inventory. We recognize revenue on sales to distributors that have contractual return rights when the products have been sold by the distributors. Revenue from sale of software products is recognized provided that a purchase order has been received,
the software has been shipped, collection of the resulting receivable is deemed probable, and the fee is fixed or determinable. To date, revenue from software transactions and sales-type leases has not been significant. We accrue for warranty costs,
sales returns, and other allowances at the time of shipment based on historical experience and expected future costs. We consider differing market conditions when recognizing revenues, such as the recent decline in capital spending in our industry
and the relative financial condition of our customers. These conditions do not impact the method by which we recognize revenues or the methodology for computing the provision for warranty and allowance for returns.



Allowances for Sales Returns and Doubtful Accounts



We have an allowance for sales returns for estimated future product returns related to
current period product revenue. We base our allowance on periodic assessments of historical trends in product return rates and current approved returned products. If the actual future returns were to deviate from the historical data on which the
reserve had been established, our revenue could be adversely affected.



We have
an allowance for doubtful accounts for estimated losses resulting from the inability of customers to make payments to our accounts receivable. We base our allowance on periodic assessments of our customers liquidity and financial condition
through analysis of information obtained from credit rating agencies, financial statement reviews, and historical collection trends. Additional allowances may be required if the liquidity or financial condition of our customers were to deteriorate,
resulting in an impairment in their ability to make payments.



Valuation of
Long-Lived Assets, including Goodwill and Other Acquisition-Related Intangible Assets



Our long-lived assets consist primarily of goodwill, other acquisition-related intangible assets (intangible assets) and property and equipment. We review long-lived assets for impairment whenever events or changes in
circumstances indicate that the carrying amount of such an asset may not be recoverable. Such events or circumstances include, but are not limited to, a significant decrease in the benefits realized from the acquired business, difficulty and delays
in integrating the business or a significant change in the operations of the acquired business or use of an asset. Goodwill and other acquisition-related intangible assets not subject to amortization are tested annually for impairment, and are
tested for impairment more frequently if events and circumstances indicate that the asset might be impaired. An impairment loss is recognized to the extent that the carrying amount exceeds the assets fair value.



We estimate the fair value of our long-lived assets based on a combination of the market,
income and replacement cost approaches. In the application of the impairment testing, we are required to make estimates of future operating trends and resulting cash flows and judgments on discount rates and other variables. Actual future results
and other assumed variables could differ from these estimates.



19



---

##### Table of Contents

As of September 30, 2003, we have intangible assets, including goodwill and other acquisition-related intangible assets
of $89.8 million ($74.9 million of goodwill, including workforce in place, and $14.9 million of other acquisition-related intangible assets) and property and equipment (net) of $22.9 million. Other acquisition-related intangible assets are comprised
mainly of technology in place and customer relationships. The majority of entities acquired by us do not have significant tangible assets; as a result, a significant portion of the purchase price is typically allocated to intangible assets and
goodwill. Our future operating performance will be impacted by the future amortization of intangible assets, potential charges related to purchased in-process research and development (IPR&D) for future acquisitions, and potential impairment
charges related to goodwill. Accordingly, the allocation of the purchase price of the acquired companies to intangible assets and goodwill has a significant impact on our future operating results. The allocation process requires management to make
significant estimates and assumptions, including estimates of future cash flows expected to be generated by the acquired assets and the appropriate discount rate for these cash flows. Should different conditions prevail, we would have to perform an
impairment review that might result in material write-downs of intangible assets and/or goodwill. Other factors we consider important which could trigger an impairment review, include, but are not limited to, significant changes in the manner of use
of our acquired assets, significant changes in the strategy for our overall business or significant negative economic trends. If this evaluation indicates that the value of an intangible asset or long-lived asset may be impaired, an assessment of
the recoverability of the net carrying value of the asset over its remaining useful life is made. If this assessment indicates that the cost of an intangible asset or long-lived asset is not recoverable, based on the estimated undiscounted future
cash flows or other comparable market valuations of the entity or technology acquired over the remaining amortization or depreciation period, the net carrying value of the related intangible asset or long-lived asset will be reduced to fair value
and the remaining amortization or depreciation period may be adjusted. For example, we recorded significant impairment charges, including $41.7 million related to goodwill and other acquired intangibles during 2001. In addition, in the fourth
quarter of 2002, we recorded approximately $50.8 million of impairment in property, plant and equipment and other assets. Due to uncertain market conditions and potential changes in our strategy and product portfolio, it is possible that forecasts
used to support our intangible assets may change in the future, which could result in additional non-cash charges that would adversely affect our results of operations and financial condition.



Restructuring Charges



During 2002, we recorded charges in connection with our restructuring programs. These restructuring charges were comprised primarily of: (i)
severance and related charges; (ii) facilities and lease cancellations and (iii) write-offs of abandoned equipment. We accounted for each of these costs in accordance with relevant accounting literature as summarized in SEC Staff Accounting Bulletin
No. 100, Restructuring and Impairment Charges. We recorded restructuring charges of $4.5 million during the nine months ended September 30, 2002. There were no restructuring charges during the nine months ended September 30, 2003. We
accounted for the individual components of our restructuring programs as described below.



We accounted for the costs associated with the reduction of our workforce in accordance with Emerging Issues Task Force (EITF) Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and
Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring) (EITF 94-3). Accordingly, we recorded the liability related to these termination costs when the following conditions have been met: (i) management with the
appropriate level of authority approves a termination plan that commits us to such plan and establishes the benefits the employees will receive upon termination; (ii) the benefit arrangement is communicated to the employees in sufficient detail to
enable the employees to determine the termination benefits; (iii) the plan specifically identifies the number of employees to be terminated, their locations and their job classifications; and (iv) the period of time to implement the plan does not
indicate changes to the plan are likely. The termination costs recorded by us were not associated with nor do they benefit continuing activities.



We accounted for the costs associated with lease termination and/or abandonment in accordance with EITF 88-10, Costs Associated with Lease Modification or
Termination (EITF 88-10). Accordingly, we recorded the costs associated with lease termination and/or abandonment when the leased property has no substantive future use or benefit to us. Under EITF 88-10, we recorded the liability associated
with lease termination and/or abandonment as the sum of the total remaining lease costs and related exit costs, less probable sublease income.



Any such costs incurred in the future will be recorded in accordance with SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities,SFAS No.
112, Employers Accounting for Post Employment Benefits,and any write-off of abandoned equipment will be accounted for in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long Lived Assets.



Actual costs relative to these estimates, along with other estimates made by management in
connection with our restructuring programs, may vary significantly depending, in part, on factors that may be beyond our control. We review the status of any ongoing restructuring activities on a quarterly basis and, if appropriate, record changes
to our restructuring obligations in current operations based on our most current estimates.



20



---

##### Table of Contents

RESULTS OF OPERATIONS



We list in the tables below the historical condensed consolidated statement of operations in dollars and as a percentage of revenue for the periods indicated.



|                                                 |  | Three MonthsEndedSeptember 30, |      |   | Nine MonthsEndedSeptember 30, |  
|------------------------------------------------ |  | ------------------------------ | ---- | - | ----------------------------- | -
|                                                 |  | 2003                           |      |   | 2002                          |  
|                                                 |  | (in millions)                  |      |   | (in millions)                 |  
|Net revenue                                      |  | $                              | 22.2 |   |                               | $
|Cost of revenue                                  |  |                                | 12.2 |   |                               |  
|                                                 |  |                                |      |   |                               |  
|Gross profit                                     |  |                                | 10.0 |   |                               |  
|                                                 |  |                                |      |   |                               |  
|Operating expenses:                              |  |                                |      |   |                               |  
|Research and product development                 |  |                                | 5.5  |   |                               |  
|Sales and marketing                              |  |                                | 4.5  |   |                               |  
|General and administrative                       |  |                                | 1.2  |   |                               |  
|Purchased in-process research and development    |  |                                |     |   |                               |  
|Restructuring charges                            |  |                                |     |   |                               |  
|Litigation settlement                            |  |                                | 1.6  |   |                               |  
|Stock-based compensation                         |  |                                | 0.8  |   |                               |  
|Amortization and impairment of intangible assets |  |                                | 2.1  |   |                               |  
|                                                 |  |                                |      |   |                               |  
|Total operating expenses                         |  |                                | 15.7 |   |                               |  
|                                                 |  |                                |      |   |                               |  
|Operating loss                                   |  |                                | (5.7 | ) |                               |  
|Interest expense and other income (expense), net |  |                                | (0.9 | ) |                               |  
|                                                 |  |                                |      |   |                               |  
|Loss before income taxes                         |  |                                | (6.6 | ) |                               |  
|Income tax (benefit) provision                   |  |                                | (3.1 | ) |                               |  
|                                                 |  |                                |      |   |                               |  
|Net loss                                         |  |                                | (3.5 | ) |                               |  
|Accretion on preferred stock                     |  |                                |     |   |                               |  
|                                                 |  |                                |      |   |                               |  
|Net loss applicable to holders of common stock   |  | $                              | (3.5 | ) |                               | $
|                                                 |  |                                |      |   |                               |  



