** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 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  June 30, 2007**                                                                                                                                                                         |
| ** **     | ** ** | ** **                                                                                                                                                                                                                     |
| ** **     | ** ** | **OR**                                                                                                                                                                                                                         |
| ** **     | ** ** | ** **                                                                                                                                                                                                                     |
| o              | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                  |
|           | ** ** | ** **                                                                                                                                                                                                                     |
| ** **     | ** ** | **For the transition period from                   to                 ** |

 

**COMMISSION FILE NUMBER 000-29661**

 

**UTSTARCOM, INC.**

(Exact name of registrant as specified in itscharter)

 

| **DELAWARE**                                                                      |       | **52-1782500**                       |
|-----------------------------------------------------------------------------------|------------|--------------------------------------|
| (State of Incorporation)                                                          |       | (I.R.S. Employer Identification No.) |
|                                                                              | ** ** |                                 |
|                                                                              |       |                                 |
| **1275 HARBOR BAY PARKWAY**                                                       |       | **94502**                            |
| **ALAMEDA, CALIFORNIA**                                                           |       | (zip code)                           |
| (Address of principal executive offices)                                          | ** ** |                                 |
|                                                                              |       |                                 |
| Registrant’s telephone number, including area  code: **(510) 864-8800** |

 

                Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.  Yes x Noo

                Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or non-accelerated filer (as defined in Rule 12b-2 ofthe Exchange Act).

Large Accelerated Filer x  Accelerated Filer o  Non-Accelerated Filer o

 

                Indicateby check mark whether the registrant is a shell company (as defined inRule 12b-2 of the Exchange Act). Yes o No x

 

                Asof September 30, 2007 there were 121,294,645 shares of the registrant’s commonstock outstanding, par value $0.00125.

 

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**TABLE OF CONTENTS**

 
| PART  I—FINANCIAL INFORMATION                                                                      | 13  |
|---------------------------------------------------------------------------------------------------------|-----|
| ITEM 1—CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (RESTATED)                                     | 13  |
| ITEM 2—MANAGEMENT’S DISCUSSION AND ANALYSIS OF  FINANCIAL CONDITION AND RESULTS OF OPERATIONS | 48  |
| ITEM 3—QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT  MARKET RISKS                                | 76  |
| ITEM  4—CONTROLS AND PROCEDURES                                                                    | 78  |
| PART II—OTHER INFORMATION                                                                          | 83  |
| ITEM 1—LEGAL PROCEEDINGS                                                                           | 83  |
| ITEM 1A—RISK FACTORS                                                                               | 86  |
| ITEM 2—UNREGISTERED SALES OF EQUITY SECURITIES AND USE  OF PROCEEDS                                | 104 |
| ITEM 3—DEFAULTS UPON SENIOR SECURITIES                                                             | 104 |
| ITEM 4—SUBMISSION OF MATTERS TO A VOTE OF SECURITY  HOLDERS                                        | 104 |
| ITEM 5—OTHER INFORMATION                                                                           | 104 |
| ITEM 6—EXHIBITS                                                                                    | 105 |
| SIGNATURES                                                                                              | 106 |

 

 

 

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**EXPLANATORY NOTE**

 

**The Company was unable to file timely its Form 10-Q for thequarterly period ended June 30, 2007 because we had commenced a voluntaryreview of historical stock option practices and the Audit Committee had alsoengaged independent counsel to conduct an investigation of sales in China andthe results of those reviews / investigations were not known at the date theForm 10-Q filing was due.  Informationcontained herein about the restatements of previously issued financialstatements has been taken from the 2006 Annual Report on Form 10-K that wasfiled with the Securities and Exchange Commission on October 10, 2007. The 2006Annual Report contains additional information about the restatements which isnot included herein.**

 

Our consolidated financial statements and relatedfinancial information included in this Quarterly Report on Form 10-Q foraccounting periods prior to the third quarter of 2006 have been restated, asdescribed below.

 

***Summary***

 

In July 2007, the Company announced the AuditCommittee of the Board of Directors (the “Audit Committee”) was conducting anindependent investigation of historical sales with certain customers in Chinaand stated that it could not rule out the possibility that the outcome of theinvestigation could impact revenue recognized for certain of such contracts asrecorded in previously issued financial statements. In September 2007, theCompany announced the investigative phase of the Audit Committee’s investigationhad been completed. After consultation with and upon the recommendation ofmanagement, the Audit Committee determined revenue in the Company’s WesternRegion of China was recognized earlier than it should have been and that thefinancial statements for the affected periods should be restated. The Companyalso announced that itspreviously issued financial statements for each of the fiscal yearsended December 31 in the period 2000 through 2005, the financial statements forthe interim periods contained in the Quarterly Reports on Form 10-Q filed withrespect to each of these years, and the quarterly reports on Form 10-Q filedwith respect to each of the quarterly periods ended March 31 and June 30,2006 should not be relied upon. In this Quarterly Report we have corrected for the effects of net salesand related costs of net sales that were recorded earlier than they should havebeen and have restated the financial statements for the three and six monthsended June 30, 2006. The net effects for the three and six months ended June30, 2006 were to recognize previously deferred revenue and an increase(decrease) of gross profit of $2.4 million and ($0.4) million, respectively,and $7.8 million and $1.0 million, respectively.

 

We also conducted a voluntary review of historical stock option practicesunder the direction of the Nominating and Corporate Governance Committee of ourBoard of Directors (“Governance Committee”). This review considered all optiongrant awards made in the period from February 29, 2000, shortly before theinitial public offering of our Common Stock, through August 2006 for compliancewith the various stock-based compensation accounting standards applicableduring this period as well as the rules of our stock option plans. We found thatin a number of instances we did not use the proper date as the measurement datein determining whether stock options had been issued with exercise prices belowthe fair value of our common stock. Therefore, we have restated our previouslyissued financial statements for the years ended December 31, 1998 through 2005to account for an additional $25.5 million of stock compensation expense thatshould have been recognized over the period together with an equal increase inadditional paid-in capital to recognize the intrinsic value assigned to theseissuances of equity securities. Related adjustments of payroll and income taxesresulted in an additional $0.5 million of expense being recognized for the 1998through 2005 period and total stockholders’ equity being reduced by a total of$2.1 million at December 31, 2005. During the first six months of 2006 anadditional $1.2 million of stock compensation expense was recognized, whichreduces our previously reported operating results for this period.  We have restated the financial statements forthe three and six months ended June 30, 2006, and during that period incremental stock compensation expense totaling$0.5 million and $1.2 million was recognized, respectively.

 

None of theserestatements had any effect on any of our cash balances, however cashequivalents were reduced at June 30, 2006 due to the correction inclassifications described below.

 

Additional informationabout these restatements and their effects on our financial statements ispresented below as well as in the Notes to Consolidated Financial Statements.

 

***China Sales Investigation***

 

The Audit Committee engaged independent counsel toconduct an investigation of sales in China following a determination by theInternal Audit group that allegations of improper activities in a sales officein the Western Region were credible. The allegations were made by a Companyemployee using the Company’s whistle blower program. The independent counselengaged the assistance of forensic accountants, and this group is collectivelyreferred to as the Investigating Team in the rest of this discussion.

 

 

3

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In conducting its procedures, the Investigating Teamfound instances where the customer contracts that evidenced the arrangementcontained obligations for the Company to deliver software upgrades when and ifmade available for the equipment sold for no additional consideration and foran unspecified period that could extend over the term of the contract. Thisadditional contract obligation is an element of “post contract support.” Inthese cases, the Investigating Team found that the contract documentation forthe same transaction submitted by the sales office to the Company’s Chinaheadquarters for accounting purposes and utilized by the Company in determiningthe amount of revenue recognized did not include evidence of such post contractsupport obligations.

 

Accounting standards governing revenue recognition forsystem sales require all revenue to be deferred while there are undeliveredelements under the arrangement unless the seller has established vendorspecific objective evidence (“VSOE”) of fair value for such contract elements.Because these arrangements included such undelivered elements, revenue shouldbe deferred based on the VSOE of the fair value of the underlying elements.VSOE of fair value represents the price charged when the same element is soldseparately. Since the Company does not sell this element separately, it has notestablished VSOE for such undelivered elements, and as such the revenue fromsuch contracts is required to be deferred and recognized over the period theCompany is obligated to provide the post contract support.

 

The China sales investigation covered each of theseven years in the period ended December 31, 2006 and included: investigatingapproximately 1,200 contracts in all of our five regions in China; reviews ofthe electronic files of 45 employees; and formal interviews of 96 employees inChina. Additionally, the China sales investigation included reviewing contractfiles, performing various financial analyses including comparison of paymentsreceived per our accounting records to the contract terms, and computerforensic procedures where destruction of electronic documents was suspected. Inthe aggregate, the Investigating Team expended approximately 25,000 hours inconducting this investigation, which commenced in February 2007 and wascompleted in September 2007 when the independent counsel and forensicaccountants presented their final report to the Audit Committee. In July 2007,we announced the Audit Committee was conducting an independent investigation ofhistorical sales with certain customers in China and we stated that we couldnot rule out the possibility that the outcome of the investigation could impactrevenue recognized for certain of such contracts as recorded in our previouslyissued financial statements.

 

Upon completion of the investigative phase of theindependent investigation by the Audit Committee, our management:

 

•                  conducted follow-up procedures to attemptto locate any additional relevant information to ensure the Company consideredall available information and documents;

 

•                  evaluated the accounting for identifiedsystem sales using the contract template and documentation found in the salescontract files from the Western Region offices. This included calculating thefinancial statement effects of correcting the accounting for all system saleswhere the contract template found at our sales offices contained post contractsupport obligations to recognize revenue and cost of net sales over theestimated period of post contract support; and

 

•                  concluded that as a result of theexistence of this undelivered post contract support obligation our previouslyissued financial statements should be restated to defer system sales contractrevenue and the related cost of net sales over the estimated period of postcontract support when a contract contained unspecified software upgrade rights.

 

The Audit Committee concurred with management’sdecisions.

 

 

4

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The effect of correcting improperly recognized revenueand cost of net sales was to (reduce) increase previously reported net sales,gross profit and net income by the following amounts (in thousands of dollars):

 

| ** **                        | ** ** | **Net sales** | ** ** | **Gross profit** | ** ** | **Net income** | ** ** |
|-----------------------------------|------------|---------------|------------|------------------|------------|----------------|------------|
| Year ended December 31,           |       |          |       |             |       |           |       |
| 2000                              |       | $             | (12,408    | )                | $          | (5,294         | )          | $ | (4,781 | ) |
|                              |       |          |       |             |       |           |       |
| 2001                              |       | (17,154       | )          | (6,330           | )          | (5,779         | )          |
|                              |       |          |       |             |       |           |       |
| 2002                              |       | (64,732       | )          | (22,924          | )          | (19,697        | )          |
|                              |       |          |       |             |       |           |       |
| 2003                              |       | (21,060       | )          | (8,014           | )          | (6,382         | )          |
|                              |       |          |       |             |       |           |       |
| Totals through December  31, 2003 |       | (115,354      | )          | (42,562          | )          | (36,639        | )          |
|                              |       |          |       |             |       |           |       |
| 2004                              |       | (104,965      | )          | (27,241          | )          | (18,594        | )          |
|                              |       |          |       |             |       |           |       |
| 2005                              |       | (58,232       | )          | (27,863          | )          | (42,433        | )          |
|                              |       |          |       |             |       |           |       |
| 2000 - 2005 Total                 |       | $             | (278,551   | )                | $          | (97,666        | )          | $ | (97,666 | ) |
|                              |       |          |       |             |       |           |       |
| 2006 quarter ended                |       |          |       |             |       |           |       |
| March 31                          |       | 5,410         |       | 1,360            |       | 1,360          |       |
|                              |       |          |       |             |       |           |       |
| June 30                           |       | 2,379         |       | (371             | )          | (371           | )          |
|                              |       |          |       |             |       |           |       |
| Total China Sales  Restatement    |       | (270,762      | )          | (96,677          | )          | (96,677        | )          |

 

 

The cumulative effect of allof the China sales restatement adjustments to our consolidated balance sheet asof December 31, 2003 resulted in a decrease in retained earnings of $36.6million, an increase in deferred revenue of $115.4 million to account forpreviously recognized sales, an increase in deferred costs of $72.8 million toaccount for previously recognized cost of net sales, and an increase indeferred tax assets and prepaid taxes of $5.9 million. In our consolidated balance sheet at June30, 2007 the net reduction in previously recognized net sales is accounted foras deferred revenue, of which $37.6 million is classified as current and $227.2million as non-current, and the related net reduction in cost of net sales of$169.7 million is accounted for as deferred costs. These amounts are being recognizedin our consolidated statements of operations over the estimated remainingperiod of post contract support.

 

Upon completing itsinvestigation, the Audit Committee concluded that the conditions and practicesrelating to systems contracts prevalent in the Western Region resultedprimarily from the failure to prevent or detect instances of override relatedto controls in China over customer agreements, lack of proper managementoversight, unclear record retention policies and procedures relating to systemscontracts, and inadequate employee training. The Investigating Team and theAudit Committee also concluded that with respect to four regions other than theWestern Region there was no evidence of fraud or misconduct or reason tosuspect such occurred. The Investigating Team and the Audit Committee alsoconcluded that there was no credible evidence of knowledge by senior managementin China or the United States of the conditions and practices related to theWestern Region of China that were discovered in the investigation. The AuditCommittee concluded that local management in several of the sales offices inthe Western Region of China did not submit appropriate information to theCompany’s senior management in China and the United States. Therefore, in prioryears, neither the Company’s management nor the Company’s independentregistered accounting firm were able to properly evaluate the effect of thatinformation on revenue recognition. The Audit Committee also concluded thatcertain members of management in China bear varying degrees of responsibilityfor inadequate oversight of activities. As a result, certain employees in Chinahave either been terminated or placed on suspension for failure to provideadequate oversight of activities.

 

We have restructured the management of the WesternRegion sales organization and are working to identify and implement changes toour policies and procedures and enhance employee training to improve internalcontrol consciousness and lessen the possibility of accounting errors occurringin the future.

 

 

***Stock Option Accounting***

 

In November 2006, we announced we had commenced avoluntary review of historical stock option practices under the leadership ofthe Governance Committee following a preliminary review by management whichidentified potential deficiencies and discrepancies in the documentation ofstock option grants. The review considered all option grant awards 

 

 

5

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made in the period from February 29, 2000, shortly before the initialpublic offering of our Common Stock, through August 2006 (“Review Period”) forcompliance with the various stock-based compensation accounting standardsapplicable during the Review Period as well as the rules of our stock optionplans. The Governance Committee engaged independent outside legal counsel toassist in the review who, in turn, engaged forensic accountants. (Separate lawfirms and separate forensic accounting firms were engaged by the AuditCommittee and the Governance Committee for the China sales investigation andthe stock option accounting review.) In the rest of this discussion, this groupcollectively is referred to as the Stock Option Review Team and their actionsand activities are referred to as the Stock Option Review. The Stock OptionReview Team members spent over 11,000 hours in this review, and the GovernanceCommittee met with the Stock Option Review Team on more than a dozen occasionsto receive, discuss, and consider the Stock Option Review Team’s information andfindings.

 

At the time the review commenced, the GovernanceCommittee consisted of three members of the Board of Directors, all of whom areindependent directors. The Committee decided to delegate supervision of thereview to Mr. Jeff Clarke, its Chairman, who joined our Board in 2005 and hadnot served on the Compensation Committee of the Board of Directors (“CompensationCommittee”) during the period under review. The Governance Committee alsoconsisted of two other independent directors, Mr. Larry D. Horner and Mr.Thomas Toy, who also serve on the Board’s Compensation Committee. Mr. AllenLenzmeier was appointed to the Governance Committee on April 27, 2007.

Review proceduresincluded:

•                  interviews of individuals involved with granting,advising, administering, or accounting for stock options, including current andformer: management, members of the Board of Directors, employees, andnon-employee professionals;

•                  review of relevant stock administration, humanresource, legal, and finance department files and records;

•                  review of stock option grant information in selectemployee personnel files;

•                  review by at least 30 attorneys and 15 forensicaccountants of approximately 250,000 potentially relevant e-mails and documentsin electronic format selected through electronic discovery techniques from over1.8 million electronic documents processed;

•                  review of the electronic database of the Company’sstock option activity maintained by a third party along with communications toand from this service provider;

•                  reconciliation of grant activity from approvaldocuments executed by the Compensation Committee with the electronic database;

•                  reconciliation of stock option grant, exercise, andcancellation information from SEC filings with select employee personnel filesand the electronic database;

•                  statistical and judgmental pattern analysis;

•                  follow-up on matters raising questions about theoption granting process and its history, conduct of those involved withgranting, advising, administering, or accounting for stock options, or theaccounting treatment for stock options; and

•                  follow-up on items or issues requested or identifiedby management or the Company’s independent registered public accounting firm.

 

The Stock Option Review Team, management, and the GovernanceCommittee decided to group stock option grants into six award categories basedon differences in what constituted substantive approval for each category underour stock option granting practices as well as giving consideration to the riskof intentional misstatement of the grant date. Guidance in a September 19, 2006letter publicly issued by the SEC’s Chief Accountant focuses on the conceptthat a measurement date under Accounting Principles Board Opinion No. 25 *Accounting for Stock Issued to Employees*(“APB 25”), theaccounting standard governing our stock option accounting through 2005, doesnot occur until the number of shares an individual employee is entitled toreceive and the exercise price is determined with finality (i.e., no longersubject to change). This is the date on which substantive approval occurred,and depending on a company’s facts and circumstances the guidance from the SECdiscussed above recognizes a company may determine that the measurement datefor some stock option grants may occur before all required granting actionshave occurred — such as final approval by the Compensation Committee. Thisalternative is available only when a review of all facts and circumstancessupports a conclusion that substantive approval occurs earlier than when allrequired granting actions have occurred and there is no evidence of fraudulentor manipulative conduct in the company’s option granting practices.

 

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In determining the measurement date to be used, theStock Option Review Team, management, and the Governance Committee agreed touse the following definitions as constituting the proper measurement date, andgenerally these dates were used in testing the stated grant dates orestablishing corrected measurement dates:

 

| **Discretionary Director and Officer Grants** |       | The date of a Compensation Committee meeting where  the grant was approved or the date the final Compensation Committee signer  approved the grant when approval occurred through unanimous written consent  documents (“UWC”).                                                                                                                                                                                                                                                         |
|-----------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **                                    | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| **Automatic Director Grants**                 |       | The date specified in the relevant stock option  plan.                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| ** **                                    | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| **Broadbase**                                 |       | The date the grantee list, including the allocation  of shares to individual grantees, was complete. Compensation Committee  approval was considered perfunctory due to delegation of authority to  management.                                                                                                                                                                                                                                                                                   |
| ** **                                    | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| **Acquisition**                               |       | The first Compensation Committee meeting following  the acquisition, provided grantees had received employment offer letters  stating the number of stock options to be granted before such date, because  this was the date at which the option exercise price was established.  Compensation Committee approval was considered perfunctory due to delegation  of authority to management.                                                                                                       |
| ** **                                    | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| **New Hire**                                  |       | The first scheduled Compensation Committee meeting  following the first day of employment, because this was the date at which the  option exercise price was established. The number of options was based on  either grant amounts specified in an employment offer letter or, in some cases,  on a matrix that assigned grant amounts based on position and level within  the Company. Compensation Committee approval was considered perfunctory due  to delegation of authority to management. |
| ** **                                    | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| **Other Merit**                               |       | The date the grantee list, including the allocation  of shares to grantees, was substantially complete. Compensation Committee  approval was considered perfunctory due to delegation of authority to  management.                                                                                                                                                                                                                                                                                |

For 12 tested grant dateswhere a corrected measurement date was required, the Stock Option Review Teamand management were unable to locate sufficient evidence to establish acorrected measurement date using our established criteria for the applicableoption grant type. In these situations alternative available evidence was usedto establish the corrected measurement date.

During the period coveredby the Stock Option Review, we granted stock options on approximately 34million shares of our Common Stock at 197 grant dates. The review specificallyexamined the appropriateness of the stated grant date for approximately 90% ofthe stock options granted, including all stock option grants made to directorsand officers, all broadbase grants and all option grants made in connectionwith business acquisitions.

 

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The findings of thisreview are summarized as follows:

 
| **Grant  Type**                      | ** ** | **Number  of grants** | ** ** | **Grants  tested**                                  | ** ** | **No  change required**                                   | ** ** | **Measurement  date changed** | ** ** |
|--------------------------------------|------------|-----------------------|------------|-----------------------------------------------------|------------|-----------------------------------------------------------|------------|-------------------------------|------------|
| ** **                           | ** ** | ** **            | ** ** | **additional  compensation**

**expense  required** | ** ** | **no  additional compensation**

**expense  required(1)** | ** ** |
| ** **                           | ** ** | ** **            | ** ** | ** **                                          | ** ** |
| ** **                           | ** ** | ** **            | ** ** | ** **                                          | ** ** |
|                                 |       |                  |       |                                                |       |                                                      |       |                          |       |   |   |
| Discretionary Director & Officer |       | 16                    |       | 16                                                  |       | 8                                                         |       | 4                             |       | 4 |   |
| Automatic Director                   |       | 5                     |       | 5                                                   |       | 5                                                         |       | —                        |       | — |   |
| Broadbase                            |       | 8                     |       | 8                                                   |       | —                                                    |       | 6                             |       | 2 |   |
| Acquisition                          |       | 10                    |       | 10                                                  |       | 10                                                        |       | —                        |       | — |   |
| New Hire                             |       | 166                   |       | 48                                                  |       | 48                                                        |       | —                        |       | — |   |
| Other Merit                          |       | 96                    |       | 41                                                  |       | 4                                                         |       | 21                            |       | 16 |   |
| Total                                |       | 301                   | (2)   | 128                                                 |       | 75                                                        |       | 31                            |       | 22 |   |

 

(1) Under APB 25there is no expense adjustment arising from using the corrected measurementdate for these grants because the amount the employee would have to pay to exercisethese stock option grants exceeded the quoted market price of our Common Stockat the corrected measurement date, and therefore, these stock option grantscontained no intrinsic value at the corrected measurement date.

 

(2)The number of grants exceedsthe number of grant dates because on certain grant dates more than one categoryof stock option grants were approved.

In late January 2007 theGovernance Committee reported its interim findings concerning the use ofincorrect measurement dates in our stock option accounting under APB 25 to ourBoard of Directors. On February 1, 2007, the Audit Committee of the Board ofDirectors then concluded, in consultation with and upon the recommendation ofmanagement, that we should correct for errors in previously reportedstock-based compensation expense through restatement of our previously issuedfinancial statements and that our previously issued financial statements forall periods should no longer be relied upon. We communicated this decision in aFebruary 1, 2007 public announcement.

 

A non-cash compensation charge, to be recognized as anexpense over a grantee’s service period, arises under APB 25 if a stock optionhas intrinsic value at its measurement date. This intrinsic value is measuredby the excess, if any, of the fair value at the date of grant of the underlyingcommon stock over the stock option’s exercise price. Our practice has been togrant stock options with exercise prices equal to the closing price of ourCommon Stock at each grant date, to use the grant date as the measurement datefor stock-based compensation purposes, and as such previously we had determinedthe granted stock options had no intrinsic value at their grant dates and nocompensation expense was recognized. However, APB 25 states the measurementdate does not occur until all essential actions necessary to grant the optionare completed, including the final determination of both the number of sharesto be granted to each employee or director and the exercise price, and theoption grant is approved by those with requisite authority. This is reinforcedby the September 19, 2006 letter issued by the SEC’s Chief Accountant whichfocuses on the need for the number of shares and exercise price of an award toan individual to be finalized to have a measurement date. This letter clarifiesthe SEC staff’s view that if it is possible that those terms could change, ameasurement date has not occurred, even if the award’s terms are not actuallychanged.