|                                                 |  | Three MonthsEndedSeptember 30, |    |  | Nine MonthsEndedSeptember 30, |   
|------------------------------------------------ |  | ------------------------------ | -- |  | ----------------------------- | --
|                                                 |  | 2003                           |    |  | 2002                          |   
|Net revenue                                      |  | 100                            | %  |  | 100                           | % 
|Cost of revenue                                  |  | 55                             | %  |  | 62                            | % 
|                                                 |  |                                |    |  |                               |   
|Gross profit                                     |  | 45                             | %  |  | 38                            | % 
|Operating expenses:                              |  |                                |    |  |                               |   
|Research and product development                 |  | 25                             | %  |  | 23                            | % 
|Sales and marketing                              |  | 20                             | %  |  | 17                            | % 
|General and administrative                       |  | 5                              | %  |  | 14                            | % 
|Purchased in-process research and development    |  |                               |    |  |                              |   
|Restructuring charges                            |  |                               |    |  |                              |   
|Litigation settlement                            |  | 7                              | %  |  |                              |   
|Stock-based compensation                         |  | 4                              | %  |  | 27                            | % 
|Amortization and impairment of intangible assets |  | 9                              | %  |  | 15                            | % 
|                                                 |  |                                |    |  |                               |   
|Total operating expenses                         |  | 70                             | %  |  | 96                            | % 
|                                                 |  |                                |    |  |                               |   
|Operating loss                                   |  | (25                            | )% |  | (58                           | )%
|Interest expense and other income (expense), net |  | (4                             | )% |  | (8                            | )%
|                                                 |  |                                |    |  |                               |   
|Loss before income taxes                         |  | (29                            | )% |  | (66                           | )%
|Income tax (benefit) provision                   |  | (14                            | )% |  |                              |   
|                                                 |  |                                |    |  |                               |   
|Net loss                                         |  | (15                            | )% |  | (66                           | )%
|Accretion on preferred stock                     |  |                               |    |  | (38                           | )%
|Net loss applicable to holders of common stock   |  | (15                            | )% |  | (104                          | )%
|                                                 |  |                                |    |  |                               |   



21



---

##### Table of Contents

Revenue



Information about our revenue for products and services for the three and nine months ended September 30, 2003 and 2002 is summarized below (in millions):



|         |  | Three Months Ended September 30, |      |      | Nine Months Ended September 30, |                   
|-------- |  | -------------------------------- | ---- | ---- | ------------------------------- | ------------------
|         |  | 2003                             |      | 2002 |                                 | Increase(Decrease)
|Products |  | $                                | 20.1 |      | $                               | 25.0              
|Services |  |                                  | 2.1  |      |                                 | 2.0               
|         |  |                                  |      |      |                                 |                   
|Total    |  | $                                | 22.2 |      | $                               | 27.0              
|         |  |                                  |      |      |                                 |                   



Information about our revenue for
North America and International markets for the three and nine months ended September 30, 2003 and 2002 is summarized below (in millions):



|              |  | Three Months Ended September 30, |      |      | Nine Months Ended September 30, |                   
|------------- |  | -------------------------------- | ---- | ---- | ------------------------------- | ------------------
|              |  | 2003                             |      | 2002 |                                 | Increase(Decrease)
|North America |  | $                                | 20.4 |      | $                               | 22.3              
|International |  |                                  | 1.8  |      |                                 | 4.7               
|              |  |                                  |      |      |                                 |                   
|Total         |  | $                                | 22.2 |      | $                               | 27.0              
|              |  |                                  |      |      |                                 |                   



Information about our revenue by
product line for the three and nine months ended September 30, 2003 and 2002 is summarized below (in millions):



|     |  | Three Months Ended September 30, |      |      | Nine Months Ended September 30, |                   
|---- |  | -------------------------------- | ---- | ---- | ------------------------------- | ------------------
|     |  | 2003                             |      | 2002 |                                 | Increase(Decrease)
|SLMS |  | $                                | 7.0  |      | $                               | 10.6              
|MUX  |  |                                  | 10.1 |      |                                 | 7.7               
|DLC  |  |                                  | 5.1  |      |                                 | 8.7               
|     |  |                                  |      |      |                                 |                   
|     |  | $                                | 22.2 |      | $                               | 27.0              
|     |  |                                  |      |      |                                 |                   



For the three months ended September
30, 2003, revenue decreased 18% or $4.8 million to $22.2 million from $27.0 million for the same period last year. For the nine months ended September 30, 2003, revenue decreased 32% or $27.9 million to $59.8 million from $87.7 million for the same
period last year. Revenue for the three months ended September 30, 2003 was $22.2 million, an increase of 8% from revenue of $20.5 million for the three months ended June 30, 2003. For the three months ended September 30, 2003, product revenue
declined by 20% or $4.9 million from the same period last year, and for the nine months ended September 30, 2003, product revenue declined 34% or $28.0 million from the same period last year. The decrease in product revenue was due to the continued
capital constraints and economic slowdown affecting the telecommunications industry and the technology industry in general. Service revenue increased 5% or $0.1 million for the three months ended September 30, 2003 and 2% or $0.1 million for the
nine months ended September 30, 2003 from the same periods last year. For the three months ended September 30, 2003, international revenue declined 62% or $2.9 million to $1.8 million compared to $4.7 million for the same period last year. For the
nine months ended September 30, 2003, international revenue decreased 70% or $11.5 million to $5.0 million compared to $16.5 million for the same period last year. International revenue represented 8% and 17% of total revenue for the three months
ended September 30, 2003 and 2002, respectively, and 8% and 19% for the nine months ended September 30, 2003 and 2002, respectively. The decline in international revenue was due to the global economic environment and declining sales to non-U.S.
based competitive local exchange carriers, or CLECs. We expect international revenue to be lower for the remainder of 2003 as compared to 2002.



Revenue for our SLMS product family was lower by $8.9 million for the first nine months of 2003 as compared to the same period last year. Revenue for our DLC product
family decreased significantly in 2003 due to the overall decline in the economic environment. Revenue for our MUX product line increased $2.1 million for the nine months ended September 30, 2003 as compared to the same period last year. Due to the
continued tight capital spending environment experienced over the past several quarters, our customers and potential customers have focused on restricting capital expenditures while sustaining revenue. As a result, carriers have continued to invest
in our MUX product line which includes legacy equipment and applications while spending cautiously on new technologies in the SLMS product line. We expect revenue from the DLC product line to be lower for the remainder of 2003 as we continue to
phase out our marketing and sales efforts with respect to the Access Concentrator, or Access Node, products.



22



---

##### Table of Contents

We expect that the product mix will continue to shift towards next generation products in SLMS with MUX and DLC revenues
to be flat or decline in the future as a percentage of total revenues.



Motorola accounted for approximately 16% and 10% of total revenue for the three months ended September 30, 2003 and 2002, respectively, and 18% and 10% for the nine months ended September 30, 2003 and 2002, respectively. Qwest accounted for
approximately 14% of total revenue for the three months ended September 30, 2003 and 12% for the nine months ended September 30, 2003. No other customer accounted for 10% or more of total revenue in the current period. Although our largest customers
have varied over time, we anticipate that our results of operations in any given period will continue to depend to a great extent on sales to a small number of large accounts. As a result, our revenue for any quarter may be subject to significant
volatility based upon changes in orders from one or a small number of key customers.



Cost of Revenue



Our cost of revenue consists primarily of
amounts paid to third-party contract manufacturers, manufacturing start-up expenses, personnel and related costs, and non-cash stock-based compensation expenses. We outsource substantially all of our product and printed circuit board assembly to
contract manufacturers. Manufacturing and engineering documentation controls are performed at our Oakland, California facility. We currently use Solectron Corporation to manufacture and assemble most of our products. We also rely on single or
limited source suppliers to manufacture key components of our products. A significant portion of our cost of revenues is related to these outsourcing arrangements.



For the three months ended September 30, 2003, cost of revenue decreased $4.6 million to $12.2 million compared to $16.8 million for the
same period last year. Total cost of revenue was 55% of revenue for the three months ended September 30, 2003, compared to 62% of revenue for the same period last year. For the nine months ended September 30, 2003, cost of revenue decreased $21.4
million to $32.8 million compared to $54.2 million for the same period last year. Total cost of revenue was 55% of revenue for the nine months ended September 30, 2003 compared to 62% for the same period last year. Cost of revenue was lower as a
percentage of revenue for the three and nine months ended September 30, 2003 due primarily to a shift in product mix towards a higher percentage of revenue from our MUX product line and an offsetting decrease in the percentage of revenue from our
DLC product line, which has higher material costs as a percentage of revenue than the MUX product line.



We expect that our cost of revenue will vary as a percentage of net revenue depending on the mix and average selling prices of products sold. We anticipate that competitive and economic pressures could cause us to
reduce our prices, adjust the carrying values of our inventory, or record inventory charges relating to discontinued products and excess or obsolete inventory.



Research and Product Development Expenses



Research and product development expenses consist primarily of salaries and related personnel costs, prototype costs, consulting costs, licensed technology costs,
recruiting costs and other costs related to the design, development, testing and enhancement of our products. We also incur significant expenses in connection with the purchase of equipment used to test our products as well as the use of our
products for internal design and learning purposes. We expense our research and product development costs as they are incurred.



For the three months ended September 30, 2003, research and development expenses decreased 10% or $0.6 million to $5.5 million compared to $6.1 million for the same
period last year. For the nine months ended September 30, 2003 research and development expenses decreased 33% or $7.9 million to $15.7 million compared to $23.6 million for the nine months ended September 30, 2002. The decrease was primarily due to
a decrease in material and personnel-related expenses resulting from our restructuring activities in 2002, which resulted in a consolidation of product offerings and more focused development programs. Personnel related expenses decreased by
approximately $0.4 million, or 11% for the three months ended September 30, 2003, and $2.8 million or 25% for the nine months ended September 30, 2003 compared to the same periods last year. Average staffing levels of our research and development
personnel were lower by approximately 30% for the nine months ended September 30, 2003 compared to the same period last year primarily due to our restructuring efforts. Material related expenses decreased by approximately $1.7 million for the nine
months ended September 30, 2003 compared to the same period last year due to lower prototype costs. Depreciation expense decreased $2.2 million for the nine months ended September 30, 2003 compared to the same period last year. The decrease was due
to $0.8 million as a result of our restructuring efforts, $0.9 million as a result of our fixed asset impairment, and $0.5 million as a result of an increase in the useful life of our lab equipment. We will continue to invest in research and product
development to attain our strategic product development objectives, while seeking to manage the associated costs through expense controls.



Sales and Marketing Expenses



Sales and marketing expenses consist primarily of salaries, commissions and the related personnel costs of sales and marketing personnel, promotions, travel and other
marketing expenses and recruiting expenses.



23



---

##### Table of Contents

For the three months ended September 30, 2003, sales and marketing expenses decreased 2% or $0.1 million to $4.5 million
compared to $4.6 million for the same period last year. For the nine months ended September 30, 2003, sales and marketing expenses decreased 15% or $2.3 million to $13.1 million compared to $15.4 million for the same period last year. The decrease
was due primarily to lower salaries and commissions, travel and other sales related expenses resulting from lower revenue. Average staffing levels of our sales and marketing personnel were lower by approximately 11% for the nine months ended
September 30, 2003 compared to the same period last year primarily due to our restructuring efforts. Salaries and commissions were $0.1 million higher for the three months ended September 30, 2003 compared to the same period last year, but were $0.5
million lower for the nine months ended September 30, 2003 compared to the same period last year. For the three months ended September 30, 2003, travel expenses were comparable to the same period last year, but were $0.5 million lower for the nine
months ended September 30, 2003 compared to the same period last year.



General and Administrative Expenses



General and
administrative expenses consist primarily of salaries and related expenses for executive, finance, human resources, information technology and administrative personnel, as well as recruiting, professional fees, insurance and other general corporate
expenses.



For the three months ended September 30, 2003 general and
administrative expenses decreased 69% or $2.7 million to $1.2 million compared to $3.9 million for the same period last year. For the nine months ended September 30, 2003, general and administrative expenses decreased 69% or $6.8 million to $3.1
million compared to $9.9 million for the same period last year. The decrease was primarily due to lower provisions for doubtful accounts of $2.5 million and $6.7 million for the three and nine months ended September 30, 2003, respectively, compared
to the same periods last year. The increased provision for doubtful accounts in 2002 was due to the financial difficulty of one of our customers.



Stock-Based Compensation Expense



Stock-based compensation expense decreased $6.3 million for the three months ended September 30, 2003 compared to the same period last year. For the nine months ended
September 30, 2003, stock-based compensation expense had a benefit of $0.8 million compared to $7.2 million expense for the same period last year. For the nine months ended September 30, 2003 and 2002, ($0.1) million and $32,000 of stock-based
compensation expense was classified as cost of revenue, respectively, and ($0.7) million and $7.2 million was classified as operating expenses, respectively. Stock-based compensation expense primarily resulted from the difference between the fair
value of our common stock and the exercise price for stock options granted to employees. Stock-based compensation benefits resulted from the reversal of previously recorded stock-based compensation expense on forfeited shares. The benefit realized
in 2002 was a result of the reduction in workforce that occurred in the first half of 2002, and the benefit realized in 2003 was a result of forfeited shares that occurred as part of our voluntary offer to eligible employees in February 2003 to
exchange certain outstanding stock options to purchase shares of our common stock.



We amortize deferred compensation over the vesting periods of the applicable options, generally over four years. For the three and nine month periods ended September 30, 2003 and 2002, stock-based compensation expense consisted of (in
thousands):



|                                                                                                         |  | Three Months Ended |     |   | Nine Months Ended |  
|-------------------------------------------------------------------------------------------------------- |  | ------------------ | --- | - | ----------------- | -
|                                                                                                         |  | September 30,2003  |     |   | September 30,2002 |  
|Amortization of deferred compensation                                                                    |  | $                  | 844 |   |                   | $
|Benefit due to reversal of previously recorded stock-based compensation expense on forfeited shares      |  |                    | (80 | ) |                   |  
|Compensation expense (benefit) relating to non-employees                                                 |  |                    | 130 |   |                   |  
|Compensation expense relating to cancellation of prior notes receivable and issuance of notes receivable |  |                    |    |   |                   |  
|Compensation expense relating to exchange of stock options                                               |  |                    |    |   |                   |  
|                                                                                                         |  |                    |     |   |                   |  
|                                                                                                         |  | $                  | 894 |   |                   | $
|                                                                                                         |  |                    |     |   |                   |  



Restructuring Charges



We responded to continuing market declines in 2002, by implementing
restructuring actions. We began our workforce reduction in the first half of 2002 by reducing our workforce by approximately 35%. As a result of these actions, we recorded restructuring charges of $4.5 million for the nine months ended September 30,
2002, relating to severance and related charges, facilities and lease cancellations and equipment write-offs. These charges were paid during 2002. There were no restructuring charges recorded in the nine months ended September 30, 2003.



24



---

##### Table of Contents

Amortization and Impairment of Intangibles



As of January 1, 2001, we adopted SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 requires that goodwill no longer
be amortized, but should be tested for impairment at least annually. For the three and nine months ended September 30, 2003 amortization of intangibles decreased $2.1 million and $6.3 million, respectively, compared to the same periods last year. In
2002, we discontinued the development of certain technology obtained from the acquisition of Optaphone Networks, Inc. and recorded an impairment charge of approximately $0.7 million. We generally amortize intangibles over a period of three to five
years. For more information, see Note 3 to the unaudited condensed consolidated financial statements.



Interest Expense and Other Income (Expense), Net



For the three months ended September 30, 2003, interest expense and other income (expense), net decreased $1.3 million from $2.2 million for the same period last year. For the nine months ended September 30, 2003,
interest expense and other income (expense), net decreased $4.3 million from $6.3 million for the same period last year. The detail is as follows (in thousands):



|                       |  | Three MonthsEndedSeptember 30, |      |   | Nine Months Ended September 30, |  
|---------------------- |  | ------------------------------ | ---- | - | ------------------------------- | -
|                       |  | 2003                           |      |   | 2002                            |  
|Interest expense       |  | $                              | (961 | ) |                                 | $
|Interest income        |  |                                | 25   |   |                                 |  
|Other income (expense) |  |                                | 57   |   |                                 |  
|                       |  |                                |      |   |                                 |  
|                       |  | $                              | (879 | ) |                                 | $
|                       |  |                                |      |   |                                 |  



Interest expense decreased for the
three and nine months ended September 30, 2003 as compared to the same periods last year due primarily to a decrease in the amount of borrowings. The average debt balance decreased 51% for the nine months ended September 30, 2003 compared to the
same period last year.



Interest income decreased for the three and nine months
ended September 30, 2003 as compared to the same periods last year due to lower average cash balances throughout the year.



Liquidity and Capital Resources



To date, we have primarily financed our operations through private sales of our capital stock and borrowings under various debt arrangements.