Based on the available evidence, the review found thatthe number of shares an individual employee was entitled to receive and/or theexercise price was not determined with finality at the stated grant date on 53tested grant dates, and we should have used a later date as the measurementdate. The principal reasons for the stated grant date not qualifying as themeasurement date under APB 25 include:

•                  certainlistings of grantees, below officer level, were incomplete and added to ormodified by stock option administration personnel after the grant was approvedby the Compensation Committee;

•                  forcertain grants where Compensation Committee approval was not consideredperfunctory, the date a UWC document was sent to Compensation Committee membersfor approval was used as the stated grant date for some discretionary officerand director grants rather than the date the UWC was signed by all CompensationCommittee members and therefore became effective; and

•                  theStock Option Review Team was unable to locate contemporaneous documentation ofsome director and officer, broadbase, new hire, and other merit grants.

Duringthe review the Company also discovered a stock option grant to a former officerthat was modified in 1998 in connection with his termination of employment.This change was never included in the Company’s stock option grant records andthe additional compensation expense resulting from the change in the option’sterms  (approximately $1.2 million)  was not recorded previously. This discovery is consistent with theStock Option Review Team’s finding that in certain instances there was a lackof formal documentation in the stock option granting process and/or expecteddocumentation is missing from the stock option administration files. Inaddition, the Stock Option Review Team found that, in many instances, there wasa lack of self-authenticating evidence to corroborate that cash exercises werecontemporaneous. As a result, the findings on the issue of backdating of cashexercises were inconclusive.

 

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We restated our consolidated financial statements torecognize additional non-cash stock-based compensation expense arising fromusing corrected measurement dates for certain stock option grants made duringthe years 2000 through 2005 and to reflect the modification of the 1998 grantdescribed above. Consistent with our historical accounting policy thisadditional stock-based compensation expense is being recognized on anaccelerated basis by treating each vesting tranche as a separate stock optiongrant (graded vesting).

 

Our accounting for stock-based compensation changed toa fair value based method in 2006 when, as required by accounting standards, weceased accounting for stock-based compensation under the intrinsic value methodpursuant to APB 25 and began accounting for stock-based compensation underStatement of Financial Accounting Standards 123(R) *Share-BasedPayments*(“SFAS 123(R)”). Under this method all stock option grantshave a fair value determined using an option pricing model, and such fair valueis used to recognize non-cash stock-based compensation expense. We restated ourunaudited condensed consolidated financial statement information for the firstand second fiscal quarters of 2006, included in Exhibit 99.1 in our AnnualReport on Form 10-K for the year ended December 31, 2006 (and as reflected inour results for the three and six months ended June 30, 2006 included in thisForm 10-Q), to recognize changes in non-cash stock-based compensation expensethat arose from a re-determination of the fair value of stock options grantedin 2005 and prior where the Governance Committee’s review resulted in acorrected measurement date. By January 1, 2006, of the 17.9 million optionsgranted in 2000 - 2005 where corrections were made to the measurement dates inthe Stock Option Review, 4.4 million options with corrected measurement datesgranted in 2000 and 2001 had fully vested. Therefore, the fair values of theoutstanding and unvested portion of the remaining 13.5 million stock optionsgranted in 2002-2005 with incorrect measurement dates were recalculated. Wealso recorded additional non-cash stock-based compensation expense in the firsttwo quarters of 2006 arising from correcting the measurement date for stockoption grants to three individuals in this period. We recognize stockcompensation expense on a straight-line basis under SFAS 123(R).

 

Those stock option grants with corrected measurementdates have also been restated using the fair value based measurement principlesof Statement of Financial Accounting Standards 123 *Accountingfor Stock-Based Compensation*(“SFAS 123”) to present, in Note 2, “Restatementof Financial Statements” of Notes to Consolidated Financial Statementscontained in Item 8 of the Company’s 2006 Annual Report, the pro forma effecton stock-based compensation expense, net income (loss), and earnings (loss) pershare amounts in 2004 and 2005 of using the fair value based method todetermine stock-based compensation expense rather than using APB 25’s intrinsicvalue method. Such disclosure is required in financial statements for periodsprior to the adoption of SFAS 123(R).

 

In addition to restating the consolidated financialstatements in response to the Governance Committee’s findings, we recordedadditional non-cash adjustments to account for the modification in 1998 of astock option grant to a former officer in connection with his termination ofemployment and to record in the first two quarters of 2006 corrections relatingto accounting for performance related stock options and restricted stockgrants, all of which were previously identified and considered immaterial.

 

Correcting the measurement date for previously grantedstock options in some cases results in additional taxable income to employeeson which additional payroll taxes are due from the employees as well as us. Wehave provided for all additional payroll taxes plus related penalties andinterest arising from the restatement of stock-based compensation, includingamounts otherwise payable by stock option recipients, and our restatedfinancial statements include an accrual in all affected years of approximately$1.5 million for all estimated payroll tax related expenses.

 

9

----

 

The corrections for the stock option restatement wereto increase (reduce) previously reported non-cash compensation expense, payrolltaxes, income taxes and net income by the following amounts (in thousands ofdollars):

 

| ** **                             | ** ** | **Non-cash  stock compensation** | ** ** | **Payroll  taxes** | ** ** | **Income  taxes** | ** ** | **Net  income** | ** ** |
|----------------------------------------|------------|----------------------------------|------------|--------------------|------------|-------------------|------------|-----------------|------------|
| ** **                             | ** ** | ** **                       | ** ** | ** **         | ** ** |
| Year ended December 31,                | ** ** | ** **                       | ** ** | ** **         | ** ** | ** **        | ** ** | ** **      | ** ** |
| 1998                                   |       | $                                | 1,244      |               | $          | —            |       | $               | (448       | ) | $ | (796 | ) |
|                                   |       |                             |       |               |       |              |       |            |       |
| 1999                                   |       | —                           |       | —             |       | —            |       | —          |       |
|                                   |       |                             |       |               |       |              |       |            |       |
| 2000                                   |       | 556                              |       | —             |       | (104              | )          | (452            | )          |
|                                   |       |                             |       |               |       |              |       |            |       |
| 2001                                   |       | 4,870                            |       | —             |       | (942              | )          | (3,928          | )          |
|                                   |       |                             |       |               |       |              |       |            |       |
| 2002                                   |       | 8,110                            |       | —             |       | (1,550            | )          | (6,560          | )          |
|                                   |       |                             |       |               |       |              |       |            |       |
| 2003                                   |       | 12,470                           |       | 900                |       | (2,281            | )          | (11,089         | )          |
|                                   |       |                             |       |               |       |              |       |            |       |
| Totals through December 31,  2003 |       | 27,250                           |       | 900                |       | (5,325            | )          | (22,825         | )          |
|                                   |       |                             |       |               |       |              |       |            |       |
| 2004                                   |       | (410                             | )          | 541                |       | 250               |       | (381            | )          |
|                                   |       |                             |       |               |       |              |       |            |       |
| 2005                                   |       | (1,290                           | )          | 60                 |       | 4,083             |       | (2,853          | )          |
|                                   |       |                             |       |               |       |              |       |            |       |
| 2000-2005 Total                        |       | 25,550                           |       | 1,501              |       | (992              | )          | (26,059         | )          |
|                                   |       |                             |       |               |       |              |       |            |       |
| 2006 quarter ended                     | ** ** | ** **                       | ** ** | ** **         | ** ** | ** **        | ** ** | ** **      | ** ** |
| March 31                               |       | 662                              |       | 9                  |       | —            |       | (671            | )          |
|                                   |       |                             |       |               |       |              |       |            |       |
| June 30                                |       | 504                              |       | 6                  |       | —            |       | (510            | )          |
|                                   |       | $                                | 26,716     |               | $          | 1,516             |       | $               | (992       | ) | $ | (27,240 | ) |

 

 

 

The Governance Committee’s review found 17.9 millionstock options of the 28.8 million options granted on our Common Stock during2000 through 2005 had incorrect measurement dates. Using the correctedmeasurement dates, 7.6 million stock options had exercise prices that exceededthe closing price of our Common Stock and therefore had no intrinsic value tobe accounted for under APB 25, and 10.3 million stock options had intrinsicvalue because their exercise prices were below the closing price of our CommonStock. These 10.3 million stock options resulted in an increase in additionalnon-cash stock-based compensation expense of $24.3 million, and an additional$1.5 million of payroll tax related expenses during 2000-2005 partially offsetby $0.5 million of income tax benefit as shown in the above table. Of the 10.3million stock options resulting in additional non-cash stock-based compensationexpense, 2.0 million options were granted to officers and directors andresulted in $6.1 million of additional non-cash stock-based compensationexpense.

 

The total effect of the stock option restatement andthe amounts for 2006, as shown in the above table, have been reflected in theDecember 31, 2006 financial statements as well as in the June 30, 2006financial statements. As a result of this restatement, net loss increased by$0.5 million and $1.2 million for the three and six months ended June 30, 2006,respectively.

 

Upon completing its review, the Governance Committeeconcluded it found no evidence of intent to manipulate the Company’s operatingresults or financial statements. A key finding of the Governance Committee wasthat there were deficiencies with the process by which stock options weregranted during the period from our initial public offering in 2000 through atleast 2005, which resulted in accounting errors. The Governance Committeeconcluded that certain members of management bear varying degrees ofresponsibility for the deficiencies in the process by which options weregranted. The Governance Committee’s review also concluded that none of thecurrent or former employees or directors of the Company engaged in intentionalwrongdoing.

 

In determining the above restatement amounts, management used allreasonably available relevant information to form conclusions it believes arereasonable as to the most likely option granting actions that occurred, thedates when such actions occurred, and the determination of grant dates forfinancial accounting purposes based on when the requirements of the accountingstandards were met. In light of significant judgment used in establishingrevised measurement dates, alternative approaches to those used by the StockOption Review Team and management could have resulted in different compensationcharges than those recorded in the restatement. The Stock Option Review Teamand management considered various alternatives throughout the course of thereview and restatement, and management believes the adjustments to measurementdates used in our review of stock option grant accounting and restatement ofour financial statements were reasonable and appropriate in our circumstances.

 

10

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***Summary of Restatement Amounts***

 

**               **The following table presents the decreasein net earnings from the restatement for each restated year:

 

| ** **                             | ** ** | **Net income (loss), as previously  reported** | ** **      | **Restatement adjustments** | ** **        | **Net income (loss),  as restated** | ** ** |
|----------------------------------------|------------|-----------------------------------------------------|-----------------|-----------------------------|-------------------|-------------------------------------|------------|
| ** **                             | ** ** | ** **                                          | **China Sales** | ** **                  | **Stock Options** | ** **                          | **Total**  | ** ** | ** ** |
| ** **                             | ** ** | ** **                                          | ** **      | ** **                  | ** **        | **(in thousands)**                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                             |       |                                                |            | **(Decrease) Increase**     |              |                                |       |
| Year ended December 31,           |       |                                                |            |                        |              |                                |       |   |   |   |   |
| 1998                                   |       |                                                |            | $                           | —            |                                | $          | (796 | ) | $ | (796 | ) |   |   |
| 1999                                   |       |                                                |            | —                      |              | —                              |       | — |   |   |   |
| 2000                                   |       |                                                |            | (4,781                      | )                 | (452                                | )          | (5,233 | ) |   |   |
| 2001                                   |       |                                                |            | (5,779                      | )                 | (3,928                              | )          | (9,707 | ) |   |   |
| 2002                                   |       | $                                                   | 107,862         |                        | (19,697           | )                                   | (6,560     | ) | (26,257 | ) | $ | 81,605 |   |
| 2003                                   |       | $                                                   | 209,856         |                        | (6,382            | )                                   | (11,089    | ) | (17,471 | ) | $ | 192,385 |   |
| Totals  through December 31, 2003 |       |                                                |            | (36,639                     | )                 | (22,825                             | )          | (59,464 | ) |   |   |
| 2004                                   |       | $                                                   | 69,824          |                        | (18,594           | )                                   | (381       | ) | (18,975 | ) | $ | 50,849 |   |
| 2005                                   |       | ($487,359                                           | )               | (42,433                     | )                 | (2,853                              | )          | (45,286 | ) | $ | (532,645 | ) |
| 2000  - 2005 Total                     |       |                                                |            | (97,666                     | )                 | (26,059                             | )          | (123,725 | ) |   |   |
|                                   |       |                                                |            |                        |              |                                |       |   |   |   |   |
| 2006 quarter ended                     |       |                                                |            |                        |              |                                |       |   |   |   |   |
| March  31                              |       | ($10,635                                            | )               | 1,360                       |              | (671                                | )          | 689 |   | $ | (9,946 | ) |
| June  30                               |       | ($21,443                                            | )               | (371                        | )                 | (510                                | )          | (881 | ) | $ | (22,324 | ) |
|                                   |       |                                                |            | $                           | (96,677           | )                                   | $          | (27,240 | ) | $ | (123,917 | ) |   |   |
|                                        |            |                                                     |                 |                             |                   |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

The cumulative effect onstockholders’ equity at December 31, 2003 from the above corrections was asfollows (in thousands):

 

| Increase (decrease) in paid-in capital and deferred stock  compensation:       |   |    |    |
|--------------------------------------------------------------------------------|--------|---------|---------|
|                                                                           |   |    |    |
|  Values assigned to stock  options                                        |   | $       | 27,250  |   |
|  Reduction of previously  recorded income tax benefits from stock options |   | (1,278  | )       |
|                                                                           |   |    |    |
|  Net increase in paid-in  capital and deferred stock compensation         |   | 25,972  |    |
|                                                                           |   |    |    |
| (Increase) decrease in accumulated deficit:                                    |   |    |    |
|                                                                           |   |    |    |
|  Revenue and related cost of  sales deferral for China system sales       |   | (36,639 | )       |
|  Additional non-cash  compensation expense from stock options             |   | (27,250 | )       |
|  Payroll taxes for values  assigned to stock options                      |   | (900    | )       |
|  Income tax benefit from  additional compensation and payroll tax expense |   | 5,325   |    |
|                                                                           |   |    |    |
|  Net increase in accumulated  deficit                                     |   | (59,464 | )       |
|                                                                           |   |    |    |
| Net decrease in stockholders’ equity at December 31, 2003                 |   | $       | (33,492 | ) |
|                                                                                |        |         |         |  |  |

 

 

11

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In restating thepreviously issued financial statements for the investigations discussed above,we also corrected other previously reported amounts. We corrected the reporting of  netsales to certain third party resellers and associated cost of net sales for thethree and six months ended June 30, 2006 to classify these amounts as relatedparty net sales and related party cost of net sales classifications of $4.2million and $3.0 million, respectively, and $12.9 million and $4.8 million,respectively, because in 2006 we determined that sales to these entities were,in substance, sales to a significant shareholder, SOFTBANK CORP. Theclassification of the accounts receivable from these sales was similarlychanged to include them in accounts receivable from related parties in the June30, 2006 consolidated balance sheet.   We also corrected our reporting of $6.2 million of time deposits atJune 30, 2006 because they did not mature within three months. Formerly thetime deposits had been reported in error as cash equivalents, but now theseamounts are included in short-term investments in the balance sheet and in thestatement of cash flows for the June 2006 reporting period.

 

 

12

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**PART I—FINANCIAL INFORMATION**

 

**ITEM 1—CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

**UTSTARCOM, INC.**

**CONDENSED CONSOLIDATED BALANCESHEETS (UNAUDITED)**

**(In thousands, except share data)**

** **
| ** **                                                                                                                                              | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------|------------|------------------|------------|
| ** **                                                                                                                                              | ** ** | **2007**     | ** ** | **2006**         | ** ** |
| **ASSETS**                                                                                                                                              | ** ** | ** **   | ** ** | ** **       | ** ** |
| Current assets:                                                                                                                                         |       |         |       |             |       |
| Cash and cash equivalents                                                                                                                               |       | $            | 509,423    |             | $          | 661,623 |   |
| Short-term investments                                                                                                                                  |       | 18,156       |       | 9,546            |       |
| Accounts  receivable, net of allowances for doubtful accounts of $56,856 and $53,894 at  June 30, 2007 and December 31, 2006, respectively              |       | 295,557      |       | 373,762          |       |
| Accounts  receivable, related parties, net of allowances for doubtful accounts of $12  and $19 at June 30, 2007 and December 31, 2006, respectively     |       | 27,335       |       | 32,318           |       |
| Notes receivable                                                                                                                                        |       | 4,083        |       | 5,060            |       |
| Inventories                                                                                                                                             |       | 466,222      |       | 440,445          |       |
| Deferred costs                                                                                                                                          |       | 186,734      |       | 195,393          |       |
| Prepaids and other current assets                                                                                                                       |       | 132,882      |       | 101,795          |       |
| Short-term restricted cash and investments                                                                                                              |       | 9,797        |       | 16,666           |       |
| Total current assets                                                                                                                                    |       | 1,650,189    |       | 1,836,608        |       |
| Property, plant and equipment, net                                                                                                                      |       | 212,873      |       | 213,155          |       |
| Long-term investments                                                                                                                                   |       | 96,407       |       | 47,809           |       |
| Goodwill                                                                                                                                                |       | 3,063        |       | 3,063            |       |
| Intangible assets                                                                                                                                       |       | 48,351       |       | 56,443           |       |
| Long-term deferred costs                                                                                                                                |       | 169,745      |       | 176,649          |       |
| Other long-term assets                                                                                                                                  |       | 38,445       |       | 40,223           |       |
| Total assets                                                                                                                                            |       | $            | 2,219,073  |             | $          | 2,373,950 |   |
|                                                                                                                                                    |       |         |       |             |       |
| **LIABILITIES, MINORITY INTEREST AND STOCKHOLDERS’  EQUITY**                                                                                       | ** ** | ** **   | ** ** | ** **       | ** ** |
| Current liabilities:                                                                                                                                    |       |         |       |             |       |
| Accounts payable                                                                                                                                        |       | $            | 219,736    |             | $          | 304,869 |   |
| Short-term debt                                                                                                                                         |       | 379,935      |       | 102,758          |       |
| Income taxes payable                                                                                                                                    |       | —       |       | 2,483            |       |
| Customer advances                                                                                                                                       |       | 298,104      |       | 265,812          |       |
| Deferred revenue                                                                                                                                        |       | 96,422       |       | 95,742           |       |
| Other current liabilities                                                                                                                               |       | 231,341      |       | 271,400          |       |
| Total current liabilities                                                                                                                               |       | 1,225,538    |       | 1,043,064        |       |
|                                                                                                                                                    |       |         |       |             |       |
| Long-term deferred revenue                                                                                                                              |       | 243,999      |       | 261,014          |       |
| Long-term debt                                                                                                                                          |       | 460          |       | 275,161          |       |
| Other long-term liabilities                                                                                                                             |       | 21,307       |       | 13,858           |       |
| Total liabilities                                                                                                                                       |       | 1,491,304    |       | 1,593,097        |       |
|                                                                                                                                                    |       |         |       |             |       |
| Commitments and contingencies (Note 15)                                                                                                                 |       |         |       |             |       |
| Minority interest in consolidated subsidiaries                                                                                                          |       | 5,331        |       | 6,493            |       |
| Stockholders’ equity:                                                                                                                              |       |         |       |             |       |
| Common stock: $0.00125 par value; 750,000,000 authorized shares; 121,299,113  issued and 121,294,645 outstanding at June 30, 2007 and December 31, 2006 |       | 152          |       | 152              |       |
| Additional paid-in capital                                                                                                                              |       | 1,210,531    |       | 1,205,592        |       |
| Accumulated deficit                                                                                                                                     |       | (611,284     | )          | (494,244         | )          |
| Accumulated other comprehensive income                                                                                                                  |       | 123,078      |       | 62,899           |       |
| Treasury stock: 4,468 shares held in treasury at June 30, 2007 and  December 31, 2006                                                                   |       | (39          | )          | (39              | )          |
| Total stockholders’ equity                                                                                                                         |       | 722,438      |       | 774,360          |       |
| Total liabilities, minority interest and stockholders’ equity                                                                                      |       | $            | 2,219,073  |             | $          | 2,373,950 |   |
|                                                                                                                                                         |            |              |            |                  |            |  |  |  |

 

See accompanying notes to the condensedconsolidated financial statements.

 

13

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**UTSTARCOM, INC.**

**CONDENSED CONSOLIDATED STATEMENTSOF OPERATIONS (UNAUDITED)**

**(In thousands, except per sharedata)**

 
| ** **                                               | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                                               | ** ** | **2007**                        | ** ** | **2006**                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                               | ** ** | ** **                      | ** ** | **(As restated)**             | ** ** | ** ** | ** ** | **(As restated)** | ** ** |
| Net sales                                                |       |                            |       |                          |       |   |   |   |   |
| Unrelated party                                          |       | $                               | 517,361    |                          | $          | 513,897 |   | $ | 979,934 |   | $ | 1,070,934 |   |
| Related party                                            |       | 20,884                          |       | 37,628                        |       | 34,212 |   | 82,572 |   |
|                                                     |       | 538,245                         |       | 551,525                       |       | 1,014,146 |   | 1,153,506 |   |
| Cost of net sales                                        |       |                            |       |                          |       |   |   |   |   |
| Unrelated party                                          |       | 441,738                         |       | 414,112                       |       | 832,277 |   | 875,697 |   |
| Related party                                            |       | 16,777                          |       | 28,463                        |       | 26,855 |   | 45,068 |   |
| Gross profit                                             |       | 79,730                          |       | 108,950                       |       | 155,014 |   | 232,741 |   |
|                                                     |       |                            |       |                          |       |   |   |   |   |
| Operating expenses:                                      |       |                            |       |                          |       |   |   |   |   |
| Selling, general and administrative                      |       | 88,865                          |       | 83,108                        |       | 168,701 |   | 166,833 |   |
| Research and development                                 |       | 42,158                          |       | 46,603                        |       | 85,819 |   | 93,005 |   |
| Amortization of intangible assets                        |       | 4,046                           |       | 4,821                         |       | 8,092 |   | 9,746 |   |
| Total operating expenses                                 |       | 135,069                         |       | 134,532                       |       | 262,612 |   | 269,584 |   |
|                                                     |       |                            |       |                          |       |   |   |   |   |
| Operating loss                                           |       | (55,339                         | )          | (25,582                       | )          | (107,598 | ) | (36,843 | ) |
|                                                     |       |                            |       |                          |       |   |   |   |   |
| Interest income                                          |       | 3,395                           |       | 3,947                         |       | 8,304 |   | 7,479 |   |
| Interest expense                                         |       | (7,321                          | )          | (3,166                        | )          | (14,046 | ) | (6,667 | ) |
| Other income (expense), net                              |       | 158                             |       | 6,887                         |       | 4,129 |   | 10,454 |   |
|                                                     |       |                            |       |                          |       |   |   |   |   |
| Loss before income taxes and minority interest           |       | (59,107                         | )          | (17,914                       | )          | (109,211 | ) | (25,577 | ) |
| Income tax expense                                       |       | (3,298                          | )          | (4,669                        | )          | (7,640 | ) | (7,508 | ) |
| Minority interest in losses of consolidated subsidiaries |       | 698                             |       | 259                           |       | 1,161 |   | 815 |   |
| Net loss                                                 |       | $                               | (61,707    | )                             | $          | (22,324 | ) | $ | (115,690 | ) | $ | (32,270 | ) |
|                                                     |       |                            |       |                          |       |   |   |   |   |
| Loss per share - Basic and diluted                       |       | $                               | (0.51      | )                             | $          | (0.19 | ) | $ | (0.96 | ) | $ | (0.27 | ) |
|                                                     |       |                            |       |                          |       |   |   |   |   |
| Weighted average shares used in per-share calculation:   |       |                            |       |                          |       |   |   |   |   |
| - Basic and diluted                                      |       | 120,982                         |       | 120,608                       |       | 120,941 |   | 120,604 |   |
|                                                          |            |                                 |            |                               |            |  |  |  |  |  |  |  |  |  |

 

See accompanying notes to the condensedconsolidated financial statements.