In November 1999, we issued 125.0 million shares of Series A redeemable convertible preferred
stock to investors in exchange for a maximum capital commitment of $500.0 million. As of September 30, 2003, we have received the full $500.0 million.



In August 2000, we entered into a $70.0 million five-year operating lease for office headquarters, research and product development, and manufacturing facilities in
Oakland, California. In March 2001, we exercised our option to purchase the land and buildings for $52.7 million. In April 2001, we borrowed $35.0 million under a secured real estate loan facility with a financial institution. Borrowings under the
loan accrue interest at 8.3% for the first six months and are adjusted biannually based on the six-month LIBOR rate, with the floor being 8% and the ceiling 14.3%. This agreement requires us to keep $6.0 million of restricted cash as security for
all obligations under the loan agreement. This debt was fully collateralized by land and buildings with a net book value of $59.5 million as of December 31, 2001. In 2002, we recorded an impairment charge of $40.4 million relating to the building,
reducing its carrying value to $20.2 million. The seller of the land retained the rights to repurchase the undeveloped portion for approximately $1.5 million subject to certain conditions.



In December 2002, we entered into a credit facility with Silicon Valley Bank that allows us
to borrow up to $25.0 million on a secured, revolving basis. Amounts advanced under the credit facility are subject to underlying eligible accounts receivable. Under the terms of the agreement, borrowings accrue interest at prime or LIBOR with a
spread that varies based on certain financial criteria. As of September 30, 2003, we have borrowed $10.8 million under this credit facility at an interest rate of 6.25%. A fee of 0.5% is assessed on any undrawn amounts. The agreement contains
financial covenants which we were in compliance with at September 30, 2003. On October 20, 2003, the Company converted $6.0 million of restricted cash held as security for obligations under a loan agreement with Fremont Investment and Loan to a
letter of credit issued by Silicon Valley Bank. This conversion provides Zhone with cash to paydown the credit facility with Silicon Valley Bank.



25



---

##### Table of Contents

In February 2003, we entered into a secured note and warrant purchase agreement with certain purchasers that provides
that we may borrow up to $30.0 million from such purchasers, of which $25.0 million has been committed to, pursuant to the issuance of promissory notes. Such purchasers include executive officers, directors and 5% stockholders. Each promissory note
will bear interest at five percent per year and will mature on the date which is the earlier of one year from the date of issuance, the closing of an equity financing with an aggregate gross offering price of at least $10 million, or upon an event
of liquidation or default. We have not issued any promissory notes to date.



On
July 27, 2003, we entered into a definitive merger agreement with Tellium, Inc. Under the terms of the agreement, as a result of the proposed merger, our current stockholders will own approximately 60% of the combined companys outstanding
shares on a fully converted basis and 40% will be held by Telliums stockholders. This transaction is subject to the approval of both companies security holders as well as other customary closing conditions. This transaction is expected
to close in November 2003 and may require substantial cash payments.



On July
29, 2003, we borrowed $2.0 million for working capital purposes from Mory Ejabat, Chairman and Chief Executive Officer of Zhone, and Jeanette Symons, Chief Technology Officer and Vice President, Engineering of Zhone. This loan will bear interest at
12% per year and will mature on the date which is the earlier of December 31, 2003, the closing of our proposed merger with Tellium, Inc. or upon an event of liquidation or default.



On August 7, 2003, we borrowed $2.0 million for working capital purposes from Jeanette Symons, Chief Technology Officer and Vice President,
Engineering of Zhone. This loan will bear interest at 12% per year and will mature on the date which is the earlier of December 31, 2003, the closing of our proposed merger with Tellium, Inc. or upon an event of liquidation or default.



At September 30, 2003, cash and cash equivalents were $2.5 million. This compares with
$10.6 million at December 31, 2002. The decrease in cash and cash equivalents of $8.1 million was attributable to cash used in operating activities of $14.8 million and cash used in investing activities of $0.4 million, offset by cash provided by
financing activities of $7.1 million.



Net cash used in operating activities
for the nine months ended September 30, 2003 was $14.8 million compared to $16.8 million for the nine months ended September 30, 2002. Net cash used in operating activities for the nine months ended September 30, 2003, consisted of the net loss of
$10.7 million, adjusted for non-cash charges totaling $2.9 million, as well as decreases in accrued liabilities and other of $10.7 million and accounts receivable of $5.2 million, offset by increases in inventory of $3.7 million and accounts payable
of $2.7 million. The decrease in net cash used in operating activities for the nine months ended September 30, 2003 compared to the same period last year is due primarily to a decrease in depreciation and amortization charges, stock-based
compensation and accrued liabilities, offset by the increase in inventory.



Net
cash used in investing activities for the nine months ended September 30, 2003 was $0.4 million compared to $21.5 million provided by investing activities for the nine months ended September 30, 2002. Cash provided by investing activities of $21.5
million for the nine months ended September 30, 2002 consisted of primarily of cash acquired from the acquisition of Vpacket Communications.



Net cash provided by financing activities for the nine months ended September 30, 2003 was $7.1 million compared to $7.4 million used in financing activities for the nine
months ended September 30, 2002. The change in the nine months ended September 30, 2003 from the same period last year is due primarily to borrowings under our credit facilities and founder loans.



Increasingly, as a result of the financial demands of major network deployments and
difficulty in accessing capital markets, network service providers are looking to their suppliers for financing assistance. From time to time we may provide or commit to extend credit or credit support to our customers. This financing may include
extending credit to customers or guaranteeing the indebtedness of customers to third parties. Depending upon market conditions, we may seek to factor these arrangements to financial institutions and investors to free up our capital and reduce the
amount of our financial commitments for such arrangements. Our ability to provide customer financing is limited and depends upon a number of factors, including our capital structure, the level of our available credit and our ability to factor
commitments to third parties. Any extension of financing to our customers will limit the capital that we have available for other uses.



We believe that our existing cash and cash equivalents, and available credit facilities will be sufficient to satisfy our anticipated cash requirements for at least the
next twelve months. However, we may require additional funds if our revenues or expenses fail to meet our current projections or to support other purposes and may need to raise additional funds through debt or equity financing or from other sources.
There can be no assurances that additional funding will be available at all, or that if available, such financing will be obtainable on terms favorable to us.



26



---

##### Table of Contents

RISK FACTORS



You should carefully consider the following risk factors, in addition to the other information set forth in this Quarterly Report on Form
10-Q, before making any investment decisions regarding our company. Each of these risk factors could adversely affect our business, financial condition and results of operations.



Risks Related to Our Business and Industry



We have entered into a merger agreement with Tellium, Inc. Failure to complete the merger with Tellium could have a material adverse
effect on our business, financial condition, and results of operations.



We have entered into a merger agreement with Tellium, Inc. Upon completion of the merger, our existing security holders would own approximately 60% of the combined companys outstanding securities on a fully-converted basis. The merger
is subject to the approval of the stockholders of both Zhone and Tellium. It is also subject to a number of other closing conditions. There can be no assurance that the merger will occur or, if it does, what effect it will have on our business,
financial condition, and results of operations. We expect to complete the merger in November 2003. If the merger with Tellium is not completed, we could suffer a number of consequences that would adversely affect our business, including:



| |  | the diversion of managements attention from our day-to-day business and the unavoidable disruption of our employees and our relationships with customers as a result of efforts
relating to the merger;
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | uncertainties relating to the anticipated merger may detract from our ability to grow revenues and minimize costs, which, in turn, may lead to a loss of market position;
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | the significant expenses we have incurred and will continue to incur in connection with the proposed transaction; and;
| | - | ----------------------------------------------------------------------------------------------------------------------



| |  | the possibility that termination of the merger agreement under some circumstances would require us to pay Tellium a termination fee of $3.0 million or to reimburse expenses incurred
by Tellium.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



We have mailed a joint proxy statement/prospectus
describing the proposed merger to all holders of Zhone stock as of the record date on September 25, 2003. The joint proxy statement/prospectus contains important information about Zhone, Tellium and the proposed merger, risks related to the merger
and the combined company and related matters. We urge you to read the definitive joint proxy statement/prospectus.



We may not achieve the benefits we expect from the merger with Tellium, which may have a material adverse effect on the combined companys business, financial
condition, and results of operations.