 

14

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**UTSTARCOM, INC.**

**CONDENSED CONSOLIDATED STATEMENTSOF CASH FLOWS (UNAUDITED)**

**(In thousands)**

 
| ** **                                                                                 | ** ** | **Six months ended   June 30, 2007** | ** ** | **Six months ended**

** June 30, 2006** | ** ** |
|--------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                                 | ** ** | ** **                           | ** ** | **(As restated)**                             | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                      |       |                                 |       |                                          |       |
| Net loss                                                                                   |       | $                                    | (115,690   | )                                             |       | $ | (32,270 | ) |
| Adjustments to reconcile net loss to net cash (used in) provided by  operating activities: |       |                                 |       |                                          |       |
| Depreciation and amortization                                                              |       | 29,737                               |       | 34,653                                        |       |
| Net (gain) loss on sale and disposal of assets                                             |       | (2,629                               | )          | 2,169                                         |       |
| Net gain on long-term investment                                                           |       | (366                                 | )          | —                                        |       |
| Stock-based compensation expense                                                           |       | 4,939                                |       | 7,542                                         |       |
| Provision for doubtful accounts                                                            |       | 2,370                                |       | 3,133                                         |       |
| (Recovery of) provision for deferred costs reserves                                        |       | (8,136                               | )          | 5,978                                         |       |
| Deferred income taxes                                                                      |       | 1,267                                |       | —                                        |       |
| Other                                                                                      |       | (366                                 | )          | (537                                          | )          |
| Changes in operating assets and liabilities:                                               |       |                                 |       |                                          |       |
| Accounts receivable                                                                        |       | 84,696                               |       | 97,596                                        |       |
| Inventories                                                                                |       | (19,369                              | )          | (36,916                                       | )          |
| Deferred costs                                                                             |       | 31,563                               |       | (6,853                                        | )          |
| Other assets                                                                               |       | (28,637                              | )          | (7,784                                        | )          |
| Accounts payable                                                                           |       | (89,502                              | )          | 39,693                                        |       |
| Income taxes payable                                                                       |       | 6,801                                |       | 3,438                                         |       |
| Customer advances                                                                          |       | 27,141                               |       | 69,280                                        |       |
| Deferred revenue                                                                           |       | (23,982                              | )          | (10,512                                       | )          |
| Other current liabilities                                                                  |       | (49,135                              | )          | (89,454                                       | )          |
| Net cash (used in) provided by operating activities                                        |       | (149,298                             | )          | 79,156                                        |       |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                      |       |                                 |       |                                          |       |
| Additions to property, plant and equipment                                                 |       | (15,425                              | )          | (12,288                                       | )          |
| Proceeds from the disposition of long-term investments                                     |       | 1,800                                |       | —                                        |       |
| Investment in affiliates, net of cash acquired                                             |       | —                               |       | (302                                          | )          |
| Proceeds from sale of semiconductor design assets                                          |       | —                               |       | 19,965                                        |       |
| Change in restricted cash and long-term investments                                        |       | 6,615                                |       | (19,994                                       | )          |
| Purchase of short-term investments                                                         |       | (21,735                              | )          | (28,032                                       | )          |
| Proceeds from sale of short-term investments                                               |       | 13,484                               |       | 25,588                                        |       |
| Other                                                                                      |       | (230                                 | )          | 1,672                                         |       |
| Net cash used in investing activities                                                      |       | (15,491                              | )          | (13,391                                       | )          |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                      |       |                                 |       |                                          |       |
| Proceeds from borrowing                                                                    |       | 64,621                               |       | 62,545                                        |       |
| Payments on borrowings                                                                     |       | (64,732                              | )          | (140,053                                      | )          |
| Other                                                                                      |       | 4,728                                |       | 1,967                                         |       |
| Net cash provided by (used in) financing activities                                        |       | 4,617                                |       | (75,541                                       | )          |
| Effect of exchange rate changes on cash and cash equivalents                               |       | 7,972                                |       | 5,225                                         |       |
| Net decrease in cash and cash equivalents                                                  |       | (152,200                             | )          | (4,551                                        | )          |
| CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD                                           |       | 661,623                              |       | 645,571                                       |       |
| CASH AND CASH EQUIVALENTS AT END OF PERIOD                                                 |       | $                                    | 509,423    |                                          | $          | 641,020 |   |
|                                                                                       |       |                                 |       |                                          |       |
| Supplemental disclosure of cash flow information:                                          |       |                                 |       |                                          |       |
| Cash paid:                                                                                 |       |                                 |       |                                          |       |
| Interest                                                                                   |       | $                                    | 7,054      |                                          | $          | 4,596 |   |
| Income taxes                                                                               |       | $                                    | 3,687      |                                          | $          | 3,529 |   |
| Non-cash operating activities                                                              |       |                                 |       |                                          |       |
| Accounts receivable transferred to notes receivable                                        |       | $                                    | 11,462     |                                          | $          | 15,376 |   |
| Property, plant and equipment exchanged for long-term investment                           |       | $                                    | —     |                                          | $          | 5,500 |   |
|                                                                                            |            |                                      |            |                                               |            |  |  |  |  |  |  |

 

Seeaccompanying notes to the condensed consolidated financial statements.

 

15

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**UTSTARCOM, INC.**

 

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(UNAUDITED)**

 

**NOTE 1 - BASIS OF PRESENTATIONAND LIQUIDITY**

 

                Theaccompanying unaudited condensed consolidated financial statements include theaccounts of UTStarcom, Inc. (“Company”) and its wholly and majority ownedsubsidiaries. All significant intercompany accounts and transactions have beeneliminated in the preparation of the condensed consolidated financialstatements. The minority interests in consolidated subsidiaries is shown separatelyin the condensed consolidated financial statements.

 

                Theaccompanying unaudited condensed consolidated financial statements as of June30, 2007 and for the three and six months ended June 30, 2007 and 2006 havebeen prepared by the Company pursuant to the rules and regulations of theSecurities and Exchange Commission (“SEC”). Certain information and footnotedisclosures normally included in financial statements prepared in accordancewith generally accepted accounting principles have been condensed or omittedpursuant to such rules and regulations. The December 31, 2006 balancesheet was derived from audited financial statements, but does not include alldisclosures required by generally accepted accounting principles. Thesecondensed consolidated financial statements should be read in conjunction withthe Company’s December 31, 2006 financial statements, including the notesthereto, and the other information set forth in the Company’s Annual Report onForm 10-K for the year ended December 31, 2006.

 

                Inthe opinion of management, the accompanying unaudited condensed consolidatedfinancial statements reflect all adjustments (consisting of only normalrecurring adjustments) considered necessary for a fair statement of the Company’sfinancial condition, the results of its operations and its cash flows for theperiods indicated. The results of operations for the three and six months endedJune 30, 2007 are not necessarily indicative of the operating results for thefull year.

 

The Company reported net losses in each quarter in theperiod beginning April 1, 2005 and continuing through June 30, 2007, which hasresulted in an accumulated deficit of $611.3 million and total stockholders’equity being reduced to $722.4 million at June 30, 2007.  Additionally, at June 30, 2007, the Companyhad short-term debt in China under its lines of credit of $105.1 millionmaturing in 2007 and  convertiblesubordinated notes, outside of China, with a principal balance of $274.6 millionthat matures in March 2008. On January 9, 2007 and July 26, 2007 the Companyand the holders of the convertible subordinated notes entered into twoagreements to prevent covenant defaults occurring from the Company’s inabilityto timely file required periodic reports containing financial statements withthe SEC.  For additional informationregarding these agreements, see Note 25. As a result of these agreements, convertible subordinated notes accruedinterest at a rate of 7.625% per annum as of January 9, 2007 and the interestrate increased to 10.875% effective as of July 26, 2007.  On October 15, 2007, the Company received anadditional notice of default from the Trustee asserting that a default hadoccurred under the Indenture (as amended by the First Supplemental Indentureand the Second Supplemental Indenture) with respect to the Notes.  The specific purported defaults referred toin the notice of default were (i) the Company’s failure to file with the SECand provide copies to the Trustee of its Quarterly Report on Form 10-Q for thefiscal quarter ended March 31, 2007 and its Quarterly Report on Form 10-Q forthe fiscal quarter ended June 30, 2007 and (ii) the Company’s failure todeliver to the Trustee its officer’s certificate of compliance required by theIndenture.  The notice of defaultprovides that the Company has 60 consecutive days from October 15, 2007 to curethe purported defaults before such defaults would constitute an “Event ofDefault” under the Indenture.  The Company filed its Q1 2007 Form 10-Q on October17, 2007, and with the filing of this Q2 2007 Form 10-Q, the Company is nowcurrent with all its periodic filings with the SEC.

 

The Company’s cash and short-term investments aggregated $527.6 million (of which$415.5 million are held in China) at June 30, 2007.

 

Credit facilities in China at June 30, 2007 totaled$702.8 million, with $358.6 million of this amount available for workingcapital purposes, of which the Company had drawn $105.1 million in outstandingborrowings, and $344.2 million was available for use in support of letters ofcredit and corporate guarantees. These facilities expire primarily in Novemberand December of 2007, and the Company believes that based upon its recentfinancial performance and financial position its lenders may reduce the totalavailable credit when it negotiates renewals of these lines. Furthermore, eachborrowing under the credit facilities is subject to the bank’s currentfavorable opinion of the credit worthiness of the Company’s China subsidiaries,as well as the bank having funds available for lending and other Chinesebanking regulations. However, the Company believes the amounts of credit itslenders may make available and the borrowings made under the renewed lines ofcredit will be sufficient to meet planned uses of these credit facilities.

 

To meet liquidity needs outside of China, the Company’ssubsidiaries in China have the ability to transfer cash to

 

16

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the Company under China’s current exchange control regulations.  The amount of cash available for transferfrom the Company’s China subsidiaries is limited both by the Company’sliquidity needs in China and by Chinese government requirements that the Chinasubsidiaries retain adequate capital levels in China to protect creditors andto have funds available for mandated employee benefits.  The Company believed the China subsidiariescould freely transfer at least $200 million to the Company as of December 31,2006, and during the nine months ended September 30, 2007 its China subsidiarieshave made such transfers totaling $150 million.

 

Although management believes the Company has asufficient amount of cash resources to finance the Company’s anticipatedworking capital and capital expenditure requirements for the next 12 months,the Company does not have enough cash outside of China to repay the convertiblenotes due on March 1, 2008. Management’s liquidity plans include a partial orcomplete refinancing of the convertible notes, renewal of the lines of creditin China, transfers of more cash from its subsidiaries in China to the extentnecessary, and, if needed, liquidation of certain investments and/or seekingnew financing arrangements. The Company’s ability to maintain sufficientliquidity is also dependent on achieving projected sales and operating marginforecasts.

 

If additional sources of liquidity were needed, theCompany would consider new debt or equity offerings or obtaining cash fromasset sales, but there is no assurance that such transactions could beconsummated on acceptable terms or at all. Failure to raise sufficient capitalwhen needed could have a material adverse effect on the business, results ofoperations and financial position of the Company.

 

**NOTE 2 - RESTATEMENT OF FINANCIALSTATEMENTS**

 

The consolidated financial statements for the threeand six months ended June 30, 2006 included herein have been restated.  The reasons for the restatement are discussedbelow.

 

***China SalesInvestigation***

 

The Audit Committee of the Company’s Board ofDirectors (“Audit Committee”) engaged independent counsel to conduct aninvestigation of sales in China following a determination by the Internal Auditgroup that allegations of improper activities in a sales office in the WesternRegion were credible. The allegations were made by a Company employee using theCompany’s whistle blower program. The independent counsel engaged theassistance of forensic accountants, and this group is collectively referred toas the Investigating Team in the rest of this discussion.

 

In conducting its procedures, the Investigating Teamfound instances where the customer contracts that evidenced thearrangement  contained obligations forthe Company to deliver software upgrades when and if made available for theequipment sold for no additional consideration and for an unspecified periodthat could extend over the term of the contract. This additional contractobligation is an element of “post contract support.”  In these cases, the Investigating Team foundthat the contract documentation for the same transaction submitted by the salesoffice to the Company’s China headquarters for accounting purposes and utilizedby the Company in determining the amount of revenue recognized did not includeevidence of such post contract support obligations.

 

Accounting standards governing revenue recognition forsystem sales require all revenue to be deferred while there are undeliveredelements under the arrangement unless the seller has established vendorspecific objective evidence (“VSOE”) of fair value for such contract elements.Because these arrangements included such undelivered elements, revenue shouldbe deferred based on the VSOE of the fair value of the underlying elements.VSOE of fair value represents the price charged when the same element is soldseparately.  Since the Company does notsell this element separately, it has not established VSOE for such undeliveredelements, and as such the revenue from such contracts is required to bedeferred and recognized over the period the Company is obligated to provide thepost contract support.

 

Upon completion of the investigative phase of theindependent investigation by the Audit Committee, management:

 

•                  conducted follow-up procedures to attemptto locate any additional relevant information to ensure the China salesinvestigation considered all available information and documents;

 

•                  evaluated the accounting for identifiedsystem sales using the contract template and documentation found in the salescontract files from the Western Region offices. This included calculating thefinancial statement effects of correcting the accounting for all system saleswhere the contract template found at the sales offices contained post contractsupport obligations to recognize revenue and cost of net sales over estimatedperiod of post contract support; and

 

17

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•                  concluded that as a result of thisundelivered post contract support obligation the Company’s previously issuedfinancial statements should be restated to defer system sales contract revenueand the related cost of net sales over the estimated period of post contractsupport when a contract contained unspecified software upgrade rights.

 

The Audit Committee concurred with management’sdecisions.

 

The effect of correcting improperly recognized revenueand cost of net sales was to (reduce) increase previously reported net sales,gross profit and net income by the following amounts (in thousands of dollars):

 

 

 

 

| ** **                         | ** ** | **Net sales** | ** ** | **Gross profit** | ** ** | **Net income** | ** ** |
|------------------------------------|------------|---------------|------------|------------------|------------|----------------|------------|
| Year ended December 31,            |       |          |       |             |       |           |       |
| 2000                               |       | $             | (12,408    | )                | $          | (5,294         | )          | $ | (4,781 | ) |
| 2001                               |       | (17,154       | )          | (6,330           | )          | (5,779         | )          |
| 2002                               |       | (64,732       | )          | (22,924          | )          | (19,697        | )          |
| 2003                               |       | (21,060       | )          | (8,014           | )          | (6,382         | )          |
| Totals through December  31, 2003  |       | (115,354      | )          | (42,562          | )          | (36,639        | )          |
| 2004                               |       | (104,965      | )          | (27,241          | )          | (18,594        | )          |
| 2005                               |       | (58,232       | )          | (27,863          | )          | (42,433        | )          |
| 2000 - 2005 Total                  |       | $             | (278,551   | )                | $          | (97,666        | )          | $ | (97,666 | ) |
|                               |       |          |       |             |       |           |       |
| Three months ended March  31, 2006 |       | 5,410         |       | 1,360            |       | 1,360          |       |
| Three months ended June  30, 2006  |       | 2,379         |       | (371             | )          | (371           | )          |
| Six months ended June 30,  2006    |       | 7,789         |       | 989              |       | 989            |       |
|                               |       | $             | (270,762   | )                | $          | (96,677        | )          | $ | (96,677 | ) |
|                                    |            |               |            |                  |            |                |            |  |  |  |  |  |

 

In our consolidated balance sheet at June 30, 2007 thenet reduction in previously recognized net sales is accounted for as deferredrevenue, of which $37.6 million is classified as current and $227.2 million asnon-current, and the related net reduction in cost of net sales of $169.7million is accounted for as deferred costs. These amounts will be recognized inour consolidated statements of operations over the estimated remaining period ofpost contract support.   Due to thisrestatement, we increased (decreased) net sales, gross profit, and net income(in thousands) for the three and six month period ended June 30, 2006 asfollows: $2,379, ($371) and ($371), respectively, and $7,789, $989 and $989,respectively.

 

*Audit Committee Findings*

 

Upon completing its investigation, the Audit Committeeconcluded that the conditions and practices relating to systems contractsprevalent in the Western Region resulted primarily from the failure to preventor detect instances of override related to controls in China over customeragreements, lack of proper management oversight, unclear record retentionpolicies and procedures relating to systems contracts, and inadequate employeetraining.  The Investigating Team and theAudit Committee also concluded that with respect to four regions other than theWestern Region there was no evidence of fraud or misconduct or reason tosuspect such occurred. The Investigating Team and the Audit Committee alsoconcluded that there was no credible evidence of knowledge by senior managementin China or the United States of the conditions and practices related to theWestern Region of China that were discovered in the investigation. The AuditCommittee concluded that local management in several of the sales offices inthe Western Region of China did not submit appropriate information to theCompany’s senior management in China and the United States. Therefore, in prioryears, neither the Company’s management nor the Company’s independentregistered accounting firm were able to properly evaluate the effect of thatinformation on revenue recognition. The Audit Committee also concluded thatcertain members of management in China bear varying degrees of responsibilityfor inadequate oversight of activities. As a result, certain employees in Chinahave either been terminated or placed on suspension for failure to provideadequate oversight of activities.

 

18

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***Governance Committee Review ofHistorical Stock Option Accounting***

 

In November 2006 the Companyannounced it had commenced a voluntary review of historical stock optionpractices under the leadership of the Nominating and Corporate GovernanceCommittee of the Company’s Board of Directors (“Governance Committee”)following a preliminary review by management which identified potentialdeficiencies and discrepancies in the documentation of stock option grants. Thereview considered all option grant awards made in the period from February 29,2000, shortly before the initial public offering of the Company’s Common Stock,through August 2006 (“Review Period”) for compliance with the variousstock-based compensation accounting standards applicable during the ReviewPeriod, the rules of the Company’s stock option plans, and the guidance onstock option accounting issued by the SEC in the September 19, 2006 letterwhich was to be considered applicable to periods prior as well as subsequent toits issuance. At the time the review commenced, the Governance Committeeconsisted of three members of the Board of Directors, all of whom areindependent directors.  Mr. AllenLenzmeier was appointed to the Governance Committee on April 27, 2007.  The Governance Committee engaged independentoutside legal counsel to assist in the review who, in turn, engaged forensicaccounting experts (collectively referred to herein as the “Review Team”).

 

The Review Team, management,and the Governance Committee decided to group stock option grants into sixaward categories based on differences in what constituted substantive approvalfor each category under the Company’s stock option granting practices as wellas giving consideration to the risk of intentional misstatement of the grantdate.  Guidance in the September 19, 2006 letter on determiningthe date when substantive approval of a stock option grant occursrecognizes that depending on a company’s facts and circumstances a company maydetermine that the measurement date for some stock option grants may occurbefore all required granting actions have occurred — such as final approval bythe Compensation Committee. This alternative is available only when a review ofall facts and circumstances supports a conclusion that substantive approvaloccurs earlier than when all required granting actions have occurred and thereis no evidence of fraudulent or manipulative conduct in the Company’s optiongranting practices.

 

In determining themeasurement date to be used, the Review Team, management, and the GovernanceCommittee agreed to use the following definitions as constituting the propermeasurement date, and generally these dates were used in testing the statedgrant dates or establishing corrected measurement dates:

 
| **Discretionary Director and Officer Grants** |       | The date of a Compensation Committee meeting where  the grant was approved or the date the final Compensation Committee signer  approved the grant when approval occurred through unanimous written consent  documents (“UWC”).                                                                                                                                                                                                                                                        |
|-----------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **                                    | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| **Automatic Director Grants**                 |       | The date specified in the relevant stock option  plan.                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| ** **                                    | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| **Broadbase**                                 |       | The date the grantee list, including the allocation  of shares to individual grantees, was complete. Compensation Committee  approval was considered perfunctory due to delegation of authority to  management.                                                                                                                                                                                                                                                                                  |
| ** **                                    | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| **Acquisition**                               |       | The first Compensation Committee meeting following  the acquisition, provided grantees had received employment offer letters  stating the number of stock options to be granted before such date because  this was the date at which the option exercise price was established.  Compensation Committee approval was considered perfunctory due to delegation  of authority to management.                                                                                                       |
| ** **                                    | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| **New Hire**                                  |       | The first scheduled Compensation Committee meeting  following the first day of employment because this was the date at which the  option exercise price was established. The number of options was based on  either grant amounts specified in an employment offer letter or, in some  cases, on a matrix that assigned grant amounts based on position and level  within the Company. Compensation Committee approval was considered  perfunctory due to delegation of authority to management. |

 

19

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| ** **      | ** ** | ** **                                                                                                                                                                                                         |
|-----------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Other Merit** |       | The date the grantee list, including the allocation  of shares to grantees, was substantially complete. Compensation Committee  approval was considered perfunctory due to delegation of authority to  management. |

 

During the Review Period,the Company granted stock options on approximately 34 million shares of theCompany’s common stock at 197 grant dates. The review specifically examined theappropriateness of the stated grant date for approximately 90% of the stockoptions granted, including all stock option grants made to directors andofficers, all broadbase options and all option grants made in connection withbusiness acquisitions. The review included an extensive examination of theCompany’s historical stock option practices — including information from stockoption administration, human resource, legal, and accounting department filesand records as well as from e-mail communications, an electronic database ofthe Company’s stock option activity maintained by a third party, andinformation stored in Company hard drives and back-up tapes. The Review Teamalso conducted interviews of individuals involved with the granting, advising,administering, or accounting for stock options, including current and former:management, members of the Board of Directors, employees, and non-employeeprofessionals.

Thefindings of this review are summarized as follows:

** **

** **

| ** **                           | ** ** | ** **            | ** ** | ** **        | ** ** | ** **              | ** ** | **Measurement date changed**                   | ** ** |
|--------------------------------------|------------|-----------------------|------------|-------------------|------------|-------------------------|------------|------------------------------------------------|------------|
| **Grant Type**                       | ** ** | **Number of  grants** | ** ** | **Grants tested** | ** ** | **No change  required** | ** ** | **additional  compensation  expense required** | ** ** | **no additional  compensation  expense required(1)** | ** ** |
|                                 |       |                  |       |              |       |                    |       |                                           |       |   |   |
| Discretionary Director & Officer |       | 16                    |       | 16                |       | 8                       |       | 4                                              |       | 4 |   |
| Automatic Director                   |       | 5                     |       | 5                 |       | 5                       |       | —                                         |       | — |   |
| Broadbase                            |       | 8                     |       | 8                 |       | —                  |       | 6                                              |       | 2 |   |
| Acquisition                          |       | 10                    |       | 10                |       | 10                      |       | —                                         |       | — |   |
| New Hire                             |       | 166                   |       | 48                |       | 48                      |       | —                                         |       | — |   |
| Other Merit                          |       | 96                    |       | 41                |       | 4                       |       | 21                                             |       | 16 |   |
| Total                                |       | 301                   | (2)        | 128               |       | 75                      |       | 31                                             |       | 22 |   |

 

(1)          Under APB 25 there is noexpense adjustment arising from using the corrected measurement date for thesegrants because the amount the employee would have to pay to exercise thesestock option grants exceeded the quoted market price of the Company’s CommonStock at the corrected measurement date, and therefore, these stock optiongrants contained no intrinsic value at the corrected measurement date.

 

(2)          The number of grants exceedsthe number of grant dates because on certain grant dates more than one categoryof stock option grants were approved.

 

Anon-cash compensation charge, to be recognized as an expense over a grantee’sservice period, arises under Accounting Principles Board Opinion No. 25 *Accountingfor Stock Issued to Employees*(“APB 25”), the accounting standardgoverning the Company’s stock option accounting through 2005, if a stockoption has intrinsic value at its measurement date. This intrinsic value ismeasured by the excess, if any, of the fair value at the date of grant of theunderlying common stock over the stock option’s exercise price. The Company’spractice has been to grant stock options with exercise prices equal to theclosing price of the underlying Company common stock at each grant date, to usethe grant date as the measurement date for stock-based compensation purposes,and as suchpreviously the Company had determined the granted stock optionshad no intrinsic value at their grant dates and no compensation expense wasrecognized.  However, APB 25 states the measurement date does notoccur until all essential actions necessary to grant the option are completed,including the final determination of both the number of shares to be granted toeach employee or director and the exercise price, and the option grant isapproved by those with requisite authority. A September 19, 2006 letterpublicly issued by the SEC’s Chief Accountant focused companies registered withthe SEC on the need for the number of shares and exercise price of an award toan individual to be finalized to have a measurement date. This letter clarifiesthe SEC staff’s view that if it is possible that those terms could change, ameasurement date has not occurred, even if the award’s terms are not actuallychanged.

 

Based on availableevidence, the review found that the number of shares an individual employee wasentitled to receive and/or the exercise price for stock option grants was notdetermined with finality at the stated grant date at 53 tested grant dates, andthe Company should have used a later date as the measurement date. Theprincipal reasons for the stated grant date not qualifying as the measurementdate under APB 25 include:

 

•                  certainlistings of grantees, below officer level, were incomplete and added to ormodified by stock option administration personnel after the grant was approvedby the Compensation Committee;

•                  forcertain grants where Compensation Committee approval was not consideredperfunctory, the date a UWC document was sent to Compensation Committee membersfor approval was used as the stated grant date for some discretionary officerand director grants rather than the date the UWC was signed by all CompensationCommittee members and therefore became effective; and

•                  theStock Option Review Team was unable to locate contemporaneous documentation ofsome director and officer, broadbase, new hire, and other merit grants.

 

20

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A total of 17.9 million stock options were granted at the 53 testedgrant dates during 2000 through 2005 where the Governance Committee’s reviewfound the Company used incorrect measurement dates. Using the correctedmeasurement dates, 10.3 million stock options had intrinsic value because theirexercise prices were below the closing price of the Company’s Common Stock atthe corrected measurement date, and 7.6 million stock options had exerciseprices that exceeded the closing price of the Company’s Common Stock andtherefore had no intrinsic value to be accounted for under APB 25. These 10.3million stock options resulted in an increase in non-cash stock-basedcompensation expense of $24.3 million during 2000 to 2005.  Of the 10.3 million stock options resultingin additional non-cash stock-based compensations expense, 2.0 million optionswere granted to officers and directors and resulted in $6.1 million ofadditional non-cash stock-based compensation expense.

 

In some cases, in correcting the measurement date for previouslygranted stock options additional taxable income to employees arises on whichadditional payroll taxes are due from the employee as well as the Company. TheCompany has assumed responsibility for all additional payroll taxes plusrelated penalties and interest arising from the restatement of stock-basedcompensation, including amounts otherwise payable by stock option recipients,and the Company’s restated financial statements include a $1.5 million accrualfor this estimated expense.

 

Because the holders of stockoptions where corrections were made to the measurement dates were not awarethat improper measurement dates were used, the Company has taken certainactions and is contemplating taking additional actions to deal with the adversepersonal income tax consequences that may be incurred by the holders of stockoptions with corrected measurement dates. Adverse personal income taxconsequences arise from the exercise of stock options vesting afterDecember 31, 2004 where the corrected measurement dates cause them to havean exercise price below the fair market value of Company’s common stock at themeasurement date (“409A Affected Options”). Such an exercise would subject theoption holder to a penalty tax under IRC Section 409A (and, as applicable,similar penalty taxes under California and other state tax laws). The Companyhas evaluated its stock option exercises through December 31, 2006 anddetermined there were no exercises of 409A Affected Options; accordingly, nopenalty tax has been incurred by employees exercising stock options throughthat date.

 

The Company is consideringhow to deal with exercises of 409A Affected Options that occur in 2007 andbeyond.  One alternative would be tooffer to amend all 409A Affected Options to change the exercise price to thefair market price of the Company’s common stock on the corrected measurementdate. These amended options would not be subject to taxation under IRCSection 409A.  Under IRSregulations, option amendments had to be completed by December 31, 2006for anyone who was an executive officer or member of the Board of Directorswhen he or she received 409A Affected Options. Therefore, prior to December 31,2006 eight of the Company’s current and former executive officers and directorsexecuted an irrevocable Protective Amendment Election Form whereby any of theirstock options will be automatically amended to restate the exercise price tothe fair market value of the Company’s common stock at the correctedmeasurement date if in the future such stock options would otherwise bedetermined to be 409A Affected Options. A similar offer to amend all 409A Affected Options held by non-officeremployees is currently under consideration, but no decision has been reachedand such an offer cannot be made until the Company is current with its SECreporting obligations.

 

During the review theCompany also discovered a stock option grant to a former officer that wasmodified in 1998 in connection with his termination of employment that shouldhave resulted in additional compensation expense. This change was neverincluded in the Company’s stock option grant records and the additionalcompensation expense resulting from the change in the option’s terms  (approximately $1.2 million)  was not recorded previously. This discoveryis consistent with the Review Team’s finding that in certain instances therewas a lack of formal documentation in the stock option granting process and/orexpected documentation is missing from the stock option administration files. In addition, the Review Team found that,in many instances, there was a lack of self-authenticating evidence to corroboratethat cash exercises were contemporaneous. As a result, the findings on theissue of backdating of cash exercises were inconclusive.

 

The Company’s accounting forstock-based compensation changed to a fair value method in 2006 when, asrequired by accounting standards, it ceased accounting for stock-basedcompensation under the intrinsic value method pursuant to APB 25 and beganaccounting for stock-based compensation pursuant to Statement of FinancialAccounting Standards 123(R) Share-Based Payments (“SFAS 123(R)”). Under thismethod all stock option grants have a fair value determined using an optionpricing model, and such fair value is used to recognize non-cash stock-basedcompensation expense. The Company recognizes stock compensation expense on astraight-line basis under SFAS 123(R).

 

21

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The table below shows theeffects of correcting the consolidated financial statements for the GovernanceCommittee’s findings and the modification in 1998 of a stock option grant to aformer officer in connection with his termination of employment. Consistentwith its historical accounting policy, this additional stock-based compensationexpense is being recognized on an accelerated basis by treating each vestingtranche as a separate stock option grant (graded vesting).  Additionally, the table gives effect tocorrections of the accounting for performance related stock options andrestricted stock grants in the first two quarters of 2006, all of which werepreviously identified and considered immaterial. The effects of correcting the errors in the Company’sprevious stock option accounting were to increase (reduce) previously reportednon-cash compensation expense, payroll taxes, income taxes and net income bythe following amounts (in thousands of dollars):

 
| ** **                         | ** ** | **Reduction (increase) in net income from** | ** ** |
|------------------------------------|------------|---------------------------------------------|------------|
| ** **                         | ** ** | **Non-cash stock  compensation**            | ** ** | **Payroll taxes** | ** ** | **Income taxes** | ** ** | **Net income** | ** ** |
| Year ended December 31,            |       |                                        |       |   |   |   |   |   |   |
| 1998                               |       | $                                           | 1,244      |   | $ | — |   | $ | (448 | ) | $ | (796 | ) |
| 1999                               |       | —                                      |       | — |   | — |   | — |   |
| 2000                               |       | 556                                         |       | — |   | (104 | ) | (452 | ) |
| 2001                               |       | 4,870                                       |       | — |   | (942 | ) | (3,928 | ) |
| 2002                               |       | 8,110                                       |       | — |   | (1,550 | ) | (6,560 | ) |
| 2003                               |       | 12,470                                      |       | 900 |   | (2,281 | ) | (11,089 | ) |
| Totals  through December 31, 2003  |       | 27,250                                      |       | 900 |   | (5,325 | ) | (22,825 | ) |
| 2004                               |       | (410                                        | )          | 541 |   | 250 |   | (381 | ) |
| 2005                               |       | (1,290                                      | )          | 60 |   | 4,083 |   | (2,853 | ) |
| 2000-2005  Total                   |       | 25,550                                      |       | 1,501 |   | (992 | ) | (26,059 | ) |
|                               |       |                                        |       |   |   |   |   |   |   |
| Three  months ended March 31, 2006 |       | 662                                         |       | 9 |   | — |   | (671 | ) |
| Three  months ended June 30, 3006  |       | 504                                         |       | 6 |   | — |   | (510 | ) |
| Six  months ended June 30, 2006    |       | 1,166                                       |       | 15 |   | — |   | (1,181 | ) |
|                               |       | $                                           | 26,716     |   | $ | 1,516 |   | $ | (992 | ) | $ | (27,240 | ) |

 

The following table showsthe Company’s stock-based compensation expense as previously reported and theimpact of the restatement (excluding payroll taxes) on stock-based compensationfor periods prior to fiscal 2006, net of income tax:

 

 
| ** **                                                                               | ** ** | **Stock-Based Compensation  Expense (Net of Tax)** | ** ** |
|------------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                                               | ** ** | **(in thousands)**                                 | ** ** |
| **Year  ended December 31,**                                                             | ** ** | **As Reported**                                    | ** ** | **Adjustments** | ** ** | **As Restated** | ** ** |
| 1998 (net of income tax benefit/(expense)  of $118, $448 and $566, respectively)         |       | $                                                  | 294        |   | $ | 796 |   | $ | 1,090 |   |
| 1999 (net of income tax benefit/(expense)  of $1,596, $0 and $1,596, respectively)       |       | 3,957                                              |       | — |   | 3,957 |   |
| 2000 (net of income tax benefit/(expense)  of $3,323, $104 and $3,427, respectively)     |       | 8,238                                              |       | 452 |   | 8,690 |   |
| 2001 (net of income tax benefit/(expense)  of $1,495, $942 and $2,437, respectively)     |       | 3,706                                              |       | 3,928 |   | 7,634 |   |
| 2002 (net of income tax benefit/(expense)  of $891, $1,550 and $2,441, respectively)     |       | 2,209                                              |       | 6,560 |   | 8,769 |   |
| 2003 (net of income tax benefit/(expense)  of $1,212, $2,281 and $3,493, respectively)   |       | 3,071                                              |       | 10,189 |   | 13,260 |   |
| 2004 (net of income tax benefit/(expense)  of $149, ($250) and ($101), respectively)     |       | 370                                                |       | (160 | ) | 210 |   |
| 2005 (net of income tax benefit/(expense)  of $105, ($4,083) and ($3,978), respectively) |       | 2,154                                              |       | 2,793 |   | 4,947 |   |
|                                                                                          |            |                                                    |            |  |  |  |  |  |  |  |

 

 

22

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*Governance Committee Findings*

 

Upon completing its review, the Governance Committeeconcluded it found no evidence of intent to manipulate the Company’s operatingresults or financial statements. A key finding of the Governance Committee wasthat there were deficiencies with the process by which stock options weregranted during the period from the Company’s initial public offering in 2000through at least 2005, which resulted in accounting errors.  The Governance Committee concluded thatcertain members of management bear varying degrees of responsibility for thedeficiencies in the process by which options were granted.  The Governance Committee’s review alsoconcluded that none of the current or former employees or directors of theCompany engaged in intentional wrongdoing.

 

***Restatement and Impact onFinancial Statements***

 

The following tablepresents the decrease in net income, by year, as a result of restating for theresults of the China sales investigation and the historical stock optionaccounting review:

 

| ** **                                  | ** ** | **Net income (loss),**      | ** ** | **Restatement adjustments** | ** ** | ** **        | ** ** |
|---------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|-------------------|------------|
| ** **                                  | ** ** | **as previously  reported** | ** ** | **China  Sales**            | ** ** | **Stock Options** | ** ** | **Total** | ** ** | **Net income (loss),  as restated** | ** ** |
| ** **                                  | ** ** | ** **                  | ** ** | **(in thousands)**          | ** ** | ** **        | ** ** |
|                                        |       |                        |       | **(Decrease) Increase**     |       |              |       |
| Year ended December 31,                     |       |                        |       | ** **                  |       |              |       |
| 1998                                        |       |                        |       | $                           | —     |              | $          | (796 | ) | $ | (796 | )  |   |   |
| 1999                                        |       |                        |       | —                      |       | —            |       | — |   |   |   |
| 2000                                        |       |                        |       | (4,781                      | )          | (452              | )          | (5,233 | )  |   |   |
| 2001                                        |       |                        |       | (5,779                      | )          | (3,928            | )          | (9,707 | )  |   |   |
| 2002                                        |       |                        |       | (19,697                     | )          | (6,560            | )          | (26,257 | )  |   |   |
| 2003                                        |       |                        |       | (6,382                      | )          | (11,089           | )          | (17,471 | )  |   |   |
| Totals  through December 31, 2003 |       |                        |       | (36,639                     | )          | (22,825           | )          | (59,464 | )  |   |   |
| 2004                                        |       | $                           | 69,824     |                        | (18,594    | )                 | (381       | ) | (18,975 | ) | $ | 50,849 |   |
| 2005                                        |       | $                           | (487,359   | )                           | (42,433    | )                 | (2,853     | ) | (45,286 | ) | $ | (532,645 | ) |
| 2000  - 2005 Total                          |       |                        |       | (97,666                     | )          | (26,059           | )          | (123,725 | )  |   |   |
|                                        |       |                        |       |                        |       |              |       |   |   |   |   |
| Three  months ended June 30, 2006 |       | $                           | (21,443    | )                           | (371       | )                 | (510       | ) | (881 | ) | $ | (22,324 | ) |
| Six  months ended June 30, 2006   |       | $                           | (32,078    | )                           | 989        |              | (1,181     | ) | (192 | ) | $ | (32,270 | ) |
|                                             |            |                             |            |                             |            |                   |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

Thecumulative effect of the restatements at December 31, 2003 was an increase toadditional paid-in capital and deferred stock-based compensation of $26.0million from $646.7 million to $672.7 million, and a decrease in retainedearnings of $59.5 million from $237.4 million to $177.9 million, and a decreasein total stockholders’ equity of $33.5 million from $887.7 million to $854.2million.

 

***OtherChanges***

 

In restating thepreviously issued financial statements for the investigations discussed above,we also corrected other previously reported amounts. We corrected the reporting of  netsales to certain third party resellers and associated cost of net sales for thethree and six months ended June 30, 2006 to classify these amounts as relatedparty net sales and related party cost of net sales classifications of $4.2million and $3.0 million, respectively, and $12.9 million and $4.8 million,respectively, because in 2006 we determined that sales to these entities were,in substance, sales to a significant shareholder, SOFTBANK CORP. Theclassification of the accounts receivable from these sales was similarlychanged to include them in accounts receivable from related parties in the June30, 2006 consolidated balance sheet.   The Company also corrected our reporting of $6.2 million oftime deposits at June 30, 2006 because they did not mature within three months.Formerly the time deposits had been reported in error as cash equivalents, butnow these amounts are included in short-term investments in the balance sheetand in the statement of cash flows for the June 2006 reporting period.

 

23

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***Restated Financial Information***

 

The following tables summarize the impact of therestatement adjustments on the condensed consolidated statement of operationsfor the three and six months ended June 30, 2006 and the condensed consolidatedstatement of cash flows for the six months ended June 30, 2006:

 

 

**UTSTARCOM, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)**

**(In thousands, except per shareamounts)**

 

 
| ** **                                                | ** ** | **Three months ended June 30,  2006** | ** ** | **Six months ended June 30, 2006** | ** ** |
|-----------------------------------------------------------|------------|---------------------------------------|------------|------------------------------------|------------|
| ** **                                                | ** ** | **As previously  reported**           | ** ** | **Adjustments**                    | ** ** | **As restated** | ** ** | **As previously  reported** | ** ** | **Adjustments** | ** ** | **As restated** | ** ** |
|                                                      |       |                                  |       |                               |       |   |   |   |   |   |   |   |   |
| Net sales                                                 |       |                                  |       |                               |       |   |   |   |   |   |   |   |   |
| Unrelated party                                           |       | $                                     | 515,733    |                               | $          | (1,836 | ) | $ | 513,897 |   | $ | 1,076,094 |   | $ | (5,160 | ) | $ | 1,070,934 |   |
| Related party                                             |       | 33,413                                |       | 4,215                              |       | 37,628 |   | 69,623 |   | 12,949 |   | 82,572 |   |
|                                                      |       | 549,146                               |       | 2,379                              |       | 551,525 |   | 1,145,717 |   | 7,789 |   | 1,153,506 |   |
| Cost of net sales                                         |       |                                  |       |                               |       |   |   |   |   |   |   |   |   |
| Unrelated party                                           |       | 414,364                               |       | (252                               | )          | 414,112 |   | 873,744 |   | 1,953 |   | 875,697 |   |
| Related party                                             |       | 25,496                                |       | 2,967                              |       | 28,463 |   | 40,233 |   | 4,835 |   | 45,068 |   |
| Gross profit                                              |       | 109,286                               |       | (336                               | )          | 108,950 |   | 231,740 |   | 1,001 |   | 232,741 |   |
| Operating expenses:                                       |       |                                  |       |                               |       |   |   |   |   |   |   |   |   |
| Selling, general and administrative                       |       | 82,423                                |       | 685                                |       | 83,108 |   | 165,593 |   | 1,240 |   | 166,833 |   |
| Research and development                                  |       | 46,743                                |       | (140                               | )          | 46,603 |   | 93,052 |   | (47 | ) | 93,005 |   |
| In-process research and development                       |       | 4,821                                 |       | —                             |       | 4,821 |   | 9,746 |   | — |   | 9,746 |   |
| Total operating expenses                                  |       | 133,987                               |       | 545                                |       | 134,532 |   | 268,391 |   | 1,193 |   | 269,584 |   |
|                                                      |       |                                  |       |                               |       |   |   |   |   |   |   |   |   |
| Operating loss                                            |       | (24,701                               | )          | (881                               | )          | (25,582 | ) | (36,651 | ) | (192 | ) | (36,843 | ) |
|                                                      |       |                                  |       |                               |       |   |   |   |   |   |   |   |   |
| Interest income                                           |       | 3,947                                 |       | —                             |       | 3,947 |   | 7,479 |   | — |   | 7,479 |   |
| Interest expense                                          |       | (3,166                                | )          | —                             |       | (3,166 | ) | (6,667 | ) | — |   | (6,667 | ) |
| Other income, net                                         |       | 6,887                                 |       | —                             |       | 6,887 |   | 10,454 |   | — |   | 10,454 |   |
| Income before income taxes and minority interest          |       | (17,033                               | )          | (881                               | )          | (17,914 | ) | (25,385 | ) | (192 | ) | (25,577 | ) |
| Income tax expense                                        |       | (4,669                                | )          | —                             |       | (4,669 | ) | (7,508 | ) | — |   | (7,508 | ) |
| Minority interest in losses of  consolidated subsidiaries |       | 259                                   |       | —                             |       | 259 |   | 815 |   | — |   | 815 |   |
| Net loss                                                  |       | $                                     | (21,443    | )                                  | $          | (881 | ) | $ | (22,324 | ) | $ | (32,078 | ) | $ | (192 | ) | $ | (32,270 | ) |
|                                                      |       |                                  |       |                               |       |   |   |   |   |   |   |   |   |
| Earnings per share - Basic and diluted                    |       | $                                     | (0.18      | )                                  | $          | (0.01 | ) | $ | (0.19 | ) | $ | (0.27 | ) | $ | — |   | $ | (0.27 | ) |
|                                                           |            |                                       |            |                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

24

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**UTSTARCOM, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)**

**(in thousands)**

 

 
| ** **                                                                                 | ** ** | **Six months ended June 30, 2006** | ** ** |
|--------------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                 | ** ** | **As previously  reported**        | ** ** | **Total  adjustments** | ** ** | **As restated** | ** ** |
|                                                                                       |       |                               |       |   |   |   |   |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                      |       |                               |       |   |   |   |   |
| Net loss                                                                                   |       | $                                  | (32,078    | ) | $ | (192 | ) | $ | (32,270 | ) |
| Adjustments to reconcile net loss to net  cash provided by (used in) operating activities: |       |                               |       |   |   |   |   |
| Depreciation and amortization                                                              |       | 34,653                             |       | — |   | 34,653 |   |
| Loss on sale and disposal of assets                                                        |       | 2,169                              |       | — |   | 2,169 |   |
| Stock-based compensation expense                                                           |       | 8,769                              |       | (1,227 | ) | 7,542 |   |
| Provision for doubtful accounts                                                            |       | 3,133                              |       | — |   | 3,133 |   |
| Provision for deferred costs                                                               |       | 5,978                              |       | — |   | 5,978 |   |
| Other                                                                                      |       | (2,930                             | )          | 2,393 |   | (537 | ) |
| Changes in operating assets and  liabilities:                                              |       |                               |       |   |   |   |   |
| Accounts receivable                                                                        |       | 97,596                             |       | — |   | 97,596 |   |
| Inventories                                                                                |       | (36,916                            | )          | — |   | (36,916 | ) |
| Deferred costs                                                                             |       | (13,677                            | )          | 6,824 |   | (6,853 | ) |
| Other assets                                                                               |       | (7,784                             | )          | — |   | (7,784 | ) |
| Accounts payable                                                                           |       | 39,693                             |       | — |   | 39,693 |   |
| Income taxes payable                                                                       |       | 3,438                              |       | — |   | 3,438 |   |
| Customer advances                                                                          |       | 69,280                             |       | — |   | 69,280 |   |
| Deferred revenue                                                                           |       | (2,699                             | )          | (7,813 | ) | (10,512 | ) |
| Other current liabilities                                                                  |       | (89,469                            | )          | 15 |   | (89,454 | ) |
| Net cash provided by operating activities                                                  |       | 79,156                             |       | — |   | 79,156 |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                      |       |                               |       |   |   |   |   |
| Additions to property, plant and equipment                                                 |       | (12,288                            | )          | — |   | (12,288 | ) |
| Investment in affiliates, net of cash  acquired                                            |       | (302                               | )          | — |   | (302 | ) |
| Proceeds from sale of semiconductor design  assets                                         |       | 19,965                             |       | — |   | 19,965 |   |
| Change in restricted cash and long-term  investments                                       |       | (19,994                            | )          | — |   | (19,994 | ) |
| Purchase of short-term investments                                                         |       | (21,810                            | )          | (6,222 | ) | (28,032 | ) |
| Proceeds from sale of short-term  investments                                              |       | 25,588                             |       | — |   | 25,588 |   |
| Other                                                                                      |       | 1,672                              |       | — |   | 1,672 |   |
| Net cash used in investing activities                                                      |       | (7,169                             | )          | (6,222 | ) | (13,391 | ) |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                      |       |                               |       |   |   |   |   |
| Proceeds from borrowing                                                                    |       | 62,545                             |       | — |   | 62,545 |   |
| Payments on borrowings                                                                     |       | (140,053                           | )          | — |   | (140,053 | ) |
| Other                                                                                      |       | 1,967                              |       | — |   | 1,967 |   |
| Net cash used in financing activities                                                      |       | (75,541                            | )          | — |   | (75,541 | ) |
| Effect of exchange rate changes on cash  and cash equivalents                              |       | 5,257                              |       | (32 | ) | 5,225 |   |
| Net increase (decrease) in cash and cash  equivalents                                      |       | 1,703                              |       | (6,254 | ) | (4,551 | ) |
| CASH AND CASH EQUIVALENTS AT BEGINNING OF  PERIOD                                          |       | 645,571                            |       | — |   | 645,571 |   |
| CASH AND CASH EQUIVALENTS AT END OF PERIOD                                                 |       | $                                  | 647,274    |   | $ | (6,254 | ) | $ | 641,020 |   |

 

25

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**NOTE****3 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

*Use of Estimates*

 

                Thepreparation of consolidated financial statements in conformity with generallyaccepted accounting principles in the United States of America requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesat the date of the consolidated financial statements and the reported amountsof revenues and expenses during the reporting period. Estimates are used forrevenue recognition, allowance for doubtful accounts and sales returns, taxvaluation allowances, reserves for inventory, deferred costs, accrued productwarranty costs, provisions for contract losses, goodwill and other long-livedasset impairments, stock-based compensation, loss contingencies andrestructuring expenses among others. Actual results could differ from those estimates.