The combined company will need to
overcome significant challenges in order to realize any benefits or synergies from the merger, including timely, efficient and successful execution of a number of post-merger strategies, including:



| |  | combining the operations of the two companies;
| | - | ----------------------------------------------



| |  | integrating and managing the combined company;
| | - | ----------------------------------------------



| |  | retaining and assimilating the key personnel of each company;
| | - | -------------------------------------------------------------



| |  | retaining existing customers of both companies;
| | - | -----------------------------------------------



| |  | resolving the outstanding management loans Tellium has with three of their executive officers, including any claims these Tellium executive officers may assert under the terms of
agreements they signed in July 2002 that were determined by Tellium board of directors to be void and unenforceable against Tellium;
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | retaining strategic partners of each company; and
| | - | -------------------------------------------------



| |  | creating and maintaining uniform standards, controls, procedures, policies, and information.
| | - | --------------------------------------------------------------------------------------------



The execution of these post-merger strategies will involve considerable risks and may not be successful. These risks include:



| |  | the potential disruption of the combined companys ongoing business and distraction of its management;
| | - | ------------------------------------------------------------------------------------------------------



27



---

##### Table of Contents

| |  | unanticipated expenses and potential delays related to integration of technology and other resources of the two companies;
| | - | --------------------------------------------------------------------------------------------------------------------------



| |  | the significant expenses the combined company will incur in connection with the proposed transaction, including transaction and severance costs and costs in connection with
resolving the outstanding management loans Tellium has with three of their executive officers;
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | the impairment of relationships with employees, suppliers, and customers as a result of any integration of new management personnel; and
| | - | ----------------------------------------------------------------------------------------------------------------------------------------



| |  | potential unknown liabilities associated with the merger and the combined operations.
| | - | -------------------------------------------------------------------------------------



Failure to overcome these risks or any other problems encountered in connection with the merger could slow the growth of the combined
company or lower the quality of its services, which could reduce customer demand and have a material adverse effect on our business, financial condition and results of operations.



Our future operating results are difficult to predict due to our limited operating history.



We began operations in September 1999. Although we expect that our internally developed
Single Line Multi-Service, or SLMS, product line will account for a substantial portion of our revenue in the future, to date we have generated a significant portion of our revenue from sales of product lines that we acquired from other companies.
Due to our limited operating history, we have difficulty accurately forecasting our revenue, and we have limited historical financial data upon which to base operating expense budgets.



If demand for our SLMS products does not develop, then our results of operations and financial condition will be adversely affected.



Our future revenue depends significantly on our ability to successfully
develop, enhance and market our SLMS products to the network service provider market. Most network service providers have made substantial investments in their current infrastructure, and they may elect to remain with their current architectures or
to adopt new architectures, such as SLMS, in limited stages or over extended periods of time. A decision by a customer to purchase our SLMS products will involve a significant capital investment. We will need to convince these service providers of
the benefits of our products for future upgrades or expansions. We do not know whether a viable market for our SLMS products will develop or be sustainable. If this market does not develop or develops more slowly than we expect, our business,
financial condition and results of operations will be seriously harmed.



We
have a history of losses and may not be able to generate sufficient revenue in the future to achieve or sustain profitability.



We have incurred significant net losses since inception. We had an accumulated deficit of approximately $589.3 million from inception in September 1999 through September
30, 2003. We cannot assure you that we will ever generate sufficient revenue to achieve or sustain profitability. Our revenue and operating results will vary significantly from quarter to quarter due to a number of factors, many of which are outside
of our control. The primary factors that may affect us include the following:



| |  | commercial acceptance of our SLMS products;
| | - | -------------------------------------------



| |  | fluctuations in demand for network access products;
| | - | ---------------------------------------------------



| |  | the length and variability of the sales cycles for our products;
| | - | ----------------------------------------------------------------



| |  | the timing and size of sales of our products;
| | - | ---------------------------------------------



| |  | our customers ability to finance their purchase of our products as well as their own operations;
| | - | -------------------------------------------------------------------------------------------------



| |  | our ability to forecast demand for our products;
| | - | ------------------------------------------------



| |  | the ability of our company and our contract manufacturers to attain and maintain production volumes and quality levels for our products;
| | - | ----------------------------------------------------------------------------------------------------------------------------------------



| |  | our ability to obtain sufficient supplies of sole or limited source components;
| | - | -------------------------------------------------------------------------------



| |  | changes in our pricing policies or the pricing policies of our competitors;
| | - | ---------------------------------------------------------------------------



28



---

##### Table of Contents

| |  | increases in the prices of the components we purchase;
| | - | ------------------------------------------------------



| |  | new product introductions and enhancements by our competitors;
| | - | --------------------------------------------------------------



| |  | our ability to develop, introduce and ship new products and product enhancements that meet customer requirements in a timely manner;
| | - | ------------------------------------------------------------------------------------------------------------------------------------



| |  | the timing and magnitude of prototype expenses;
| | - | -----------------------------------------------



| |  | our ability to attract and retain key personnel;
| | - | ------------------------------------------------



| |  | our sales of common stock or other securities in the future;
| | - | ------------------------------------------------------------



| |  | costs related to acquisitions of technologies or businesses; and
| | - | ----------------------------------------------------------------



| |  | general economic conditions as well as those specific to the communications, Internet and related industries.
| | - | -------------------------------------------------------------------------------------------------------------



We have large fixed expenses, and expect to continue to incur costs for research and product
development, sales and marketing, customer support and general and administration. Our operating expenses are largely based on anticipated personnel requirements and revenue trends, and a high percentage of our expenses are, and will continue to be,
fixed. In addition, we may be required to spend more on research and development than originally budgeted to respond to industry trends. We may also incur significant new costs related to possible acquisitions and the integration of new
technologies. Given our stage of development, and the rate at which competition in our industry is intensifying, we may not be able to adequately control our costs and expenses or achieve or maintain adequate operating margins. As a result, our
ability to achieve and sustain profitability will depend on our ability to generate and sustain substantially higher revenue while maintaining reasonable cost and expense levels. If we fail to increase our revenue significantly from current levels,
or if we experience delays in generating or recognizing revenue, we will continue to incur substantial operating losses.



Our target customer base is concentrated, and the loss of one or more of our customers could harm our business.



The target customers for our products are network service providers that operate voice, data
and video communications networks. There are a limited number of potential customers in our target market. During the three and nine months ended September 30, 2003, two customers accounted for approximately 30% and 30% of our revenue, respectively.
During the three and nine months ended September 30, 2002, one customer accounted for approximately 10% and 10% of our revenue, respectively. Substantially all of our future revenue will depend on sales of our products to a limited number of
customers. Any failure of one or more communications service providers to purchase products from us for any reason, including any downturn in their businesses, would seriously harm our business, financial condition and results of operations.



The long and variable sales cycles for our products may cause revenue and
operating results to vary significantly from quarter to quarter.



The
target customers for our products have substantial and complex networks that they traditionally expand in large increments on a periodic basis. Accordingly, our marketing efforts are largely focused on prospective customers that may purchase our
products as part of a large-scale network deployment. Our target customers typically require a lengthy evaluation, testing and product qualification process. Throughout this process, we are often required to spend considerable time and incur
significant expense educating and providing information to prospective customers about the uses and features of our products. Even after a company makes the final decision to purchase our products, it may deploy our products slowly. The timing of
deployment of our products varies widely, and depends on a number of factors, including:



| |  | our customers skill sets;
| | - | --------------------------



| |  | geographic density of potential subscribers;
| | - | --------------------------------------------



| |  | the degree of configuration necessary to deploy our products; and
| | - | -----------------------------------------------------------------



| |  | our customers ability to finance their purchase of our products as well as their operations.
| | - | ---------------------------------------------------------------------------------------------



As a result of any of these factors, our revenue and operating results may vary significantly from quarter to quarter.



29



---

##### Table of Contents

Capital constraints in the telecommunications industry could restrict the ability of our customers to buy our
products.



The telecommunications industry has recently experienced
extreme capital constraints. The reduction of capital equipment acquisition budgets or the inability of our target customers to obtain capital could cause them to reduce or discontinue purchase of our products, and as a result we could experience
reduced revenues or operating results. In addition, many of the target customers for our products are emerging companies with limited operating histories. These companies require substantial capital for the development, construction and expansion of
their businesses. Neither equity nor debt financing may be available to these companies on favorable terms, if at all. To the extent that these companies are unable to obtain the financing they need, our ability to make future sales to these
customers and realize revenue from any such sales could be harmed. In addition, to the extent we choose to provide financing to these prospective customers, we will be subject to additional financial risk which could increase our expenses.



The success of our business depends on our executive officers and key
employees, and the loss of the services of one or more of them could harm our business.



Our future success depends upon the continued services of our executive officers and other key engineering, manufacturing, operations, sales, marketing and support personnel who have critical industry experience and
relationships that we rely on to build our business, particularly Morteza Ejabat, our co-founder, Chairman and Chief Executive Officer. The loss of the services of any of our key employees, including Mr. Ejabat, could delay the development and
production of our products and negatively impact our ability to maintain customer relationships, which would harm our business, financial condition and results of operations.



If we are unable to successfully manage and expand our international operations, our business could be harmed.