 

*Revenue Recognition*

 

                Revenuesfrom sales of telecommunications equipment and handsets are recognized whenpersuasive evidence of an arrangement exists, delivery has occurred, the fee isfixed or determinable and collectibility is probable. If the payment due fromthe customer is not fixed or determinable due to extended payment terms,revenue is recognized as payments become due from the customer, assuming allother criteria for revenue recognition are met. Any payments received prior torevenue recognition are recorded as customer advances. Normal payment termsdiffer for various reasons amongst different customer regions, depending uponcommon business practices for customers within a region. Billing to customersfor shipping and handling are recorded as revenues and the associated costs arerecorded as costs of revenues. Any expected losses on contracts are recognizedwhen identified on an individual basis in accordance with the prevailingaccounting guidance for the respective contract.

 

                Salesmay be generated from complex contractual arrangements that require significantrevenue recognition judgments, particularly in the area of contracts withmultiple deliverable elements (multiple element arrangements). Where multipleelements exist in an arrangement, the contract price is allocated to thedifferent elements based upon and in proportion to verifiable objectiveevidence of the fair value of the various elements, as governed under EmergingIssues Task Force Issue (“EITF”) No. 00-21, “Accounting for RevenueArrangements with Multiple Deliverables” and SEC Staff Accounting BulletinNo. 104 “Revenue Recognition.” Multiple element arrangements primarilyinvolve the sale of equipment, installation, training and post-contractsupport. Revenue is recognized as each element is earned, namely uponinstallation and acceptance of equipment or delivery of handsets, provided thatthe fair value of the undelivered element(s) has been determined, the deliveredelement(s) has stand-alone value, there is no right of return ondelivered element(s), and the Company is in control of the undeliveredelement(s). For arrangements that include service elements, includingpromotional support and installation, for which verifiable objective evidenceof the fair value does not exist, revenue is deferred until such services aredeemed complete, or until the time the Company can establish verifiableobjective evidence of the fair value.

 

                Finalacceptance is required for revenue recognition when installation services arenot considered perfunctory. Final acceptance indicates that the customer hasfully accepted delivery of equipment and the Company is entitled to the fullpayment. The Company does not recognize revenue before final acceptance isgranted by the customer if acceptance is considered substantive to thetransaction.

 

                Wheremultiple elements exist in an arrangement that includes software, and thesoftware is considered more than incidental to the equipment or services in thearrangement, software and software related elements are recognized under theprovisions of Statement of Position 97-2 “Software Revenue Recognition,” asamended, and EITF No. 03-05 “Applicability of SOP 97-2 to Non-SoftwareDeliverables Containing More Than Incidental Software.” The Company allocatesrevenues to each element of software arrangements based on vendor specificobjective evidence (“VSOE”). VSOE of fair value of each element is based on theprice charged when the same element is sold separately. The Company uses theresidual method to recognize revenue when an arrangement includes one or moreelements to be delivered at a future date and VSOE of the fair value of all theundelivered elements exists. Under the residual method, the fair value of theundelivered elements is deferred and the remaining portion of the contractprice is recognized as revenue when all other revenue recognition criteria aremet. If VSOE of fair value of one or more undelivered elements does not exist,all revenue for delivered and undelivered elements is deferred until deliveryof all elements occurs or when VSOE of fair value of the undelivered elementscan be established.  In some cases theCompany has agreed to give software upgrade rights on a “when and if madeavailable” basis for equipment sold for no additional consideration and for anunspecified period which could extend over the term of the contract.  This additional contract obligation is anelement of “post contract support.”  TheCompany has not established VSOE for such contract element.  Accordingly, the revenues from such contractsare recognized ratably over the period during which the post contract supportis expected to be provided.  The expectedperiod of support is generally the term of the contract.  In some cases where there is no

 

 

26

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stated contractual term, revenue is recognized ratablyover the estimated period of support. The Company reviews assumptions regardingthe estimated post contract support periods on a regular basis.  If the Company determines that it isnecessary to revise the Company’s estimates of the support periods, the amountof revenue recognized over the life of the contract would not be affected.  However, to the extent the new assumptionsregarding the post contract support periods were different than originalassumptions, the contract revenues would be recognized over the remainingexpected period of support.

 

Contract accounting is utilized for contracts thatinclude a requirement for significant software modification or customization;when utilized the Company generally accounts for such contracts using thecompleted contract method of accounting, whereby no revenue is recognized priorto the completion of the project, because for contracts involving uniquerequirements the Company is unable to make reasonably dependable estimates ofits progress towards meeting contractual requirements. In the event estimatedtotal project costs exceed estimated total project revenues, the entireestimated loss is charged to operations in the period in which the loss becomesprobable and can be reasonably estimated. The complexity of the estimationprocess and judgments about internal and external factors including laborutilization, changes to specifications and testing requirements, time requiredfor performance and resulting incurrence of contract penalties, and theperformance of subcontractors affect the estimation process.

 

                TheCompany recognizes revenue for system integration, installation and trainingupon completion of performance and if all other revenue recognition criteriaare met. Other service revenue, principally related to maintenance and supportcontracts, is recognized ratably over the maintenance term. Revenues fromservices were less than 10% of revenues for all periods present.

 

                TheCompany also sells products through resellers. Revenue is generally recognizedwhen the standard price protection period, which ranges from 30 to90 days, has lapsed. If collectibility cannot be reasonably assured in areseller arrangement, revenue is recognized upon sell through to the endcustomer and receipt of cash. There may be additional obligations in resellerarrangements such as inventory rotation, or stock exchange rights on theproduct. As such, revenue is recognized in accordance with Statement ofFinancial Accounting Standards (“SFAS”) No. 48, “Revenue Recognition WhenRight of Return Exists.” In most cases, the Company has developed reasonableestimates for stock exchanges based on historical experience with similar typesof sales of similar products.

 

                TheCompany has sales agreements with certain wireless customers that provide for arebate of the selling price to such customers if the particular product issubsequently sold at a lower price to such customers or to a differentcustomer. The rebate period extends for a relatively short period of time.Historically, the amounts of such rebates paid to customers have not beenmaterial. The Company estimates the amount of the rebate based upon the termsof each individual arrangement, historical experience and future expectationsof price reductions and then records its estimate of the rebate amount at thetime of the sale. The Company also enters into sales incentive programs, suchas co-marketing arrangements, with certain wireless and handset customers. TheCompany records the incurred incentive as a reduction of revenue when the salesrevenue is recognized.

 

                Theassessment of collectibility is also a factor in determining whether revenueshould be recognized. The Company assesses collectibility based on a number offactors, including payment history and the credit-worthiness of the customer.The Company does not request collateral from its customers. In internationalsales, the Company may require letters of credit from its customers that can bedrawn on demand if the customer defaults on its payment. If the Companydetermines that collection of a payment is not reasonably assured, the Companydefers revenue recognition until collection becomes reasonably assured, whichis generally upon receipt of cash.

 

                Occasionally,the Company enters into revenue sharing arrangements. Under these arrangements,the Company collects payment only after its customer, the telecommunicationsservice provider, collects service revenues. When the Company enters a revenuesharing arrangement, the Company does not recognize revenue until collection isreasonably assured.

 

                Becauseof the nature of doing business in China and other emerging markets, theCompany’s billings and/or customer payments may not correlate with thecontractual payment terms and the Company generally does not enforcecontractual payment terms prior to final acceptance. Accordingly, accountsreceivable are not recorded until the Company recognizes the related customerrevenue. Advances from customers are recognized when the Company has collectedcash from the customer, prior to recognizing revenue.  The Company had current deferred revenue of$96.4 million and $95.7 million, and long-term deferred revenue of $244.0 millionand $261.0 million, at June 30, 2007 and December 31, 2006, respectively.

 

 

27

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*Inventories*

 

                Inventoriesconsist of product held at the Company’s manufacturing facility and warehouses,as well as finished goods at customer sites for which the customer has takenpossession, but based on specific contractual terms, title has not yet passedto the customer. The Company may ship inventory to existing customers thatrequire additional equipment to expand their existing networks prior to thesigning of an expansion contract. Inventories are stated at the lower of costor market value, net of write-downs for excess, slow moving and obsoleteinventory. With the exception of the handset inventory for our PersonalCommunications Division (“PCD”), which is based on weighted average cost,inventory cost is computed using standard cost, which approximates actual coston a first-in, first-out basis. Inventory is written down forestimated obsolescence or unmarketable inventory equal to the differencebetween inventory cost and the estimated market value.

 

*Deferred costs*

 

                Deferredcosts consist of product shipped to the customer for which the rights andobligations of ownership have passed to the customer but revenue has not yetbeen recognized. All deferred costs are stated at cost. Management periodicallyassesses the recoverability of deferred costs and provides reserves againstdeferred cost balances when recovery of deferred costs is not probable.Recoverability is evaluated based on various factors including the length oftime the product has been held at the customer site, the viability of payment,including assessment of product demand if a revenue sharing arrangement existsand/or the evaluation if a related transaction will result in a gross marginloss. In a loss situation for a transaction, the deferred cost balance isadjusted for an impairment equal to the value of the excess of cost over theamount of revenue that will be eventually recognized for the transaction.  Revenue and cost of sales are recorded whenfinal acceptance is received from the customer. With greater concentration ofproduct at customer sites with specific or individual customer, the financialconditions of any specific or individual customer may result in increasedconcentration risk exposure for the Company’s inventory.

 

For any post contract support services where  the revenue is deferred, the entire relateddeferred direct costs are classified as a noncurrent asset, consistent with thedefinition of a current asset per Accounting Research Bulletin No. 43, “WorkingCapital: Current Assets and Current Liabilities.”

 

*Stock-Based Compensation*

 

                Priorto January 1, 2006, the Company accounted for share-based payment awards under AccountingPrinciples Board Opinion No. 25 Accounting for Stock Issued to Employees (“APB25”), and provided the required pro formadisclosures under SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS123”)  In accordance with APB 25,non-cash compensation expense was recognized for any options for which theexercise price was below the market price on the actual grant date, based onthe difference between the exercise price and the market price.  The expense was recognized ratably over theassociated service period, which was generally the option vesting term.

 

On January 1, 2006, the Company adopted SFASNo. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123(R)”),using the modified prospective transition method. Stock-basedcompensation expense recognized during the period is based on the value of theportion of share-based payment awards that is ultimately expected tovest.  Stock-based compensationexpense recognized in the consolidated statement of operations for the yearended December 31, 2006 included compensation expense for share-basedpayment awards granted prior to, but not yet vested as of December 31,2005 based on the grant date fair value estimated in accordance with the proforma provisions of SFAS 123 and compensation expense for the share-basedpayment awards granted subsequent to December 31, 2005 based on the grantdate fair value estimated in accordance with the provisions ofSFAS 123(R).  The Company used theBlack-Scholes option-pricing model (“Black-Scholes model”) method of valuationfor share-based awards granted on or prior to December 31, 2005, and continuesto use the Black-Scholes model for subsequent share-based payment awards.  On November 10, 2005, the FinancialAccounting Standards Board (“FASB”) issued FASB Staff Position No. FAS123(R)-3, “Transition Election Related to Accounting for Tax Effects ofShare-Based Payment Awards.”  The Companyadopted the alternative transition method provided in the FASB Staff Positionfor calculating the tax effects of stock-based compensation pursuant to SFAS123(R).  The alternative transitionmethod includes simplified methods for establishing the beginning balance ofthe additional paid-in-capital pool (“APIC pool”) related to the tax effects ofemployee stock-based compensation, and to determine the subsequent impact onthe APIC pool and consolidated statements of cash flows of the tax effects ofemployee stock-based compensation awards that are outstanding upon adoption ofSFAS 123(R).  The Company accounts for utilization of windfall taxbenefits based on tax law ordering and considered only the direct effects ofstock-based compensation for purposes of measuring the windfall at settlementof an award.

 

 

28

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*Income Taxes*

 

The Company accounts for income taxes under the liabilitymethod, and deferred income taxes are recognized for the differences betweenthe tax bases of assets and liabilities and their financial statement amountsbased on enacted tax rates. Valuation allowances are established when necessaryto reduce deferred tax assets to the amount expected to be realized. TheCompany is required to adjust its deferred tax asset and liabilities in theperiod when tax rates or the provisions of the income tax laws change.

In 2006, due to developments in its business, theCompany determined that earnings from certain subsidiaries were not permanentlyreinvested outside the United States. The Company provides U.S. taxes onforeign undistributed earnings that are not considered to be permanentlyreinvested outside the United States. Under APB 23 “Accounting for IncomeTaxes—Special Areas,” deferred income taxes must be provided on the unremittedearnings of foreign subsidiaries unless such earnings could be deemed to bepermanently reinvested outside the United States. Prior to 2006, the Companyhad not provided for U.S. tax on any foreign unremitted earnings because theCompany did not intend to repatriate such earnings.

As described in Note 21, effective January 1,2007, the Company adopted FASB Interpretation No. 48 (“FIN 48”), “Accountingfor Uncertainty in Income Taxes, an interpretation of FASB StatementNo. 109.”

 

**NOTE 4 - STOCK-BASED COMPENSATION**

 

                TheCompany has granted restricted stock awards to its employees under the 1997 and2006 Plans.  Such awards generally vestover a period of one to four years from the date of grant.  The restricted stock awards have the votingrights of common stock and the shares underlying the restricted stock awardsare considered issued and outstanding. On February 28, 2006, the Company granted rights to purchase 301,133shares of restricted stock to executive officers of the Company which wereallowed to lapse unexercised in March 2006. In their place, on February 1, 2007, the Compensation Committee of theBoard of Directors of the Company (“Committee”) determined that certainexecutive officers, based on their level of performance during the Company’s2006 fiscal year, were eligible to receive 203,000 shares of common stock inthe aggregate (“Performance Stock”).  TheCommittee’s determination is subject to compliance with applicable law, and theCommittee will issue the Performance Stock after the Company is in compliancewith all SEC reporting requirements.  ThePerformance Stock was included in the Company’s computation of stock-basedcompensation expense and was zero and $0.5 million for the three months endedJune 30, 2007 and 2006, respectively, and $0.2 million and $0.7 million for thesix months ended June 30, 2007 and 2006, respectively.

 

In addition, on February 28, 2006, the Committee granted602,267 performance options under the 1997 and 2006 Plans.  On February 1, 2007, the Committeedetermined, based on each executive officer’s level of performance during theCompany’s 2006 fiscal year, that 406,000 shares underlying the performanceoptions vested as of February 28, 2007. Each performance option has an exercise price of $6.25 per share, whichequals the closing price of the Company’s common stock on the NASDAQ StockMarket on the date of grant, February 28, 2006. The 196,267 performance options not declared vested by the Committeewere cancelled and returned to the Company. The performance options are included in the Company’s computation ofstock-based compensation expense and was zero and $0.6 million for the threemonths ended June 30, 2007 and 2006, respectively, and $0.5 million and $0.7 millionfor the six months ended June 30, 2007 and 2006, respectively.

 

Upon shareholder approval of the 2006 Plan in July 2006,the Company terminated the 1997 Plan.  Noadditional grants have been made from the 1997 Plan since that time.

 

 

                Thetotal stock-based compensation cost recognized in the condensedconsolidated statement of operations was as follows:

 
| ** **                                                    | ** **   | **Three months ended June 30,** | ** **   | **Six months ended June 30,** | ** **   |
|---------------------------------------------------------------|--------------|---------------------------------|--------------|-------------------------------|--------------|
| ** **                                                    | ** **   | **2007**                        | ** **   | **2006**                      | ** **   | **2007** | ** ** | **2006** | ** ** |
| ** **                                                    | ** **   | ** **                      | ** **   | **(As restated)**             | ** **   | ** ** | ** ** | **(As restated)** | ** ** |
| ** **                                                    | ** **   | **(in thousands)**              | ** **   |
| ***Stock-based compensation expense by type of award***       | *** *** | *** ***                    | *** *** | *** ***                  | *** *** | *** *** | *** *** | *** *** | *** *** |
| Employee stock options and purchase plan                      |         | $                               | 1,600        |                          | $            | 4,086 |   | $ | 3,219 |   | $ | 8,129 |   |
| Restricted stock                                              |         | 584                             |         | 1,031                         |         | 1,720 |   | 1,806 |   |
| Forfeitures  related to disposal of a component of a business |         | —                          |         | —                        |         | — |   | (2,393 | ) |
| Total                                                         |         | $                               | 2,184        |                          | $            | 5,117 |   | $ | 4,939 |   | $ | 7,542 |   |
|                                                               |              |                                 |              |                               |              |  |  |  |  |  |  |  |  |  |  |

 

For additional information regarding the Company’sstock-based compensation plans, see the Company’s Annual Report onForm 10-K for the year ended December 31, 2006.

 

 

29

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**NOTE****5 - LOSS PERSHARE**

 

Basic earnings per share (“EPS”) is computed by dividingnet loss available to common stockholders by the weighted average number ofshares of the Company’s common stock outstanding during the period, whichexcludes unvested restricted shares. Diluted EPS presents the amount of netloss available to each share of common stock outstanding during the period pluseach share of common stock that would have been outstanding assuming theCompany had issued shares of common stock for all dilutive potential commonshares outstanding during the period. The Company’s potential common sharesinclude employee stock options, unvested restricted shares, a written calloption, warrants, convertible subordinated notes and vested acquisition-relatedstock options.

 

                Thefollowing is a summary of the calculation of basic and diluted EPS:

 
| ** **                                                     | ** **   | **Three months ended June 30, ,**        | ** **   | **Six months ended June 30** | ** **   |
|----------------------------------------------------------------|--------------|------------------------------------------|--------------|------------------------------|--------------|
| ** **                                                     | ** **   | **2007**                                 | ** **   | **2006**                     | ** **   | **2007** | ** ** | **2006** | ** ** |
| ** **                                                     | ** **   | ** **                               | ** **   | **(As restated)**            | ** **   | ** ** | ** ** | **(As restated)** | ** ** |
| *** ***                                                   | ** **   | **(in thousands except per share data)** | ** **   |
| ***Numerator***                                                |         |                                     |         |                         |         |   |   |   |   |
| Net loss for basic EPS computation                             |         | $                                        | (61,707      | )                            | $            | (22,324 | ) | $ | (115,690 | ) | $ | (32,270 | ) |
| Effect of dilutive securities - convertible subordinated notes |         | —                                   |         | —                       |         | — |   | — |   |
| Net loss adjusted for dilutive securities                      |         | $                                        | (61,707      | )                            | $            | (22,324 | ) | $ | (115,690 | ) | $ | (32,270 | ) |
|                                                           |         |                                     |         |                         |         |   |   |   |   |
| ***Denominator***                                              | *** *** | *** ***                             | *** *** | *** ***                 | *** *** | *** *** | *** *** | *** *** | *** *** |
| Shares used to compute basic EPS                               |         | 120,982                                  |         | 120,608                      |         | 120,941 |   | 120,604 |   |
| Dilutive common stock equivalent shares                        |         | —                                   |         | —                       |         | — |   | — |   |
| Shares used to compute diluted EPS                             |         | 120,982                                  |         | 120,608                      |         | 120,941 |   | 120,604 |   |
|                                                           |         |                                     |         |                         |         |   |   |   |   |
| Loss per share - basic and diluted                             |         | $                                        | (0.51        | )                            | $            | (0.19 | ) | $ | (0.96 | ) | $ | (0.27 | ) |
|                                                                |              |                                          |              |                              |              |  |  |  |  |  |  |  |  |  |  |

 

 

For the three and six months ended June 30, 2007 and2006, no potential common shares were dilutive because of the net loss in eachof these periods, and basic and dilutive EPS are the same.  The following table summarizes the totalpotential shares of common stock that were excluded from the diluted per sharecalculation, because to include them would have been anti-dilutive for theperiod.

 
| ** **                                   | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|----------------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                                   | ** ** | **2007**                        | ** ** | **2006**                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                   | ** ** | ** **                      | ** ** | **(As restated)**             | ** ** | ** ** | ** ** | **(As restated)** | ** ** |
| ** **                                   | ** ** | **(in thousands)**              | ** ** | **(in thousands)**            | ** ** |
| Stock options                                |       | 18,302                          |       | 22,867                        |       | 18,812 |   | 22,867 |   |
| Conversion of convertible subordinated notes |       | 11,543                          |       | 11,543                        |       | 11,543 |   | 11,543 |   |
| Unvested restricted shares                   |       | 516                             |       | 816                           |       | 575 |   | 699 |   |
|                                         |       | 30,361                          |       | 35,226                        |       | 30,930 |   | 35,109 |   |

 

**NOTE 6 - COMPREHENSIVE LOSS**

 

                Thereconciliation of net loss to comprehensive loss for the three and six monthsended June 30, 2007 and 2006 is as follows:

 
| ** **                            | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|---------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                            | ** ** | **2007**                        | ** ** | **2006**                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                            | ** ** | ** **                      | ** ** | **(As restated)**             | ** ** | ** ** | ** ** | **(As restated)** | ** ** |
| *** ***                          | ** ** | **(in thousands)**              | ** ** | **(in thousands)**            | ** ** |
| ***Comprehensive  income***           |       |                            |       |                          |       |   |   |   |   |   |   |   |   |
| Net loss                              |       | $                               | (61,707    | )                             | $          | (22,324 | ) | $ | (115,690 | ) | $ | (32,270 | ) |
| Unrealized gain (loss) on investments |       | 52,141                          |       | (21                           | )          | 48,271 |   | 2 |   |
| Foreign currency translation          |       | 7,241                           |       | 1,499                         |       | 11,908 |   | 3,265 |   |
| Total comprehensive loss              |       | $                               | (2,325     | )                             | $          | (20,846 | ) | $ | (55,511 | ) | $ | (29,003 | ) |

 

 

 

30

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**NOTE 7 - CASH, CASH EQUIVALENTS ANDSHORT-TERM INVESTMENTS**

 

                Cashand cash equivalents consist of instruments with maturities of three months orless at the date of purchase. There were no available-for-sale securities includedin cash and cash equivalents at June 30, 2007 or December 31, 2006.Short-term investments, consisting entirely of available-for-sale securities,were $18.2 million and $9.5 million at June 30, 2007 and December 31,2006, respectively. The available-for-sale securities currently consist of banktime deposits, but can consist of government-backed notes, commercialpaper, floating rate corporate bonds and fixed income corporate bonds. Theseinvestments are recorded at fair value. Any unrealized holding gains or lossesare reported as a component of other comprehensive income. Realized gains andlosses are reported in earnings.

 

                TheCompany accepts bank notes receivable with maturity dates of between three andsix months from its customers in China in the normal course of business. TheCompany may discount these bank notes with banking institutions in China. Asale of these notes is reflected as a reduction of cash and cash equivalents orshort-term investments and the proceeds of the settlement of these notes areincluded in cash flows from operating activities in the consolidated statementof cash flows. There were no bank notes sold during the three and six monthsended June 30, 2007 and 2006.

 

**NOTE 8 - RESTRICTED CASH AND INVESTMENTS**

 

                AtJune 30, 2007 the Company had short-term restricted cash and investments of$9.8 million and long-term restricted cash of $16.7 million included in otherlong-term assets. At December 31, 2006 the Company had short-termrestricted cash and investments of $16.7 million and long-term restrictedcash of $16.5 million included in other long-term assets. These amountsprimarily collateralize the Company’s issuances of standby and commercialletters of credit.

 

**NOTE 9 - ACCOUNTS AND NOTES RECEIVABLE**

 

                TheCompany accepts bank notes and commercial notes receivable from its customersin China in the normal course of business. The notes are typically non-interest bearing, with maturity datesbetween three and six months.  Bank notesare included in short-term investments. Commercial notes receivable available for sale were $4.1 million and$5.1 million at June 30, 2007 and December 31, 2006,respectively.  The Company may discountthese notes with banking institutions in China. A sale of these notes is reflected as a reduction of notes receivableand the proceeds of the settlement of these notes are included in cash flowsfrom operating activities in the consolidated statement of cash flows.  Any notes that have been sold are not includedin the Company’s consolidated balance sheets as the criteria for sale treatmentestablished by SFAS No. 140, “Accounting for Transfers and Servicing ofFinancial Assets and Extinguishment of Liabilities” (“SFAS 140”), havebeen met. Under SFAS 140, upon a transfer, the transferor or entity mustderecognize financial assets when control has been surrendered and thetransferee obtains control over the assets. In addition, the transferred assetshave been isolated from the transferor, beyond the reach of its creditors, andthe transferee has the right, without conditions or constraints, to pledge orexchange the assets it has received.  There wereno notes receivable sold during the three and six months ended June 30, 2007and 2006.