We currently have international operations consisting of sales, technical support and
marketing teams in China, Hong Kong, Japan, Singapore and Italy. We expect to continue expanding our international operations in the future. The successful management and expansion of our international operations requires significant human and
financial resources. Further, our international operations may be subject to certain risks and challenges that could harm our operating results, including:



| |  | expenses associated with developing and customizing our products for foreign countries;
| | - | ---------------------------------------------------------------------------------------



| |  | unexpected changes in regulatory requirements, taxes, trade laws and tariffs;
| | - | -----------------------------------------------------------------------------



| |  | fluctuations in currency exchange rates;
| | - | ----------------------------------------



| |  | longer sales cycles for our products;
| | - | -------------------------------------



| |  | greater difficulty in accounts receivable collection and longer collection periods;
| | - | -----------------------------------------------------------------------------------



| |  | difficulties and costs of staffing and managing foreign operations;
| | - | -------------------------------------------------------------------



| |  | reduced protection for intellectual property rights;
| | - | ----------------------------------------------------



| |  | potentially adverse tax consequences; and
| | - | -----------------------------------------



| |  | changes in a countrys or regions political and economic conditions.
| | - | ---------------------------------------------------------------------



Any of these factors could harm our existing international operations and business or impair our ability to continue expanding into
international markets.



Risks Related to the Communications
Industry



The market we serve is highly competitive and, as an early
stage company, we may not be able to achieve or maintain profitability.



Competition in the communications equipment market is intense. We are aware of many companies in related markets that address particular aspects of the features and functions that our products will provide. Currently, our primary
competitors include large equipment companies, such as Advanced Fibre Communications, Alcatel, Lucent Technologies and UT Starcom. We also may face competition from other large communications equipment companies or other companies with significant
market presence and financial resources that may enter our market in the future. In addition, a number of new public and private companies have announced plans for new products to address the same network needs that our products address, both
domestically and abroad. Some of these international companies have lower cost structures.



30



---

##### Table of Contents

Many of our competitors have longer operating histories, greater name recognition, larger customer bases and greater
financial, technical, sales and marketing resources than we do and may be able to undertake more extensive marketing efforts, adopt more aggressive pricing policies and provide more customer financing than we can. Moreover, our competitors may
foresee the course of market developments more accurately than we do and could develop new technologies that render our products less valuable or obsolete.



In our markets, competitive factors include:



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



| |  | reliability and scalability;
| | - | ----------------------------



| |  | ease of installation and use;
| | - | -----------------------------



| |  | interoperability with existing products;
| | - | ----------------------------------------



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



| |  | geographic footprints for products;
| | - | -----------------------------------



| |  | ability to support customer financing;
| | - | --------------------------------------



| |  | breadth of services;
| | - | --------------------



| |  | price;
| | - | ------



| |  | technical support and customer service; and
| | - | -------------------------------------------



| |  | brand recognition.
| | - | ------------------



If we are unable to compete successfully against our current and future competitors, we may have difficulty obtaining customers, and we could experience price reductions, order cancellations, increased expenses and
reduced gross margins, any of which would harm our business, financial condition and results of operations.



The communications industry is subject to government regulations, which could harm our business.



The Federal Communications Commission, or FCC, has jurisdiction over the entire communications industry in the United States and, as a result, our existing and future
products and our customers products are subject to FCC rules and regulations. Current and future FCC rules and regulations affecting communications services could negatively affect our business. The uncertainty associated with future FCC
decisions may result in telephone companies delaying decisions regarding expenditures for equipment for broadband services. In addition, international regulatory bodies establish standards that may govern our products in foreign markets. Domestic
and international regulatory requirements could result in postponements or cancellations of product orders, which would harm our business, financial condition and results of operations. Further, we cannot be certain that we will be successful in
obtaining or maintaining any regulatory approvals that may, in the future, be required to operate our business.



We are subject to general economic and market conditions.



Our business is subject to the effects of general economic conditions in the United States and worldwide, and to market conditions in the telecommunications and
networking industries in particular. Since 2001, our operating results have been adversely affected by unfavorable global economic conditions, the failure of a number of communications service providers and reduced capital spending by many other
communications service providers. These adverse conditions have resulted in a smaller market that is more difficult to predict and caused a substantial reduction in demand for telecommunications equipment, including our products.



31



---

##### Table of Contents

Certain trends and factors that affect the telecommunications industry, which are beyond our control and may affect our
operations, include:



| |  | adverse changes in the public and private equity and debt markets and our ability, as well as the ability of our customers and suppliers, to obtain financing or to fund working
capital and capital expenditures;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | visibility to, and the actual size and timing of, capital expenditures by our customers;
| | - | ----------------------------------------------------------------------------------------



| |  | inventory practices, including the timing of product and service deployment, of our customers;
| | - | ----------------------------------------------------------------------------------------------



| |  | conditions in the broader market for communications products, including data networking products and computerized information access equipment and services;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | governmental regulation or intervention affecting communications or data networking; and
| | - | ----------------------------------------------------------------------------------------



| |  | the effects of war and acts of terrorism, such as disruptions in general global economic activity, changes in logistics and security arrangements and reduced customer demand for our
products and services.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



If the economic conditions in the United
States and globally do not improve, or if they worsen from current levels, we may continue to experience material adverse impacts on our business, operating results, and financial condition.



Risks Related to Our Products



Because our products are complex and will be deployed in complex environments, our
products may have defects that we discover only after full deployment, which could seriously harm our business.



Our products are complex and are designed to be deployed in large quantities across complex networks. Because of the nature of these products, they can only be fully
tested when completely deployed in large networks with high amounts of traffic. Our customers may discover errors or defects in our hardware or software, or our products may not operate as expected, after they have been fully deployed. If we are
unable to fix defects or other problems that may be identified after full deployment, we could experience:



| |  | loss of revenue and market share;
| | - | ---------------------------------



| |  | loss of existing customers;
| | - | ---------------------------



| |  | failure to attract new customers or achieve market acceptance;
| | - | --------------------------------------------------------------



| |  | diversion of development resources;
| | - | -----------------------------------



| |  | increased service and warranty costs;
| | - | -------------------------------------



| |  | legal actions by our customers; and
| | - | -----------------------------------



| |  | increased insurance costs.
| | - | --------------------------



Defects, integration issues or other performance problems in our products could also result in financial or other damages to our customers. Our customers could seek damages for related losses from us, which could
seriously harm our business, financial condition and results of operations. A product liability claim brought against us, even if unsuccessful, would likely be time consuming and costly and would put a strain on our management and resources. The
occurrence of any of these problems would seriously harm our business, financial condition and results of operations.



If we fail to enhance our existing products or develop and introduce new products that meet changing customer requirements and technological advances, our ability to
sell our products would be materially adversely affected.



Our target
markets are characterized by rapid technological advances, evolving industry standards, changes in end-user requirements, frequent new product introductions and changes in communications offerings from network service providers. Our future success
will significantly depend on our ability to anticipate or adapt to such changes and to offer, on a timely and cost-effective basis, products that meet changing customer demands and industry standards. We may not have sufficient resources to
successfully and accurately anticipate technological and market trends, manage long development cycles or develop, introduce and market new products and enhancements. We currently license technology, and from time to time, we may be required to
license additional technology from



32



---

##### Table of Contents

third parties to sell or develop our products and product enhancements. We cannot assure you that our existing and future third-party licenses will be
available to us on commercially reasonable terms, if at all. Our inability to maintain or obtain any third-party license required to sell or develop our products and product enhancements could require us to obtain substitute technology of lower
quality or performance standards or at greater cost. If we are not able to develop new products or enhancements to existing products on a timely and cost-effective basis, or if our new products or enhancements fail to achieve market acceptance, our
business, financial condition and results of operations would be materially adversely affected.



Our business will be adversely affected if we are unable to protect our intellectual property rights from third-party challenges.



We rely on a combination of copyrights, patents, trademarks and trade secret laws and restrictions on disclosure to protect our intellectual
property rights. We also enter into confidentiality or license agreements with our employees, consultants and corporate partners and control access to and distribution of our software, documentation and other proprietary information. Despite our
efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain and use our products or technology. Monitoring unauthorized use of our technology is difficult, and we do not know whether the steps we have
taken will prevent unauthorized use of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States.



In the future we may become involved in disputes over intellectual property, which could subject us to significant liability, divert the
time and attention of our management and prevent us from selling our products.



We or our customers may be party to litigation in the future to protect our intellectual property or to respond to allegations that we infringe others intellectual property. We may receive in the future communications from third
parties inquiring about their interest in licensing certain of the third partys intellectual property or more generally identifying intellectual property that may be the basis of a future infringement claim. We have received letters from
Lucent Technologies stating that many of our products are using technology covered by or related to Lucent patents and inviting us to discuss a licensing arrangement with Lucent. To date, no lawsuit or other formal action has been filed by Lucent.
However, we cannot assure you that we would be successful in defending against any Lucent infringement claims. To the extent we are not successful in defending such claims, we may be subject to substantial damages (including possible treble damages
and attorneys fees).