 

                InAugust 2005, the Company entered into a Committed Receivables PurchaseAgreement (“Agreement”) with a commercial bank, whereby the Company may sell upto $100.0 million of its eligible accounts receivable, as defined in theAgreement.  The Agreement containsprovisions customary in transactions of this nature including certaincommitment fees.  During the three andsix months ended June 30, 2007, no receivables have been sold pursuant toprovisions of the Agreement.  In March2007, the Agreement was amended and restated to reflect that the purchase oftrade receivables shall be at the sole discretion of the commercial bank, withno associated commitment fees

 

 

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**NOTE****10 -INVENTORIES**

 

                Asof June 30, 2007 and December 31, 2006, total inventories consisted of thefollowing:

 

| ** **                           | ** ** | **June 30,**       | ** ** | **December 31,** | ** ** |
|--------------------------------------|------------|--------------------|------------|------------------|------------|
| ** **                           | ** ** | **2007**           | ** ** | **2006**         | ** ** |
| ** **                           | ** ** | **(in thousands)** | ** ** |
| ***Inventories***                    |       |               |       |             |       |   |   |
| Raw materials                        |       | $                  | 46,074     |             | $          | 72,230 |   |
| Work-in-process                      |       | 40,338             |       | 43,542           |       |
| Finished goods under Company control |       | 379,810            |       | 324,673          |       |
| Total inventories                    |       | $                  | 466,222    |             | $          | 440,445 |   |
|                                      |            |                    |            |                  |            |  |  |  |

 

**NOTE 11 - GOODWILL AND INTANGIBLE ASSETS**

 

                Asof June 30, 2007 and December 31, 2006, goodwill was $3.1 million, theentire amount of which was allocated to the services operating segment. As ofJune 30, 2007 and December 31, 2006, intangible assets consisted of thefollowing:

 
| ** **                          | ** ** | **June 30, 2007**   | ** ** | **December 31, 2006** | ** ** |
|-------------------------------------|------------|---------------------|------------|-----------------------|------------|
| ** **                          | ** ** | **Gross**           | ** ** | ** **            | ** ** | **Net** | ** ** | **Gross** | ** ** | ** ** | ** ** | **Net** | ** ** |
| ** **                          | ** ** | **Carrying**        | ** ** | **Accumulated**       | ** ** | **Carrying** | ** ** | **Carrying** | ** ** | **Accumulated** | ** ** | **Carrying** | ** ** |
| ** **                          | ** ** | **Amount**          | ** ** | **Amortization**      | ** ** | **Amount** | ** ** | **Amount** | ** ** | **Amortization** | ** ** | **Amount** | ** ** |
| *** ***                        | ** ** | **(in thousands )** | ** ** |
| ***Amortized  intangible assets:*** |       |                |       |                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Existing technology                 |       | $                   | 39,530     |                  | $          | (30,833 | ) | $ | 8,697 |   | $ | 39,530 |   | $ | (27,824 | ) | $ | 11,706 |   |
| Customer relationships              |       | 57,220              |       | (21,610               | )          | 35,610 |   | 57,220 |   | (18,544 | ) | 38,676 |   |
| Trade names                         |       | 4,940               |       | (4,496                | )          | 444 |   | 4,940 |   | (3,829 | ) | 1,111 |   |
| Non-compete agreement               |       | 10,800              |       | (7,200                | )          | 3,600 |   | 10,800 |   | (5,850 | ) | 4,950 |   |
|                                |       | $                   | 112,490    |                  | $          | (64,139 | ) | $ | 48,351 |   | $ | 112,490 |   | $ | (56,047 | ) | $ | 56,443 |   |
|                                     |            |                     |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

Amortization expense was $4.0 million and$4.8 million for the three months ended June 30, 2007 and 2006,respectively, and was $8.1 million and $9.7 million for the six months endedJune 30, 2007 and 2006, respectively. The estimated aggregate amortizationexpense for intangibles for the remainder of 2007 and each of the next four yearsand thereafter is as follows:

 

| ** **                  | ** ** | **June 30, 2007**  | ** ** |
|-----------------------------|------------|--------------------|------------|
| *** ***                | ** ** | **(in thousands)** | ** ** |
| ***Amortization  expense*** |       |               |       |   |
| Remainder of 2007           |       | $                  | 7,869      |   |
| 2008                        |       | 12,745             |       |
| 2009                        |       | 6,874              |       |
| 2010                        |       | 5,132              |       |
| 2011                        |       | 5,132              |       |
| Thereafter                  |       | 10,599             |       |
| Total                       |       | $                  | 48,351     |   |

 

 

 

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**NOTE 12 - LONG-TERM INVESTMENT**

 

| ** **                   | ** ** | **June 30,**       | ** ** | **December 31,** | ** ** |
|------------------------------|------------|--------------------|------------|------------------|------------|
| ** **                   | ** ** | **2007**           | ** ** | **2006**         | ** ** |
| *** ***                 | ** ** | **(in thousands)** | ** ** |
| ***Long-term  investments*** |       |               |       |             |       |   |   |
| Gemdale Company, Ltd.        |       | $                  | 62,171     |             | $          | 32,781 |   |
| Global Asia Partners L.P.    |       | 2,067              |       | 1,700            |       |
| Fiberxon, Ltd.               |       | 3,000              |       | 3,000            |       |
| ImmenStar, Inc.              |       | —             |       | 2,000            |       |
| Cortina Systems, Inc.        |       | 3,013              |       | —           |       |
| GCT SemiConductor, Inc.      |       | 3,000              |       | 3,000            |       |
| Xalted Networks              |       | 3,302              |       | 3,302            |       |
| Infinera                     |       | 19,747             |       | 1,902            |       |
| Others                       |       | 107                |       | 124              |       |
| Total                        |       | $                  | 96,407     |             | $          | 47,809 |   |

 

*Gemdale*

 

Gemdale Co., Ltd.  (“Gemdale”) is a real estate company thatinvests and develops properties in China, primarily in Shanghai, Beijing,Shenzhen and Wuhan.  As of June 30, 2007the Company had a 2% ownership interest in Gemdale.  The investment is classified as equitysecurities available-for-sale and recorded at fair value.  An unrealized gain on the investment andrelated receivable totaling $63.1 millionwas recorded in accumulated other comprehensive income as of June 30, 2007.

 

*Global Asia Partners L.P.*

 

                GlobalAsia Partners L.P. (“GAP”) is a venture capital fund formed to make privateequity investments in private and pre-IPO technology and telecommunicationscompanies in Asia.  As of June 30, 2007,the Company owned 49% of the funds outstanding partnership units.  In the second quarter of 2007, the Companyand the other limited partner decided to liquidate the partnership, and sellcertain investments held by GAP. Earnings in the equity interest in GAP were $0.4 million that resultedin an increase to the Company’s investment in GAP at June 30, 2007, and toother income (expense), net, for the three and six months ended June 30, 2007.

 

*Infinera*

 

**               **On June 7, 2007, InfineraCorporation (“Infinera”) closed on its initial public offering of 14,000,000shares of common stock at a price of $13.00 per share. Infinera also announcedthat the underwriters of the offering exercised in full their option topurchase an additional 2,100,000 shares of Infinera common stock, bringing thetotal initial public offering size to $209.3 million.  After the initial public offering, theCompany was entitled to convert its 669,643 shares of Series D and 2,500,000shares of Series E Preferred Stock into 792,410 shares of Infinera’s commonstock; subject to Rule 144 trading restrictions and 180 days lock up periodstarting June 2007 through December 2007.

 

                Asa result of the initial public offering, the value of the Infinera shares ownedby the Company was readily determinable and the investment was classified as anequity security available-for-sale in accordance with SFAS No. 115, “Accountingfor Certain Investments in Debt and Equity Securities.”  The closing price per share of Infineracommon stock on June 29, 2007 was $24.92 and the value of theCompany’s investment was $19.7 million. In the second quarter of 2007, the Company recorded an unrealized gainof $17.8 million, in other comprehensive income, representing the differencebetween the fair value of the investment on June 29, 2007 and the initialinvestment amount of $1.9 million.

 

*Cellon International Holdings Corporation*

 

In the fourth quarter of 2006, the Company recorded a$13.5 million other-than-temporary impairment charge to write down the Company’sinvestment in Cellon International Holdings Corporation (“Cellon”), and furtherrecorded a write down of a prepaid royalty balance of $3.0 million related toCellon.  Based on the deterioration ofCellon’s financial condition, the Company determined that the carrying value ofthe investment was at an amount above the fair value of the investment, and thedecline was other-than temporary.  OnJune 18, 2007, Cellon’s shareholders passed a resolution approving thevoluntary liquidation of Cellon.

 

 

33

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*Cortina/ ImmenStar*

InSeptember 2004, the Company invested $2.0 million in Series A preferred stockof ImmenStar, Inc. (“ImmenStar”). ImmenStar is a development stage company that was designing a chip thatcan be used in the Company’s product. This investment was accounted for under the cost method. In February2007, ImmenStar was acquired by Cortina Systems, Inc., a privately ownedcompany.  In exchange for the Company’sinvestment in ImmenStar, the Company received 3.6 million shares of Series DPreferred Stock of Cortina Systems, Inc., $1.8 million cash in March 2007 andis entitled to receive an additional 0.4 million shares of Series D PreferredStock and $0.2 million cash currently in escrow.  As a result of the acquisition, the Companyrecorded a gain on investment of $2.8 million, in other income, net, and owns1.3% interest of Cortina Systems, Inc. on a fully diluted basis. The Companyaccounts for its investment in Cortina Systems, Inc. using the cost method.

 

**NOTE 13 - DEBT**

 

                Thefollowing represents the outstanding borrowings at June 30, 2007 andDecember 31, 2006:

 

| ** **                                                 | ** ** | **June 30,**       | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------|------------|--------------------|------------|------------------|------------|
| ** **                                                 | ** ** | **2007**           | ** ** | **2006**         | ** ** |
| *** ***                                               | ** ** | **(in thousands)** | ** ** |
| ***Debt***                                                 |       |               |       |             |       |   |   |
| Bank loans                                                 |       | $                  | 105,098    |             | $          | 102,510 |   |
| Capital lease obligations, at 4.7%-10.0%, due through 2011 |       | 697                |       | 809              |       |
| Convertible subordinated notes, due March 1, 2008          |       | 274,600            |       | 274,600          |       |
| Total debt                                                 |       | 380,395            |       | 377,919          |       |
| Long-term debt                                             |       | 460                |       | 275,161          |       |
| Short-term debt                                            |       | $                  | 379,935    |             | $          | 102,758 |   |
|                                                            |            |                    |            |                  |            |  |  |  |

 

 

                AtJune 30, 2007, the Company had loans with various banks totaling $105.1 millionwith interest rates ranging from 5.51 % to 5.75 % per annum. These bank loansthat are denominated in Chinese Renminbi mature during 2007 and the firstquarter of 2008, and are included in short-term debt. There are no significantcovenants associated with these loans.

 

The Company also had available credit facilities in Chinaat June 30, 2007 totaling $702.8 million, of which $358.6 million wasavailable for working capital purposes. The Company had drawn $105.1 million inoutstanding borrowings as of June 30, 2007, and $344.2 million was availablefor use in support of letters of credit and corporate guarantees. Thesefacilities expire primarily in 2007.

 

                OnMarch 12, 2003, the Company completed an offering of $402.5 millionof 7/8% convertible subordinated notes due March 1, 2008 to qualifiedbuyers pursuant to Rule 144A under the Securities Act of 1933. The notesare convertible into the Company’s common stock at a conversion price of $23.79per share and are subordinated to all present and future senior debt of theCompany. Holders of the notes may convert their notes only if: (i) theprice of the Company’s common stock issuable upon conversion of a note reachesa specified threshold, (ii) specified corporate transactions occur, or(iii) the trading price for the notes falls below certain thresholds. Atthe initial conversion price, each $1,000 principal amount of notes will beconvertible into approximately 42.0345 shares of common stock. Expensesassociated with the convertible subordinated notes issuance were $11.7 millionand have been recorded in other long-term assets and are being amortizedover the life of the notes.

 

                TheCompany has entered into a convertible bond hedge and call option transaction.The convertible bond hedge allows the Company to purchase 11.5 millionshares of its common stock at $23.79 per share from the other party to theagreement. The written call option allows the holder to purchase11.5 million shares of the Company’s common stock from the Company at$32.025 per share. Both the bond hedge and call option transactions may besettled at the Company’s option either in cash or net shares and expire onMarch 1, 2008.

 

                TheCompany recorded these instruments at cost, and their carrying value at June30, 2007 equaled their original cost as adjusted for amendments related to theearly extinguishment of debt. The convertible bond hedge and call optiontransactions are expected to reduce the potential dilution from conversion ofthe notes. The options have been included in stockholders’ equity in accordancewith the guidance in EITF No. 00-19, “Accounting for Derivative FinancialInstruments Indexed to, and Potentially Settled in, a Company’s Own Stock.”

 

 

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On November 15, 2006, the Company received a noticeasserting that its failure to timely file its Quarterly Report on Form 10-Q forthe period ended September 30, 2006 had caused a default under the Indenture,which if not cured within 60 days, would cause an event of default. The Companysolicited and obtained the requisite consents from holders of the convertiblesubordinated notes due March 2008 to a waiver effective January 9, 2007 of anydefault which may have occurred prior to such date due to the delay in filingand non-compliance with certain covenants, and the Company and the Trusteeentered into a First Supplemental Indenture, dated January 9, 2007, providingthat any failure by the Company to comply with certain covenants of theoriginal indenture would not result in a default or an event of default throughMay 31, 2007. The First Supplemental Indenture provided for additional interestat a rate of 6.75% per annum in special interest on the notes from and afterJanuary 9, 2007 to the March 1, 2008 maturity date of the notes, unless thenotes are earlier repurchased or converted. Payments of the special interestwere to be made in addition to and at the same time and in the same manner asregularly scheduled payments of interest to holders entitled to such regularlyscheduled payments of interest. As a result of the First SupplementalIndenture, the convertible subordinated notes accrued interest at a rate of7.625% per annum as of January 9, 2007.

 

On May 31, 2007, the Company received a notice of defaultfor the convertible subordinated asserting that a default had occurred underthe indenture, as amended by the First Supplemental Indenture (“the Indenture”)with respect to the Company’s convertible subordinated notes due in March2008.  The specific purported defaultsreferred to in the notice of default were (1) the Company’s failure to file itsQuarterly Report on Form 10-Q for the fiscal quarter ended September 30, 2006,its annual report on Form 10-K for the year ended December 31, 2006 and its QuarterlyReport on Form 10-Q for the fiscal quarter ended March 31, 2007 and (2) theCompany’s failure to deliver to the Trustee the officer’s certificate ofcompliance of the Company required by the Indenture. For information regardingthe subsequent solicitation of consents from the holders of the notes, therelated amendments to the indenture governing the notes and the Company’sreceipt of a notice of default on October 15, 2007, see Note 25 entitled “SubsequentEvents” below.

 

**NOTE 14 - WARRANTY OBLIGATIONS AND OTHERGUARANTEES**

 

                TheCompany provides a warranty on its equipment and handset sales for a periodgenerally ranging from one to three years from the time of final acceptance.Very rarely, the Company has entered into arrangements to provide limitedwarranty services for periods longer than three years. The longest of suchwarranty periods is ten years. The Company provides for the expected cost ofproduct warranties at the time that revenue is recognized based on anassessment of past warranty experience.

 

                Warrantyobligations, included in other current liabilities, are as follows:

 
| ** **                                       | ** ** | ** **                      | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|------------|------------|------------|------------|
| ** **                                       | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
| ** **                                       | ** ** | **2007**                        | ** ** | **2006**                      | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|                                             | ** ** | **(in  thousands)**             | ** ** | **(in  thousands)**           | ** ** |
| Beginning of period                              |       | $                               | 57,311     |                          | $          | 68,702     |       | $          | 63,900     |   | $ | 76,719 |   |
| Accruals for warranties issued during the period |       | 7,769                           |       | 2,821                         |       | 11,066     |       | 11,770     |       |
| Settlements made during the period               |       | (11,464                         | )          | (7,415                        | )          | (21,350    | )          | (24,381    | )          |
| Balance at end of period                         |       | $                               | 53,616     |                          | $          | 64,108     |       | $          | 53,616     |   | $ | 64,108 |   |

 

During 2005, the Company recorded a special warrantycharge for equipment sold to Softbank during 2003 and 2004. Since the agreementto repair these parts exceeds the Company’s normal warranty terms the Companyrecorded special warranty charges of $11.7 million for certainasynchronous digital subscriber line (“ADSL”) products, $4.0 millionprimarily for multi-service optical transport product (“NetRingÔ”) equipment and $14.9 million for Gigabit Ethernet Passive OpticalNetwork (“GEPON”) equipment. The special warranty balance was $10.3 million and$18.9 million at June 30, 2007 and 2006, respectively, and is included in theabove amounts. All of these products are in the Broadband Infrastructuresegment.

 

                Certainof the Company’s sales contracts include provisions under which customers wouldbe indemnified by the Company in the event of, among other things, a third-partyclaim against the customer for intellectual property rights infringementrelated to the Company’s products. There are no limitations on the maximumpotential future payments under these guarantees. The Company has not accruedany amount in relation to these provisions as no such claims have been made andthe Company believes it has valid, enforceable rights to the intellectual propertyembedded in its products.

 

 

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**NOTE 15 - COMMITMENTS AND CONTINGENCIES**

 

*Leases*

 

                TheCompany leases certain facilities under non-cancelable operating leases thatexpire at various dates through 2013. The minimum future lease payments underthe leases at June 30, 2007 were as follows:

 

| ** **                   | ** ** | **June 30,**        | ** ** |
|------------------------------|------------|---------------------|------------|
| ** **                   | ** ** | **2007**            | ** ** |
| ***Lease  commitments***     | ** ** | **(in  thousands)** | ** ** |
| 1 year                       |       | $                   | 14,306     |   |
| 2 year                       |       | 9,921               |       |
| 3 year                       |       | 5,855               |       |
| 4 year                       |       | 1,141               |       |
| 5 year and after             |       | 1,204               |       |
| Total minimum lease payments |       | $                   | 32,427     |   |

 

 

 

                Rentexpense for the three and six months ended June 30, 2007 was $4.7 million and$9.5 million, respectively. Rent expense for the three and six months endedJune 30, 2006 was $4.9 million and $10.1 million, respectively.

 

*Contractual obligations and commercialcommitments:*

 

                As of June 30, 2007 the Company’s obligations undercontractual obligations and commercial commitments are as follows:

 
| ** **                     | ** ** | **June 30, 2007**          | ** ** |
|--------------------------------|------------|----------------------------|------------|
| ** **                     | ** ** | **Payments due by period** | ** ** |
| ** **                     | ** ** | ** **                 | ** ** | **Less than** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                     | ** ** | **Total**                  | ** ** | **1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** |
| ***Obligations***              | ** ** | **(in  thousands )**       | ** ** |
| Bank loans                     |       | $                          | 105,098    |   | $ | 105,098 |   | $ | — |   | $ | — |   |
| Convertible subordinated notes |       | $                          | 274,600    |   | $ | 274,600 |   | $ | — |   | $ | — |   |
| Interest payable on debt       |       | $                          | 21,730     |   | $ | 21,730 |   | $ | — |   | $ | — |   |
| Letters of credit              |       | $                          | 43,012     |   | $ | 26,284 |   | $ | 16,728 |   | $ | — |   |
| Long-term purchase obligations |       | $                          | 7,752      |   | $ | 1,145 |   | $ | 6,607 |   | $ | — |   |
|                                |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |

 

*Letters of credit*

 

                TheCompany issues standby letters of credit primarily to support internationalsales activities outside of China. When the Company submits a bid for a sale,often the potential customer will require that the Company issue a bid bond ora standby letter of credit to demonstrate its commitment through the bidprocess. In addition, the Company may be required to issue standby letters ofcredit as guarantees for advance customer payments upon contract signing orperformance guarantees. The standby letters of credit usually expire withoutbeing drawn by the beneficiary thereof. Finally, the Company may issuecommercial letters of credit in support of purchase commitments.

 

*Long-term purchase obligations*

 

                AtJune 30, 2007, long-term purchase obligations include non-cancelable agreementsto purchase components, primarily in connection with last time buy agreements.As of June 30, 2007, total commitments under these agreements wereapproximately $7.8 million. Additionally, the Company has agreed to purchaseglobal data services from Verizon Communications, Inc. (“Verizon”). At June 30,2007, the remaining commitment to Verizon under this agreement is approximately$0.4 million. In connection with the sale of assets to Marvell TechnologyGroup Ltd (“Marvell”), the Company has agreed to purchase from Marvellcertain chipsets that will be included in the Company’s PAS handsets through2011. These chipsets will be included in certain handset products designed andmanufactured by the Company.

 

 

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*Intellectual property*

 

                Certainsales contracts include provisions under which customers would be indemnifiedby the Company in the event of, among other things, a third-party claimagainst the customer for intellectual property rights infringement related tothe Company’s products. There are no limitations on the maximum potentialfuture payments under these guarantees. The Company has not accrued any amountsin relation to these provisions as no such claims have been made and theCompany believes it has valid enforceable rights to the intellectual propertyembedded in its products.

 

*Income Tax Obligations*

 

                Effective January 1, 2007, the Company adopted the provisions of FIN48.  As of June 30, 2007,theCompany had $74.0 million of liabilities for unrecognized tax benefits. Ifrecognized, the portion of liabilities for unrecognized tax benefits that woulddecrease the provision for income taxes and increase the Company’s net incomeis $7.1 million. The impact on net income reflects the liabilities forunrecognized tax benefits net of certain deferred tax assets and the federaltax benefit of state income tax items totaling $66.9 million. The Company isnot updating the disclosures in its contractual obligations and commercialcommitments table because of the difficulty in making reasonably reliableestimates of the timing of cash settlements with the respective taxingauthorities.

 

 

 

*Litigation*

 

*Securities Class Action Litigation*

                Beginning in October 2004,several shareholder class actions alleging federal securities violations werefiled against the Company and various officers and directors of the Company. The actions have been consolidated in United StatesDistrict Court for the Northern District of California under the caption*In re UTStarcom, Inc. Securities Litigation*,Master File No. C-04-4908-JW(PVT). The lead plaintiffs in the case filed aFirst Amended Consolidated Complaint on July 26, 2005. The First AmendedComplaint alleged violations of the Securities Exchange Act of 1934, and wasbrought on behalf of a putative class of shareholders who purchased our stockafter April 16, 2003 and before September 20, 2004. On April 13,2006, the lead plaintiffs filed a Second Amended Complaint adding newallegations and extending the end of the class period to October 6, 2005.In addition to the Company defendants, the plaintiffs are also suing Softbank.Plaintiffs’ complaint seeks recovery of damages in an unspecified amount.

                On June 2, 2006, the Company andthe individual defendants filed a motion to dismiss the Second AmendedComplaint. On March 21, 2007, the Court granted defendants’ motion anddismissed plaintiffs’ Second Amended Complaint. The Court granted plaintiffsleave to file a Third Amended Complaint, which plaintiffs filed on May 25,2007. On July 13, 2007, the Company and the individual defendants filed amotion to dismiss and a motion to strike the Third Amended Complaint.

                On September 4, 2007, a second shareholder classaction complaint captioned *Peter Rudolph v.UTStarcom, et al.*, Case No. C-07-4578 SI, was filed in the UnitedStates District Court for the Northern District of California against theCompany and some of the Company’s current and former directors and officers.The complaint alleges violations of the Securities Exchange Act of 1934 throughundisclosed improper accounting practices concerning the Company’s historicalequity award grants. Plaintiff seeks unspecified damages on behalf of apurported class of purchasers of the Company’s common stock between July 24,2002 and September 4, 2007.

                Dueto the preliminary status of these lawsuits and uncertainties related tolitigation, the Company is unable to evaluate the likelihood of either afavorable or unfavorable outcome. Accordingly, the Company is unable at thistime to estimate the effects of these complaints on the Company’s financialposition, results of operations, or cash flows.

 

*Governmental Investigations*

                TheCompany has received notice of a formal inquiry by the staff of the Securities& Exchange Commission (“SEC”) into certain aspects of the Company’sfinancial disclosures during prior reporting periods and certain other issues.In addition, in December 2005, the U.S. Embassy in Mongolia informed theCompany that it had forwarded to the Department of Justice (“DOJ”) allegationsthat an agent of the Company’s Mongolia joint venture had offered payments to aMongolian government official in possible violation of the Foreign CorruptPractices Act (the “FCPA”). The Company through our Audit Committee, authorizedan independent investigation into possible violations of the FCPA, and theCompany has been in contact with the DOJ and SEC regarding the investigation.The investigation has identified possible FCPA violations in Mongolia,Southeast Asia, India, and China, as well as possible violations of U.S.immigration laws. The DOJ has requested that the Company voluntarilyproduce documents related to the investigation and the SEC has subpoenaed

 

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the Company for documents.The Company has executed tolling agreements extending the statute oflimitations for the FCPA issues under investigation by the SEC and DOJ and theimmigration issues under investigation by the DOJ. At this time, the Company cannot predictwhen any inquiry will be completed or what the outcome of any inquiry will be.

 

*ShareholderLitigation*

OnNovember 17, 2006, a shareholder derivative complaint captioned *Ernesto Espinoza v. Ying Wu et al.*, CaseNo. RG06298775, was filed against certain of the Company’s current and formerofficers and directors in the Superior Court of the County of Alameda,California. The complaint alleges that the individual defendants, among otherthings, breached their duties, were unjustly enriched, and violated theCalifornia Corporations Code in connection with the timing of stock optiongrants. The complaint names the Company as a nominal defendant and seeksunspecified monetary damages against the individual defendants and variousforms of injunctive relief. On February 2, 2007, the Company and the individualdefendants filed demurrers against the complaint. On April 11, 2007, the Court sustained the individualdefendants’ demurrer, overruled the Company’s demurrer, ordered the plaintiffto file an amended complaint, and ordered the Company to answer the originalcomplaint. The plaintiff filed an amended complaint and the Company has filed ananswer to the amended complaint. On August 21, 2007, the individual defendantsfiled demurrers against the amended complaint. The Court sustained theindividual defendants’ demurrers and ordered the plaintiff to file a secondamended complaint.

Dueto the preliminary status of this complaint and uncertainties related tolitigation, the Company is unable to evaluate the likelihood of either afavorable or unfavorable outcome. Accordingly, the Company is unable at thistime to estimate the effects of this complaint on the Company’s financialposition, results of operations, or cash flows.

 

*IPOAllocation*

                OnOctober 31, 2001, a complaint was filed in United States District Courtfor the Southern District of New York against the Company, some of the Company’sdirectors and officers and various underwriters for the Company’s initialpublic offering. Substantially similar actions were filed concerning theinitial public offerings for more than 300 different issuers, and the caseswere coordinated as *In re Initial PublicOffering Securities Litigation*, 21 MC 92 for pretrial purposes. InApril 2002, a consolidated amended complaint was filed in the matteragainst the Company, captioned *In reUTStarcom, Initial Public Offering Securities Litigation*, CivilAction No. 01-CV-9604. Plaintiffs allege violations of the Securities Actof 1933 and the Securities Exchange Act of 1934 through undisclosed improperunderwriting practices concerning the allocation of IPO shares in exchange forexcessive brokerage commissions, agreements to purchase shares at higher pricesin the aftermarket and misleading analyst reports. Plaintiffs seek unspecifieddamages on behalf of a purported class of purchasers of the Company’s commonstock between March 2, 2000 and December 6, 2000. The Company’sdirectors and officers have been dismissed without prejudice pursuant to astipulation. On February 19, 2003, the Court granted in part and denied inpart a motion to dismiss brought by defendants including the Company. Theorder dismissed all claims against the Company except for a claim brought underSection 11 of the Securities Act of 1933, which alleges that theregistration statement filed in accordance with the IPO was misleading. InJune 2004, a stipulation of settlement and release of claims against theissuer defendants, including the Company, was submitted to the court forapproval. The terms of the settlement, if approved, would have dismissed andreleased all claims against the participating defendants (including theCompany). In August 2005, the Court preliminarily approved the settlement.In December 2006, the Court of Appeals for the Second Circuit reversed theCourt’s October 2004 order certifying a class in six test cases that wereselected by the underwriter defendants and plaintiffs in the coordinatedproceedings. The Company’s case is not one of the testcases. Because class certification was a condition of the settlement, it wasunlikely that the settlement would receive final Court approval. On June 25,2007, the Court entered an order terminating the proposed settlement based on astipulation among the parties to the settlement. Plaintiffs have filed amendedmaster allegations and amended complaints in the six test cases. It is unclearwhether there will be any revised or future settlement. If the litigationproceeds, the Company believes that the Company has meritorious defenses andintend to defend the action vigorously. The total amount of the loss associatedwith the above litigation is not determinable at this time. Therefore, theCompany is unable to currently estimate the loss, if any, associated with thelitigation.

 

*PassaveLitigation*

In November 2005, the Company filed suitin the Superior Court of California, County of Santa Clara, againstPassave, Inc. (“Passave”) for breaches of contract and warranties inconnection with a semiconductor device sold by Passave, Ltd. (Passave’s wholly-­owned subsidiary) to the Company. The Company’s complaint alleges thatthe Passave device, known as the PAS5001M3 chip, has exhibited certainoperational malfunctions within some of our Fiber-to-the-Home product line, andhas thereby caused damage to the Company. The parties entered into a settlementagreement in favor of the Company, dated August 7, 2007, and have sincedismissed all claims with prejudice.

 

 

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*UTStarcom, Inc. v. Starent Patent InfringementLitigations*

On February 16, 2005, theCompany filed a suit against Starent for patent infringement in the U.S.District Court for the Northern District of California. In the Complaint, theCompany asserts that Starent infringes UTStarcom patent U.S. Reg. No.  6,829,473 (“the ‘473 patent”) through Starent’sdevelopment and testing of a software upgrade for its customer’s installedST-16 Intelligent Mobile Gateways. The Company seeks declaratory and injunctiverelief. Starent subsequently filed its answer and counterclaims, denying theCompany’s allegations and seeking a declaration that the patent-in-suit is notinfringed, is invalid, and is unenforceable. On June 16, 2005, the Companyfiled a motion to strike Starent’s affirmative defense and dismiss Starent’scounterclaim alleging inequitable conduct. On July 19, 2005, the partiesstipulated that Starent would file an amended answer and counterclaim by July27, 2005 and that the Company  wouldwithdraw the Company’s motion to strike. On August 10, 2005, the Companyresponded to Starent’s amended counterclaim filed on July 27, 2005. In early December 2006, the Company filed areissue application for the ‘473 patent with the United States Patent andTrademark Office. Starent has also filed for reexamination of the ‘473 patent.The reexamination and reissue are currently copending. The litigation is stillin a preliminary stage and its outcome cannot be predicted, although theCompany believes the litigation has merit. Nonetheless, the Company believesthat any adverse judgment on Starent’s counterclaims will not have a materialadverse effect on the Company’s business, financial condition, or results ofoperations.

 

On May 8, 2007, the Company filed an additional suitagainst Starent and sixteen individual defendants (who were all formeremployees of 3Com’s CommWorks division which the Company acquired certainassets of in May of 2003) in the Northern District of Illinois. The causes ofaction include claims for patent infringement, misappropriation of tradesecrets, intentional interference with business relations and prospectiveeconomic advantage and declarations of ownership of certain patent rights. Inits Complaint, the Company asserts that Starent infringes UTStarcom patents U.S. Reg. Nos. 7,173,905; 6,978,128; 6,963,582; 6,975,900; and 6,684,256 throughthe manufacture, use, offer, for sale, and sale of Starent’s ST16 IntelligentMobile Gateway and ST40 multimedia code platform, that the individualDefendants and Starent have misappropriated valuable Company trade secrets byimproperly taking and using the Company’s confidential and proprietaryinformation for the benefit of Starent, that the individual defendants andStarent have interfered with the Company’s business relations and prospectiveeconomic advantage by using the misappropriated information to obtain andenhance sales of Starent’s products, and that several of Starent’s patent applicationsand one issued patent are based on information obtained by the former employeeswhile at the Company (CommWorks) and on that basis belong to UTStarcom. TheCompany seeks compensatory damages, punitive damages and injunctive relief.After the court denied the defendants motion to dismiss the misappropriation oftrade secrets claims, onAugust 30, 2007, Starent answered the Company’s complaint, denying the Company’sallegations and asserting a number of affirmative defenses and counterclaims,including non-infringement of the subject patents and alleged tortiousinterference with prospective economic advantage. The Company has filed amotion to dismiss most of the counterclaims and the court has orderedappointment of a special master to handle discovery, which is just beginning.The Company believes that any adverse judgment on Starent’s counterclaims willnot have a material adverse effect on the Company’s business, financialcondition or results of operations.

 

*Telemetrix, Inc. Arbitration*

 

OnOctober 19, 2006, Telemetrix, Inc. (“Telemetrix”) filed a formalRequest for Arbitration against the Company to the World Intellectual PropertyOrganization (“WIPO”) in Geneva, Switzerland. The Request for Arbitration sought unspecified damages arising from a contract betweenTelemetrix and Telos Technology, Inc., dated October 22, 2003. The Companyassumed Telos’ rights and obligations under this contract pursuant to theCompany’spurchase of Telos’ assets on May19, 2004.  Telemetrix alleged nine causesof action, including breach of contract, fraud, negligent misrepresentation, interferencewith contractual relations, and interference with prospective economicadvantage. In December 2006, the Company filed a formal response to the Requestfor Arbitration, denying all material factual allegations asserted byTelemetrix. An arbitrator was selected by theparties, and, on August 2, 2007, the arbitrator granted a pleading motion in favor of the Company due toTelemetrix’s failure to allege sufficient facts in support of a majority of itscauses of action. On August 17, 2007, Telemetrix filed an Amended Statement ofClaim, alleging six causes of action, including breach of contract, fraud,interference with contractual relations and interference with prospective economicadvantage. The previous hearing date of December 11-13 has been vacated. Nohearing date has been rescheduled. Discovery has begun.

 

*TelosTechnology, Inc. Litigation*

OnNovember 22, 2005, plaintiffs Telos Technology, Inc., TelosTechnology (Canada), Inc., Telos Technology (Bermuda) Ltd., and TelosEngineering Limited (collectively, the “Telos Plaintiffs”) filed a Complaintagainst the Company in the Superior Court of California, County of Santa Clara.The Complaint alleges five causes of action, including breach of contract,breach of the implied covenant of good faith and fair dealing, fraudulentinducement, intentional misrepresentation

 

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and negligentmisrepresentation, all of which arise from the Asset Purchase Agreement betweenthe parties dated April 21, 2004. The Telos Plaintiffs assert that theCompany breached the express and implied terms of the Asset Purchase Agreementand made representations to the Telos Plaintiffs during negotiations that itnever intended to fulfill. The Telos Plaintiffs sought at least$19 million in damages, unspecified punitive damages and attorneys’ fees.The parties executed a settlement agreement in the amount of $4.5 million onAugust 20, 2007 and the case was dismissed on September 26, 2007 withprejudice.

 

*Other Litigation*

 

                The Company is a party to otherlitigation matters and claims that are normal in the course of operations, andwhile the results of such litigation matters and claims cannot be predictedwith certainty, the Company believes that the final outcome of such matterswill not have a material adverse impact on the Company’s financial position,results of operations or cash flows.

 

**NOTE 16 - SEGMENT REPORTING**

 

The Company has organized its business in a mannerconsistent with the chief operating decision makers’ view and management of thebusiness. The Company offers products and services through four operatingunits, (i) Network Solutions, (ii) PCD, (iii) Handsets and(iv) Services. The Network Solutions operating unit provides its productsand services through two reporting segments; Broadband Infrastructure andWireless Infrastructure. Each reporting segment and operating unit isresponsible for managing its own performance.

 

                TheCompany currently evaluates operating performance of and allocates resources tothe reporting segments based on segment gross profit. Cost of sales and directexpenses in relation to production are assigned to the reporting segments. Theaccounting policies used in measuring segment assets and operating performanceare the same as those used by corporate and are consistently applied across allsegments.

 

                Summarizedbelow are the Company’s segment sales revenue and gross profit for the threeand six months ended June 30, 2007 and 2006, respectively.

 

 

| ** **                    | ** ** | **Three months ended June 30,**  | ** ** | **Six months ended June 30,**  | ** ** |
|-------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                    | ** ** | **2007**                         | ** ** | **% of net sales**             | ** ** | **2006** | ** ** | **% of net sales** | ** ** | **2007** | ** ** | **% of net sales** | ** ** | **2006** | ** ** | **% of net sales** | ** ** |
| ** **                    | ** ** | ** **                       | ** ** | ** **                     | ** ** | **(As restated)** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **(As restated)** | ** ** | ** ** | ** ** |
| *** ***                  | ** ** | **(in  thousands )**             | ** ** | **(in  thousands )**           | ** ** |
| ***Net Sales by Segment***    |       |                             |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Broadband Infrastructure      |       | $                                | 39,383     |                           | 7          | % | $ | 44,769 |   | 8 | % | $ | 70,605 |   | 7 | % | $ | 102,020 |   | 9 | % |
| Wireless Infrastructure       |       | 63,091                           |       | 12                             | %          | 115,965 |   | 21 | % | 132,970 |   | 13 | % | 221,698 |   | 19 | % |
| Network Solutions             |       | 102,474                          |       | 19                             | %          | 160,734 |   | 29 | % | 203,575 |   | 20 | % | 323,718 |   | 28 | % |
| PCD                           |       | 357,797                          |       | 66                             | %          | 266,247 |   | 49 | % | 646,127 |   | 64 | % | 589,242 |   | 51 | % |
| Handsets                      |       | 62,177                           |       | 12                             | %          | 107,069 |   | 19 | % | 131,896 |   | 13 | % | 206,103 |   | 18 | % |
| Service                       |       | 15,797                           |       | 3                              | %          | 17,475 |   | 3 | % | 32,548 |   | 3 | % | 34,443 |   | 3 | % |
|                          |       | $                                | 538,245    |                           | 100        | % | $ | 551,525 |   | 100 | % | $ | 1,014,146 |   | 100 | % | $ | 1,153,506 |   | 100 | % |
|                          |       |                             |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |
|                          | ** ** | **Three  months ended June 30,** | ** ** | **Six  months ended June 30,** | ** ** |
|                          | ** ** | ** **                       | ** ** | **Gross**                      | ** ** | ** ** | ** ** | **Gross** | ** ** | ** ** | ** ** | **Gross** | ** ** | ** ** | ** ** | **Gross** | ** ** |
|                          | ** ** | **2007**                         | ** ** | **Profit %**                   | ** ** | **2006** | ** ** | **Profit %** | ** ** | **2007** | ** ** | **Profit %** | ** ** | **2006** | ** ** | **Profit %** | ** ** |
|                          | ** ** | ** **                       | ** ** | ** **                     | ** ** | **(As  restated)** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **(As  restated)** | ** ** | ** ** | ** ** |
| *** ***                  | ** ** | **(in  thousands )**             | ** ** | **(in  thousands )**           | ** ** |
| ***Gross profit by Segment*** |       |                             |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Broadband Infrastructure      |       | $                                | 8,946      |                           | 23         | % | $ | 4,889 |   | 11 | % | $ | 13,947 |   | 20 | % | $ | 27,975 |   | 27 | % |
| Wireless Infrastructure       |       | 28,572                           |       | 45                             | %          | 53,857 |   | 46 | % | 52,837 |   | 40 | % | 104,618 |   | 47 | % |
| Network Solutions             |       | 37,518                           |       | 37                             | %          | 58,746 |   | 37 | % | 66,784 |   | 33 | % | 132,593 |   | 41 | % |
| PCD                           |       | 15,922                           |       | 4                              | %          | 12,321 |   | 5 | % | 32,767 |   | 5 | % | 26,710 |   | 5 | % |
| Handsets                      |       | 22,396                           |       | 36                             | %          | 32,896 |   | 31 | % | 47,443 |   | 36 | % | 64,509 |   | 31 | % |
| Service                       |       | 3,894                            |       | 25                             | %          | 4,987 |   | 29 | % | 8,020 |   | 25 | % | 8,929 |   | 26 | % |
|                          |       | $                                | 79,730     |                           | 15         | % | $ | 108,950 |   | 20 | % | $ | 155,014 |   | 15 | % | $ | 232,741 |   | 20 | % |
|                               |            |                                  |            |                                |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

40

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                Assetsby segment are as follows:

| ** **               | ** **   | ** **              | ** **   | ** **        | ** **   |
|--------------------------|--------------|-------------------------|--------------|-------------------|--------------|
| ** **               | ** **   | **June 30,**            | ** **   | **December 31,**  | ** **   |
| ** **               | ** **   | **2007**                | ** **   | **2006**          | ** **   |
|                     | ** **   | **(in  thousands )**    | ** **   |
| ***Long-lived assets***  | *** *** | *** ***            | *** *** | *** ***      | *** *** |
| Broadband Infrastructure |         | $                       | 43,200       |              | $            | 43,157 |   |
| Wireless Infrastructure  |         | 79,771                  |         | 79,691            |         |
| Network Solutions        |         | 122,971                 |         | 122,848           |         |
| PCD                      |         | 1,884                   |         | 2,377             |         |
| Handsets                 |         | 43,640                  |         | 43,596            |         |
| Service                  |         | 44,378                  |         | 44,334            |         |
|                     |         | $                       | 212,873      |              | $            | 213,155 |   |
|                     |         |                    |         |              |         |
|                     | ** **   | **June 30,**            | ** **   | **December  31,** | ** **   |
|                     | ** **   | **2007**                | ** **   | **2006**          | ** **   |
|                     | ** **   | **(in  thousands****)** |
| ***Total assets***       | *** *** | *** ***            | *** *** | *** ***      | *** *** |
| Broadband Infrastructure |         | $                       | 580,505      |              | $            | 438,190 |   |
| Wireless Infrastructure  |         | 794,890                 |         | 909,450           |         |
| Network Solutions        |         | 1,375,395               |         | 1,347,640         |         |
| PCD                      |         | 320,536                 |         | 414,295           |         |
| Handsets                 |         | 424,887                 |         | 505,693           |         |
| Service                  |         | 98,255                  |         | 106,322           |         |
|                     |         | $                       | 2,219,073    |              | $            | 2,373,950 |   |
|                          |              |                         |              |                   |              |  |  |  |  |

 

 

 

                Netsales are attributed to a geographical area based upon the location of thecustomer. Net sales data by geographical area are as follows:

 

| ** **                 | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|----------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                 | ** ** | **% of net**                    | ** ** | **% of net**                  | ** ** | ** ** | ** ** | **% of net** | ** ** | ** ** | ** ** | **% of net** | ** ** | ** ** | ** ** | **% of net** | ** ** |
| ** **                 | ** ** | **2007**                        | ** ** | **sales**                     | ** ** | **2006** | ** ** | **sales** | ** ** | **2007** | ** ** | **sales** | ** ** | **2006** | ** ** | **sales** | ** ** |
| ** **                 | ** ** | ** **                      | ** ** | ** **                    | ** ** | **(As restated)** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **(As restated)** | ** ** | ** ** | ** ** |
| ***Net  sales by region*** | ** ** | **(in  thousands )**            | ** ** | **(in  thousands )**          | ** ** |
| United States              |       | $                               | 361,334    |                          | 67         | % | $ | 266,352 |   | 48 | % | $ | 654,502 |   | 65 | % | $ | 596,116 |   | 52 | % |
| China                      |       | 129,222                         |       | 24                            | %          | 205,316 |   | 37 | % | 265,956 |   | 26 | % | 405,126 |   | 35 | % |
| Japan                      |       | 20,523                          |       | 4                             | %          | 38,071 |   | 7 | % | 34,838 |   | 3 | % | 85,731 |   | 7 | % |
| Other                      |       | 27,166                          |       | 5                             | %          | 41,786 |   | 8 | % | 58,850 |   | 6 | % | 66,533 |   | 6 | % |
| Total net sales            |       | $                               | 538,245    |                          | 100        | % | $ | 551,525 |   | 100 | % | $ | 1,014,146 |   | 100 | % | $ | 1,153,506 |   | 100 | % |
|                            |            |                                 |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

                Long-livedassets, consisting of property, plant and equipment by geographical area are asfollows:

 

| ** **              | ** ** | ** **           | ** ** | ** **       | ** ** |
|-------------------------|------------|----------------------|------------|------------------|------------|
| ** **              | ** ** | **June 30,**         | ** ** | **December 31,** | ** ** |
| ** **              | ** ** | **2007**             | ** ** | **2006**         | ** ** |
| ***Long-lived assets*** | ** ** | **(in  thousands )** |
| U.S.                    |       | $                    | 15,989     |             | $          | 14,354 |   |
| China                   |       | 189,902              |       | 191,517          |       |
| Other                   |       | 6,982                |       | 7,284            |       |
| Total long-lived assets |       | $                    | 212,873    |             | $          | 213,155 |   |

 

 

 

41

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**NOTE 17 - TRANSACTIONS WITH RELATEDPARTIES AND CERTAIN INVESTEES**

 

                Thefollowing is a summary of the Company’s transactions with related parties andother investees:

 

| ** **                    | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|-------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                    | ** ** | **Net sales**                   | ** ** | **Net sales**                 | ** ** |
| ** **                    | ** ** | **2007**                        | ** ** | **2006**                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                    | ** ** | ** **                      | ** ** | **(As restated)**             | ** ** | ** ** | ** ** | **(As restated)** | ** ** |
| ** **                    | ** ** | **(in thousands)**              | ** ** | **(in thousands)**            | ** ** |
| Softbank                      |       | $                               | 15,383     |                          | $          | 36,027 |   | $ | 26,918 |   | $ | 79,053 |   |
| Japan Telecom, Ltd            |       | 4,848                           |       | 1,466                         |       | 6,429 |   | 3,256 |   |
| Total Softbank and affiliates |       | 20,231                          |       | 37,493                        |       | 33,347 |   | 82,309 |   |
| Xalted Networks, Inc.         |       | 224                             |       | —                        |       | 224 |   | — |   |
| ORG, Inc.                     |       | 429                             |       | 135                           |       | 641 |   | 263 |   |
| Total                         |       | $                               | 20,884     |                          | $          | 37,628 |   | $ | 34,212 |   | $ | 82,572 |   |
|                          |       |                            |       |                          |       |   |   |   |   |
|                               |            |                                 |            |                               |            |  |  |  |  |  |  |  |  |  |  |

 

 

| ** **              | ** ** | **Accounts receivable** | ** ** | **Accounts payable** | ** ** |
|-------------------------|------------|-------------------------|------------|----------------------|------------|
| ** **              | ** ** | **June 30,**            | ** ** | **December 31,**     | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
| ** **              | ** ** | **2007**                | ** ** | **2006**             | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **              | ** ** | **(in thousands)**      | ** ** |
| Softbank and affiliates |       | $                       | 26,194     |                 | $          | 29,941 |   | $ | 582 |   | $ | 535 |   |
| MDC Holding, Ltd.       |       | 1,103                   |       | 1,300                |       | — |   | — |   |
| Fiberxon, Ltd.          |       | 10                      |       | 44                   |       | 1,320 |   | 368 |   |
| ORG, Inc.               |       | —                  |       | 1,025                |       | — |   | — |   |
| GCT Semiconductor, Inc. |       | —                  |       | —               |       | 49 |   | 1,051 |   |
| Acoustek Int'l, Inc.    |       | —                  |       | —               |       | 51 |   | 51 |   |
| Cortina/Immenstar       |       | —                  |       | —               |       | 18 |   | 345 |   |
| Other                   |       | 28                      |       | 8                    |       | 7 |   | 50 |   |
| Total                   |       | $                       | 27,335     |                 | $          | 32,318 |   | $ | 2,027 |   | $ | 2,400 |   |

 

 

| ** **              | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|-------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **              | ** ** | **Purchases**                   | ** ** | **Purchases**                 | ** ** |
| ** **              | ** ** | **2007**                        | ** ** | **2006**                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **              | ** ** | **(in thousands)**              | ** ** | **(in thousands)**            | ** ** |
| Softbank and affiliates |       | $                               | 1,015      |                          | $          | — |   | $ | 1,499 |   | $ | — |   |
| Fiberxon, Ltd.          |       | 1,812                           |       | 72                            |       | 3,615 |   | 406 |   |
| GCT Semiconductor, Inc. |       | 576                             |       | 2,089                         |       | 1,753 |   | 4,374 |   |
| Cortina/Immenstar       |       | 1,389                           |       | 526                           |       | 1,402 |   | 543 |   |
| Audiovox Comm. Corp     |       | 353                             |       | 481                           |       | 758 |   | 715 |   |
| Total                   |       | $                               | 5,145      |                          | $          | 3,168 |   | $ | 9,027 |   | $ | 6,038 |   |

 

 

 

*Softbank and affiliates*

 

                TheCompany recognized revenue with respect to sales of telecommunicationsequipment to affiliates of Softbank, a significant stockholder of the Company.Softbank offers ADSL coverage throughout Japan, which is marketed under thename “YAHOO! BB.” The Company supports Softbank’s fiber-to-the-home servicethrough sales of its carrier class GEPON product as well as its NetRingÔ. In addition, the Company supports Softbank’s new internet protocoltelevision (“IPTV”), through sales of its RollingStreamÔ product. Included in revenue for the six months ended June 30, 2006 arefees of $17.0 million and $10.1 million charged for the cancellation oforders for broadband infrastructure products, and wireless infrastructureproducts, respectively.