If a party accuses us of infringing upon its
proprietary rights, we would have to defend ourselves and possibly our customers against the alleged infringement. We cannot assure you that we would prevail in any intellectual property litigation, given its complex technical issues and inherent
uncertainties. If we are unsuccessful in any such litigation, we could be subject to significant liability for damages and loss of our proprietary rights. Intellectual property litigation, regardless of its outcome, would likely be time consuming
and expensive to resolve. Any such litigation could force us to stop selling, incorporating or using our products that include the challenged intellectual property, or redesign those products that use the technology. In addition, if a party accuses
us of infringing upon its proprietary rights, we may have to enter into royalty or licensing agreements, which may not be available on terms acceptable to us, if at all. Any of these results could have a material adverse effect on our business,
financial condition and results of operations.



Risks Related
to Our Product Manufacturing



Our reliance on Solectron for all of our
manufacturing requirements could cause us to lose orders if this third party manufacturer fails to satisfy our cost, quality and delivery requirements.



We currently contract with Solectron for most of our manufacturing requirements. Any manufacturing disruption could impair our ability to fulfill orders. Our future
success will depend, in significant part, on our ability to have Solectron or others manufacture our products cost-effectively and in sufficient volumes. We face a number of risks associated with our dependence on third-party manufacturers
including:



| |  | reduced control over delivery schedules;
| | - | ----------------------------------------



| |  | the potential lack of adequate capacity during periods of excess demand;
| | - | ------------------------------------------------------------------------



| |  | manufacturing yields and costs;
| | - | -------------------------------



| |  | quality assurance;
| | - | ------------------



| |  | increases in prices; and
| | - | ------------------------



| |  | the potential misappropriation of our intellectual property.
| | - | ------------------------------------------------------------



33



---

##### Table of Contents

We have no long-term contracts or arrangements with any of our vendors that guarantee product availability, the
continuation of particular payment terms or the extension of credit limits. We have experienced in the past, and may experience in the future, problems with our contract manufacturers, such as inferior quality, insufficient quantities and late
delivery of products. To date, these problems have not materially adversely affected us. We may not be able to obtain additional volume purchase or manufacturing arrangements on terms that we consider acceptable, if at all. If we enter into a
high-volume or long-term supply arrangement and subsequently decide that we cannot use the products or services provided for in the agreement, our business will be harmed. We cannot assure you that we will be able to effectively manage our
relationship with our contract manufacturer, or that this manufacturer will meet our future requirements for timely delivery of products of sufficient quality or quantity. Any of these difficulties could harm our relationships with customers and
cause us to lose orders.



Our existing contracts with Solectron expire in
October 2003 and March 2004. If we are unsuccessful in renegotiating these agreements, then we may be required to manufacture our products internally or find another outside contract manufacturer. If we fail to successfully transition manufacturing
operations in-house or fail to locate and qualify suitable manufacturing candidates capable of satisfying our product specifications or quantity requirements, then we may experience product shortages and, as a result, be unable to fulfill customer
orders accurately and timely which could negatively affect our customer relationships and operating results. Further, new third-party manufacturers may encounter difficulties in the manufacture of our products resulting in product delivery delays.



We depend on sole or limited source suppliers for several key components.
If we are unable to obtain these components on a timely basis, we will be unable to meet our customers product delivery requirements, which would harm our business.



We currently purchase several key components from single or limited sources pursuant to limited term supply contracts. If any of our sole or
limited source suppliers experiences capacity constraints, work stoppages or any other reduction or disruption in output, it may be unable to meet our delivery schedule. Our suppliers may enter into exclusive arrangements with our competitors, be
acquired by our competitors, stop selling their products or components to us at commercially reasonable prices, refuse to sell their products or components to us at any price or be unable to obtain or have difficulty obtaining components for their
products from their suppliers.



In these events, we could be forced to commence
a time consuming and difficult process of identifying and qualifying an alternative supplier of the key components. There is no guarantee that such a search would be successful. If we do not receive critical components from our suppliers in a timely
manner, we will be unable to meet our customers product delivery requirements. Any failure to meet a customers delivery requirements could harm our reputation and decrease our sales, which would harm our business, financial condition and
results of operations.



Our headquarters and certain suppliers are all
located in Northern California where natural disasters or service outages or restrictions could occur and harm our facilities and key personnel, which would restrict or prevent us from providing services to our customers.



Our corporate headquarters and principal research and development center and product testing
facilities as well as many of our suppliers are located in Northern California, which has historically been vulnerable to natural disasters, such as earthquakes, fires and floods. In addition, this area has historically been rapidly growing and
large demands on infrastructure services, including electrical and other utility services, could result in significant or more frequent outages or restrictions on the use of such services. The occurrence of a natural disaster or such service outages
or restrictions might disrupt the local economy and pose physical risks to our employees and our property. We do not presently have redundant, multiple site capacity in the event of a natural disaster or service outages or restrictions. Accordingly,
in the event of a disaster or service outages or restrictions adversely affecting our operations, our business would suffer.



If we fail to attract and retain qualified personnel, our business might be harmed.



Our future success will depend in large part upon our ability to identify, attract and retain qualified individuals, particularly research
and development and customer service engineers and sales and marketing personnel. Our products are generally of a highly technical nature, and therefore require a sophisticated sales effort targeted at several key people within each prospective
customers organization. Our target customers are large network service providers that require high levels of service and support from our customer service engineers and our sales and marketing personnel. Competition for these employees in our
industry and in the San Francisco Bay Area in particular, as well as other areas in which we recruit, may be intense, and we may not be successful in attracting or retaining these personnel. If we are not able to hire the kind and number of
marketing and sales personnel and customer service engineers required by our product offerings and customers, we may not reach the level of sales necessary to achieve profitability or may be impaired from meeting existing customer demands, either of
which could materially harm our business.



34



---

##### Table of Contents

Our business will suffer if we fail to properly manage our growth and continually improve our internal controls and
systems.



We have expanded our operations rapidly since our inception. The
number of our employees has grown from eight as of September 30, 1999 to 228 as of September 30, 2003. As our business grows, we expect to increase the scope of our operations and the number of our employees. Our ability to successfully offer our
products and implement our business plan in a rapidly evolving market requires an effective planning and management process. To manage our growth properly, we must:



| |  | hire, train, manage and retain qualified personnel, including engineers and research and development personnel;
| | - | ---------------------------------------------------------------------------------------------------------------



| |  | carefully manage and expand our manufacturing relationships and related controls and reporting systems;
| | - | -------------------------------------------------------------------------------------------------------



| |  | effectively manage multiple relationships with our customers, suppliers and other third parties;
| | - | ------------------------------------------------------------------------------------------------



| |  | implement additional operational controls, reporting and financial systems and procedures; and
| | - | ----------------------------------------------------------------------------------------------



| |  | successfully integrate employees of acquired companies.
| | - | -------------------------------------------------------



Failure to do any of the above in an efficient and timely manner could seriously harm our business, financial condition and results of operations.



Any strategic acquisitions or investments we make could disrupt our business and seriously
harm our financial condition.



On an ongoing basis, we expect to consider
acquisitions of, or investments in, complementary companies, products or technologies to supplement our internal growth. Since inception, we have acquired eight companies or product lines, and we are likely to acquire additional businesses, products
or technologies in the future. On July 27, 2003, we entered into a merger agreement with Tellium, Inc. pursuant to which our current stockholders will own approximately 60% of the combined companys outstanding shares on a fully converted basis
and Telliums stockholders will own approximately 40% of the combined companys outstanding shares on a fully converted basis. We may encounter difficulties identifying and acquiring suitable candidates on reasonable terms.



If we do complete future acquisitions, we could:



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



| |  | consume cash;
| | - | -------------



| |  | incur substantial debt;
| | - | -----------------------



| |  | assume liabilities;
| | - | -------------------



| |  | increase our ongoing operating expenses and level of fixed costs;
| | - | -----------------------------------------------------------------



| |  | record goodwill and non-amortizable intangible assets that will be subject to impairment testing and potential periodic impairment charges;
| | - | -------------------------------------------------------------------------------------------------------------------------------------------



| |  | incur amortization expenses related to certain intangible assets;
| | - | -----------------------------------------------------------------



| |  | incur large and immediate write-offs; or
| | - | ----------------------------------------



| |  | become subject to litigation.
| | - | -----------------------------



Any strategic acquisitions or investments that we make in the future will involve numerous risks, including:



| |  | problems combining the acquired operations, technologies or products;
| | - | ---------------------------------------------------------------------



| |  | unanticipated costs;
| | - | --------------------



| |  | diversion of managements time and attention from our existing business;
| | - | ------------------------------------------------------------------------



| |  | adverse effects on existing business relationships with suppliers and customers;
| | - | --------------------------------------------------------------------------------



35



---

##### Table of Contents

| |  | risks associated with entering markets in which we have no or limited prior experience; and
| | - | -------------------------------------------------------------------------------------------



| |  | potential loss of key employees, particularly those of acquired companies.
| | - | --------------------------------------------------------------------------



We do not know whether we will be able to successfully integrate the businesses, products, technologies or personnel that we might acquire in the future or that any
strategic investments we make will meet our financial or other investment objectives. Any failure to do so could seriously harm our business, financial condition and results of operations.



If we are unable to obtain additional capital to fund our existing and future operations,
we may be required to reduce the scope of our planned product development and marketing and sales efforts, which would harm our business, financial condition and results of operations.



The development and marketing of new products and the expansion of our direct sales
operation and associated support personnel requires a significant commitment of resources. We may incur significant operating losses or expend significant amounts of capital if:



| |  | the market for our products develops more slowly than anticipated;
| | - | ------------------------------------------------------------------



| |  | we fail to establish market share or generate revenue at anticipated levels;
| | - | ----------------------------------------------------------------------------



| |  | our capital expenditure forecasts change or prove inaccurate; or
| | - | ----------------------------------------------------------------



| |  | we fail to respond to unforeseen challenges or take advantage of unanticipated opportunities.
| | - | ---------------------------------------------------------------------------------------------



As a result, we may need to raise substantial additional capital. Additional capital, if required, may not be available on acceptable terms,
or at all. If additional capital is raised through the issuance of debt securities, the terms of such debt could impose financial or other restrictions on our operations. If we are unable to obtain additional capital or are required to obtain
additional capital on terms that are not favorable to us, we may be required to reduce the scope of our planned product development and sales and marketing efforts, which would harm our business, financial condition and results of operations.



Risks Related to Our Equity



Insiders have substantial control over us, including the ability to influence the outcome
of key transactions, including our sale to another company.



Our executive
officers, directors and entities affiliated with them beneficially own, in the aggregate, approximately 77% of our outstanding common stock and substantially all of our outstanding preferred stock. These stockholders, if acting together, will be
able to influence significantly all matters requiring approval by our stockholders, including the election of directors and the approval of mergers or other business combination transactions. Circumstances may arise in which the interests of these
stockholders could conflict with the interests of our other stockholders. These stockholders could delay or prevent a change in control of our company even if such a transaction would be beneficial to our other stockholders.



There is no public market for our common stock and if our proposed merger with Tellium is
not consummated, there may never be one; and we cannot predict what the trading price of our common stock in any public market might be.



There is no public market for our common stock and if our proposed merger with Tellium is not consummated, we cannot assure you that there will ever be one. If we ever
sell our common stock in a registered public offering, the offering price for our common stock will be determined through our negotiations with the underwriters and may not bear any relationship to the price at which our capital stock was sold
before the offering or any other established criteria of our value. We cannot predict the prices at which any of our common stock will trade following the completion of the merger with Tellium or otherwise at any time in the future.



Our stockholders will incur dilution as a result of the exercise of outstanding options
and warrants and any future sale of equity or equity-linked debt securities.



The exercise of outstanding options and warrants and the future sale of any equity or equity-linked debt securities, including any additional securities issued in connection with acquisitions, will result in dilution to our then-existing
stockholders. Any dilution resulting from the future sale of equity or equity-linked debt securities will be more substantial if the price paid for such securities is less than the price paid by our then-existing stockholders for our outstanding
capital stock.



36



---

##### Table of Contents

We do not plan to pay dividends in the foreseeable future.



We do not anticipate paying cash dividends to our stockholders in the foreseeable future.
Accordingly, our stockholders must rely on sales of their capital stock after price appreciation, which may never occur, as the only way to realize a return on their investment.



Item 3. Quantitative and Qualitative Disclosures about Market Risk



Cash and Cash Equivalents



Zhone considers all cash and highly liquid investments purchased with an original maturity of less than three months to be cash equivalents.



Cash and cash equivalents consisted of the following as of September 30, 2003 and December 31, 2002 (in thousands):



|                           |  | September 30,2003 |       | December 31,2002
|-------------------------- |  | ----------------- | ----- | ----------------
|Cash and cash equivalents: |  |                   |       |                 
|Cash                       |  | $                 | 2,497 |                 
|Money market funds         |  |                   | 5     |                 
|Repurchase agreements      |  |                   |      |                 
|                           |  |                   |       |                 
|                           |  | $                 | 2,502 |                 
|                           |  |                   |       |                 



Concentration of Credit Risk



Financial instruments which potentially subject us to concentrations of
credit risk consist primarily of cash and cash equivalents and accounts receivable. Cash and cash equivalents consist principally of demand deposit and money market accounts, commercial paper, and debt securities of domestic municipalities with
credit ratings of AA or better. Cash and cash equivalents are principally held with various domestic financial institutions with high-credit standing. As of September 30, 2003, we had accounts receivable balances from three customers individually
representing 20%, 11% and 10% of accounts receivable, respectively.



Interest Rate Risk



Our exposure to market risk for changes in
interest rates relates primarily to our investment portfolio and long-term debt. We do not use derivative financial instruments in our investment portfolio. We do not hold financial instruments for trading or speculative purposes. We manage our
interest rate risk by maintaining an investment portfolio primarily consisting of debt instruments of high credit quality and relatively short average maturities. We do not consider our cash and cash equivalents to be subject to interest rate risk
due to their short maturities. All short-term investments mature in three months or less.



Foreign Currency Risk



We transact
business in various foreign countries. Substantially all of our assets are located in the United States. We have product development activities in Canada and sales operations throughout Europe, Asia, the Middle East and Latin America. Accordingly,
our operating results are also exposed to changes in exchange rates between the U.S. dollar and those currencies. During 2003 and 2002, we did not hedge any of our local currency cash flows. While our financial results to date have not been
materially affected by any changes in currency exchange rates, devaluation of the U.S. dollar against these currencies may affect our future operating results.



Item 4. Controls and Procedures



Evaluation of
Disclosure Controls and Procedures. Under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, we evaluated the effectiveness of our disclosure controls and procedures,
as such term is defined in Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and
procedures were effective as of the end of the period covered by this quarterly report.



Changes in Internal Control over Financial Reporting. There was no change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended) during our third
fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.



37



---

##### Table of Contents

PART II. OTHER INFORMATION



Item 1. Legal Proceedings



Litigation



On October 16, 2003, we agreed with HeliOss Communications, Inc. to
dismiss HeliOss claims filed against us on March 27, 2003 in the Superior Court of the State of California, County of Alameda, in an action entitled HeliOss Communications, Inc. v. Zhone Technologies, Inc., case no. RG 03088921 and our
cross-complaint against HeliOss, in consideration of a $1.6 million payment from Zhone to HeliOss. Under the terms of the settlement, if this payment is not made by us on or before November 26, 2003, we must pay HeliOss $400,000 plus an additional
$100,000 per month over the following 16 months.



From time to time, we may be
involved in additional litigation relating to claims arising out of our operations. We are not currently engaged in any legal proceedings that, individually or in the aggregate, we expect would have a material adverse effect on our business.



Item 2. Changes in Securities and Use of Proceeds



Not applicable.



Item 3. Defaults Upon Senior Securities



Not applicable.



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



Not applicable.



Item 5. Other Information



Not
applicable.



Item 6. Exhibits and Reports on Form 8-K



| | (a) | Exhibits
| | --- | --------



|Exhibit |  | Description                                                                                                                     
|------- |  | --------------------------------------------------------------------------------------------------------------------------------
|31.1    |  | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                             
|        | 
|31.2    |  | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                             
|        | 
|32      |  | Certification of Chief Executive Officer and Chief Financial Officer, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.



| | (b) | Reports on Form 8-K
| | --- | -------------------



On October 13, 2003, we filed a current report on Form 8-K related to the restatement of our financial statements for the year ended December 31, 2002 and for the six months ended June 30, 2003.



On October 16, 2003, we filed a current report on Form 8-K related to our financial results
for the quarter ended September 30, 2003.



On October 30, 2003, we filed a
current report on Form 8-K related to our settlement of the HeliOss litigation.



38



---

##### Table of Contents

SIGNATURE



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



|                        |  | ZHONE TECHNOLOGIES, INC.
|----------------------- |  | ------------------------
|                        |  |                         
|Date: November 12, 2003 |  | By:                     
|                        |  | Name:                   
|                        |  | Title:                  



39