 

                Salesto Softbank include a three year service period and a penalty clause if productfailure rates exceed a certain level over a seven year period. As of June 30,2007, the Company’s customer advance balance related to Softbank agreements was$2.3 million compared to no balance as of December 31, 2006. The currentdeferred revenue balance related to Softbank was $9.8 million and $11.6 millionas of June 30, 2007 and December 31, 2006, respectively. As of June 30, 2007,the Company’s noncurrent deferred revenue balance related to Softbank was $9.3million compared to $11.5 million as of December 31, 2006.

 

 

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                DuringAugust 2004, the Company entered into several agreements with JapanTelecom Co., Ltd (“JT”), a wholly owned subsidiary of Softbank. Theseagreements relate to the sale of *i*AN-8000equipment with specified value and delivery dates, as well as an oral agreementwhich subsequently converted into specific service contracts to manage a salespromotional program for JT. The Company has determined that the serviceactivities revenue should be recorded net of expected promotional spending.

 

On July 17, 2003, the Company entered into aMezzanine Loan Agreement with BB Modem Rental PLC (“BB Modem”), an affiliate ofSoftbank. Under the terms of the agreement, the Company loaned BB Modem$10.1 million at an effective interest rate of 12.01% per annum, for thepurpose of investing in a portfolio of ADSL modems and associated modem rentalagreements, from Softbank. Softbank will continue to service such modems andmodem rental agreements. The Company’s loan was subordinated to certain seniorlenders of BB Modem, and repayments were paid to the Company over a 42-monthperiod through January 31, 2007, with a substantial portion of theprincipal amount of the loan schedule repaid during the last 16 months ofthis period. During the three months ended June 30, 2007 and 2006, the Companyrecorded zero and $0.2 million, respectively, in interest income withrespect to this loan. During the six months ended June 30, 2007 and 2006 theCompany recorded an immaterial amount and $0.4 million, respectively, ininterest income with respect to this loan. The loan receivable was fullysettled during the first quarter of 2007 and therefore was a zero balance as ofJune 30, 2007 compared to a balance of approximately $1.0 million as ofDecember 31, 2006, which was included in prepaid and other current assets.

 

                Asof June 30, 2007, Softbank beneficially owned approximately 12% of the Company’soutstanding stock.

 

*ORG, Inc.*

 

                TheCompany has a 49% ownership in Global Asia Partners L.P. which in turn is asignificant shareholder in ORG, Inc., a reseller of infrastructureequipment for broadband access. In January 2005, the Company entered into areseller agreement with ORG, Inc., which was terminated in August 2006; howeveran immaterial amount of revenue for pre-August 2006 deliveries was recognizedin the three and six months ended June 30, 2007.

 

*MDC Holding, Ltd.*

 

The Company has an outstandingaccounts receivable balance with MDC Holding, Ltd. (“MDC”) related to a PASsystem purchase. Certain employees of the Company were shareholders of MDC asof June 30, 2007.  MDC is in the businessof providing value-added services, such as short message, voicemail orring-tone services for PAS telecom networks.

 

*Fiberxon, Ltd.*

 

                TheCompany has an outstanding purchase commitment of $0.7 million as of June 30,2007 with Fiberxon, Ltd. (“Fiberxon”) in which the Company has a 7% ownershipinterest, to purchase component parts for optical networking products. TheCompany had purchases from Fiberxon of $1.8 million and $0.1 million for the three months ended June 30, 2007and 2006, respectively; and $3.6 million and $0.4 million for the six monthsended June 30, 2007 and 2006, respectively. For information regarding Fiberxon’smerger see Note 25.

 

*GCT Semiconductor, Inc.*

 

                The Company has a 2% ownership interest in GCTSemiconductors, Inc., which designs, develops and markets integrated costcircuit products for the wireless communications industry.

 

*Acoustek Int’l, Inc.*

 

                TheCompany has obtained consulting services from Acoustek Int’l Inc. (“Acoustek”),which employed Minnie Huang, spouse of William Huang, the Company’s formerSenior Vice President and Chief Technology Officer. Mr. Huang’s employment withthe Company terminated on December 31, 2006. The Company made no paymentsduring the six months ended June 30, 2007 compared to $0.1 million for the sameperiod in 2006 to Acoustek for consulting services.

 

*Cortina / Immenstar*

 

*               *The Company has an outstanding purchasecommitment of $0.5 million as of June 30, 2007 with Cortina Systems, Inc, inwhich the Company has a 1.3% ownership interest on a fully diluted basis, topurchase chips that are used in the Company’s product.

 

 

43

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*Xalted Networks, Inc.*

 

                TheCompany has received purchase orders from Xalted Networks (“Xalted”) totalingapproximately $1.3 million in 2005 for telecommunications equipment thatis for product not typically sold by the Company to other customers. TheCompany is charging a ten percent procurement fee to Xalted for obtaining andreselling these products. The equipment was delivered during 2005 but revenuerecognition process was not completed until the three months ended June 30,2007.

 

**NOTE 18 - RESTRUCTURING COSTS**

 

                Asof June 30, 2007 and December 31, 2006, the restructuring accrual, includedwithin accrued liabilities in the condensed consolidated balance sheet, wasapproximately $17,000 and $122,000, respectively. The balance of the liabilityrelates to non-cancelable lease payments for the New Jersey facility. TheCompany expects the remaining accrual to be paid by the third quarter of 2007.

 

**NOTE 19 - OTHER INCOME (EXPENSE)**

 

                Theother income (expense) balances for the three and six months ended June 30,2007 and 2006 are comprised of the following items:

 
| ** **                           | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|--------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                           | ** ** | **2007**                        | ** ** | **2006**                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| ***Other  income and expense***      | ** ** | **(in thousands)**              | ** ** | **(in thousands)**            | ** ** |
| Foreign exchange gains (losses)      |       | $                               | (244       | )                             | $          | 2,922 |   | $ | 814 |   | $ | 5,736 |   |
| Chinese government financial subsidy |       | 160                             |       | 168                           |       | 514 |   | 753 |   |
| Dividend income                      |       | —                          |       | 707                           |       | — |   | 707 |   |
| Gain of sale of assets               |       | —                          |       | 2,527                         |       | — |   | 2,527 |   |
| Gain on sale Immenstar investment    |       | —                          |       | —                        |       | 2,813 |   | — |   |
| Earnings in equity interest in GAP   |       | 366                             |       | —                        |       | 366 |   | — |   |
| Other                                |       | (124                            | )          | 563                           |       | (378 | ) | 731 |   |
| Total                                |       | $                               | 158        |                          | $          | 6,887 |   | $ | 4,129 |   | $ | 10,454 |   |
|                                      |            |                                 |            |                               |            |  |  |  |  |  |  |  |  |  |

 

 

**NOTE 20 - CREDIT RISK AND CONCENTRATION**

 

                Thefollowing customers accounted for 10% or more of the Company’s net sales:

 

| ** **          | ** ** | **Three  months ended June 30,** | ** ** | **Six  months ended June 30,** |
|---------------------|------------|----------------------------------|------------|--------------------------------|
| ** **          | ** ** | ** **                       | ** ** | ** **                     |
| ** **          | ** ** | **% of Net**                     | ** ** | **% of  Net**                  |
| **2007**            | ** ** | **Sales**                        | ** ** | **Sales**                      |
| **Verizon**         |       | 21%                              |       | 19%                            |
| **T-Mobile**        |       | 19%                              |       | 16%                            |
| **Sprint Spectrum** |       | 10%                              |       | 11%                            |
| ** **          | ** ** | ** **                       | ** ** | ** **                     |
| **2006**            | ** ** | ** **                       | ** ** | ** **                     |
| **Verizon**         |       | 9%                               |       | 13%                            |
| **Sprint Spectrum** |       | 7%                               |       | 10%                            |

 

 

At June 30, 2007, T-Mobile accounted for 15% of theCompany’s accounts receivable and no customer accounted for 10%, or more, ofaccounts receivable at December 31, 2006.

 

Approximately 18% and 28% of the Company’s net salesduring the three months ended June 30, 2007 and 2006, respectively,  and approximately 18 % and 27% of the Company’snet sales during the six months ended June 30, 2007 and 2006, respectively,were to entities affiliated with the government of China. Accounts receivablebalances from these China

 

 

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government affiliated entities or state owned enterpriseswere $135.5 million and $170.4 million, respectively, as of June 30, 2007 andDecember 31, 2006. The Company extends credit to its customers in Chinagenerally without requiring collateral. In global sales outside of China, theCompany often requires letters of credit from its customers. The Company hadaccounts receivable from the Jiangsu province of 11% at December 31, 2006.  The Company monitors its exposure for creditlosses and maintains allowances for doubtful accounts.

 

Approximately 24% and 37% of the Company’s net salesduring the three months ended June 30, 2007 and 2006, respectively,  and approximately 26 % and 35% of the Company’snet sales during the six months ended June 30, 2007 and 2006, respectively,were made in China.  Accordingly, thepolitical, economic and legal environment, as well as the general state ofChina’s economy may influence the Company’s business, financial condition andresults of operations. The Company’s operations in China are subject to specialconsiderations and significant risks not typically associated with companies inthe United States. These include risks associated with, among others, thepolitical, economic and legal environments and foreign currency exchange. TheCompany’s results may be adversely affected by, among other things, changes inthe political, economic and social conditions in China, and by changes ingovernmental policies with respect to laws and regulations, changes in China’stelecommunications industry and regulatory rules and policies,anti-inflationary measures, currency conversion and remittance abroad, andrates and methods of taxation.

 

**NOTE 21 - INCOME TAX ASSETS ANDLIABILITIES**

 

In June 2006, the FASB issued FIN 48. Theinterpretation contains a two-step approach to recognizing and measuringuncertain tax positions accounted for in accordance with SFAS No. 109, “Accountingfor Income Taxes.” The first step is to evaluate the tax position forrecognition by determining if the weight of available evidence indicates thatit is more likely than not that the position will be sustained on audit,including resolution of related appeals or litigation processes, if any. Thesecond step is to measure the tax benefit as the largest amount which is morethan 50% likely of being realized upon ultimate settlement.

 

The Company adopted the provisions of FASBInterpretation No. 48, “Accounting for Uncertainty in Income Taxes-aninterpretation of FASB Statement No. 109” (“FIN 48”) on January 1, 2007. As aresult of the implementation of FIN 48, the Company recognized a $1.4 millionincrease in the liability for unrecognized tax benefits which, as required, wasaccounted for as a reduction to the January 1, 2007 opening balance of retainedearnings.  As of January 1, 2007, theCompany had $69.9 million of liabilities for unrecognized tax benefits. Ifrecognized, the portion of liabilities for unrecognized tax benefits that woulddecrease the provision for income taxes and increase the Company’s net income is$6.4 million. The impact on net income reflects the liabilities forunrecognized tax benefits net of certain deferred tax assets and the federaltax benefit of state income tax items totaling $63.5 million. The adoptionresulted in a reclassification of tax liabilities totaling $6.4 million fromcurrent to non-current.  As of June 30,2007, the Company’s liabilities for unrecognized tax benefits totaled $74.0million and are included in other long-term liabilities, net of certaindeferred tax assets and the federal tax benefit of state income tax items. Ifrecognized, the portion of liabilities for unrecognized tax benefits that woulddecrease the provision for income taxes and increase the Company’s net incomeis approximately $7.1 million. The total liabilities for unrecognized taxbenefits and the increase for the current period of these liabilities relateprimarily to the allocations of revenue and costs among our global operations.

 

The Company recognizesinterest expense and penalties related to the above unrecognized tax benefitswithin income tax expense. The Company had accrued interest and penalties ofapproximately $2.2 million as of January 1, 2007 and approximately $2.6 millionas of June 30, 2007.

 

The Company is subject to taxation in the U.S. federaljurisdiction and various U.S. state and foreign jurisdictions. The Company’s income tax returns for the 2003,2004, and 2005 tax years are currently under audit by the United StatesInternal Revenue Service. The Company is also under audit by the taxingauthorities in China on a recurring basis. The material jurisdictions that theCompany is subject to examination are in the United States and China. TheCompany does not anticipate a significant change to the total amount ofliabilities for unrecognized tax benefits within the next 12 months.

 

Inestablishing its deferred income tax assets and liabilities, the Company makesjudgments and interpretations based on the enacted tax laws and published taxguidance applicable to its operations as well as the amount and jurisdiction offuture taxable income. The Company records deferred tax assets and liabilitiesand evaluates the need for valuation allowances to reduce the deferred taxassets to realizable amounts. The Company will maintain a full valuationallowance on its net deferred tax assets in China, the United States, and othercountries until an appropriate level of profitability that generates taxableincome is sustained or until the Company is able to develop tax strategies thatwould enable it to conclude that it is more likely than not that a portion ofits deferred tax assets will be realizable. Any reversal of valuationallowances will favorably impact our results of operations in the period of thereversal.

 

45

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Income tax expense was $3.3 million and $4.7 million for the three months ended June 30, 2007 and 2006,respectively.  Income tax expense was $7.6 million and $7.5 million for the six months ended June 30, 2007 and 2006,respectively. There are two primary reasons why the Company has taxexpense while the Company has pretax losses. First, the Company has notprovided any tax benefit on the forecasted current year losses incurred and taxcredits generated in the United States and other countries, because managementbelieves that it is more likely than not that the tax benefit associated withthese losses will not be realized. Second, the Company continues to accrue taxexpense in jurisdictions where the Company has been historically profitable.Estimates of the annual effective tax rate at the end of the interim periodsare based on evaluations of possible future events and transactions and may besubject to subsequent refinement or revision.

 

**NOTE 22 - RECENT ACCOUNTINGPRONOUNCEMENTS**

 

In September 2006, the FASB issued SFAS No. 157, “FairValue Measurements,” (“SFAS 157”).  SFAS157 defines fair value, establishes a framework for measuring fair value ingenerally accepted accounting principles, and expands disclosures about fairvalue measurements.  The provisions ofthis standard apply to other accounting pronouncements that require or permitfair value measurements.  SFAS 157becomes effective for the Company on January 1, 2008.  Upon adoption, the provisions of SFAS 157 areto be applied prospectively with limited exceptions.  The Company is currently evaluating the effects of SFAS 157 on itsconsolidated financial statements.

 

In February 2007, the FASB issued SFAS No. 159, “The FairValue Option for Financial Assets and Financial Liabilities” (“SFAS 159”).  This statement permits, but does not require,companies to report at fair value the majority of recognized financial assets,financial liabilities and firm commitments. Under this standard, unrealizedgains and losses on items for which the fair value option is elected arereported in earnings at each subsequent reporting date.  SFAS 159 becomes effective for the Company onJanuary 1, 2008. The Company is currently evaluating the effects of SFAS 159 on itsconsolidated financial statements.

 

**NOTE 23 - VARIABLE INTEREST ENTITY**

 

The FASB issued FASB Interpretation No. 46, “Consolidationof Variable Interest Entities” (“FIN 46”). FIN 46 requires that if an entity is the primary beneficiary of avariable interest entity (“VIE”), the assets, liabilities, and results ofoperations of the VIE should be included in the consolidated financialstatements of the entity.

 

During the fourth quarter of 2005, the Company providedan interest free, $12.4 million loan to a party in China as seed capitalfor a venture organized to participate in providing technical service,networking technology, and equipment to the emerging market for IPTV productsin China.  The loan is partially securedby an indirect ownership interest in the venture, is payable in 10 yearsand may be called early without penalty. As a result of the foregoing, and the fact that the venture’s continuingviability is heavily dependent on the further provision of network and terminalequipment by the Company, the Company has determined that the venture is a VIEand that the Company is the primary beneficiary of the venture.  Therefore, this venture is consolidated intothe Company’s results as of June 30, 2007. This VIE had insignificant revenue during the three and six months endedJune 30, 2007 and 2006, and had net losses of $1.7 million and $3.2million for the three and six months ended June 30, 2007, respectively, and hadnet losses of $0.7 million and $1.4 million for the three and six months endedJune 30, 2006, respectively.  Theconsolidation of this VIE represented $20.7 million and $17.2 millionof the total assets of the Company as of June 30, 2007 and December 31,2006.  The liabilities of the VIEconsolidated by the Company do not represent additional claims on the Company’sgeneral assets; rather they represent claims against the specific assets of theVIE.  Likewise, the assets of the VIEconsolidated by the Company do not represent additional assets available tosatisfy claims against the Company’s general assets.  The creditors’ of the VIE do not haverecourse to the Company thereby limiting the liability risks associated withthe Company’s variable interests in the VIE.

 

In the first quarter of 2005, the Company invested in anadditional entity, which is considered a VIE where the Company is the primarybeneficiary and does not hold a majority voting interest.  The company was established to install,develop and operate a PAS network in Mongolia. The creditors of this VIE have no recourse to the Company.  In December 2005, the U.S. Embassy inMongolia informed the Company that it had forwarded to the Department ofJustice allegations that an agent of the joint venture had offered payments toa Mongolian government official, in possible violation of the Foreign Corrupt PracticesAct.  The Audit Committee authorized anindependent investigation into the matter. As a result of the investigation, the Company wrote off$1.2 million of intangibles and established a $2.6 million VATliability at December 31, 2005.  Theinvestigation is still ongoing.  Theconsolidation of this entity resulted in a $6.0 million increase in

 

46

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both total assets and total liabilities and equity as ofDecember 31, 2005.  In the firstquarter of 2006, the Company decided to terminate the joint venture arrangementand wrote off the remaining net assets, of approximately$4.7 million.  In November 2006, theBoard of Directors of the VIE approved dissolution of the joint venture.  As a result, the Company ceased to be theprimary beneficiary of this VIE and the asset and the liabilities of the VIEwere not consolidated as of December 31, 2006. The $2.6 million VAT liability was reversed accordingly as management concludedthat it is remote that the Company would be required to pay such tax for thejoint venture.

 

**NOTE 24 - SALE OF ASSETS**

 

*Marvell Technology Group Ltd.*

 

InFebruary 2006, the Company sold substantially all of the assets andselected liabilities of its semiconductor design business division to MarvellTechnology Group Ltd. (“Marvell”). The Company received $35.4 millionin cash, net of $0.6 million of transaction costs, and an additional$4.3 million in cash was paid by Marvell to the Company inAugust 2007. Included in the cash received was $16.0 million earned by theCompany as a result of achieving certain defined milestones. The Companyreceived payment of this $16.0 million in October 2006. The assets soldinclude the assets related to the prior acquisition of Advanced CommunicationsDevices Corporation in 2001, and other system-on-chip semiconductors. Inconnection with the sale of assets, the Company has entered into a supplyagreement with Marvell.

 

In connection with the sale of assets, the Company hasentered into a supply agreement with Marvell to purchase chipsets for theCompany’s handset products over the next five years. The value allocated to thesupply agreement of $20.2 million is included in other current and long-termliabilities, and is being amortized in proportion to the quantities of chipsetspurchased under the supply agreement over the next five years. As of June 30,2007, approximately $2.7 million has been amortized against cost of sales.

 

**NOTE 25 - SUBSEQUENT EVENTS**

 

*Notice of Default and SecondSupplemental Indenture*

 

On May 31, 2007, the Company received a notice of defaultfor the convertible subordinated notes asserting that a default had occurredunder the indenture, as amended by the First Supplemental Indenture (“theIndenture”) with respect to the Company’s convertible subordinated notes due inMarch 2008.  The specific purporteddefaults referred to in the notice of default were (1) the Company’s  failure to file its Quarterly Report on Form10-Q for the fiscal quarter ended September 30, 2006, its annual report on Form10-K for the year ended December 31, 2006 and its Quarterly Report on Form 10-Qfor the fiscal quarter ended March 31, 2007 and (2) the Company’s failure todeliver to the Trustee the officer’s certificate of compliance of the Companyrequired by the Indenture.

 

Subsequently, the Companysolicited and obtained the requisite consents from the holders of the notes toa waiver, effective July 26, 2007, of any default which may have occurred priorto such date due to the delay in filing and non-compliance with certaincovenants, andthe Company entered into a Second Supplemental Indenture with theTrustee, dated July 26, 2007, after receiving consent from holders of more than50% of the outstanding aggregate principal amount of the convertible subordinatednotes in connection with the Company’s consent solicitation announced July 19,2007. The Second Supplemental Indenture provided that the convertiblesubordinated notes accrue additional interest at a rate of (a) 6.75% per annumin special interest from and after January 9, 2007 to and including July 25,2007, and (b) 10% per annum in special interest from and after July 26, 2007 tothe date the notes are paid, prepaid, redeemed converted or otherwise cease tobe outstanding. The special interest rate provided by the Second SupplementalIndenture represented an increase of 3.25% per annum over the special interestrate of 6.75% provided by the First Supplemental Indenture.  As a result of the Second Supplemental Indenture,the convertible subordinated notes now bear a stated interest rate of10.875%.  Payments of special interestwill be made in addition to, and at the same time and in the same manner as,regularly scheduled payments of interest to holders entitled to such regularlyscheduled payments of interest.

The Second SupplementalIndenture also provided that (i) during the period from and including July 26,2007 to and including October 15, 2007 (“Covenant Reversion Date”), any failureby the Company to comply with the covenants contained in the original agreementrelated to the filing of reports required to be filed with the SEC, and thefurnishing of copies of the SEC reports and certain compliance certificates tothe Trustee, will not constitute a default, and that (ii) if, but for theSecond Supplemental Indenture, a default would be deemed to have occurred as aresult of a failure to comply with such covenants and such default remainsuncured and is continuing as of the Covenant Reversion Date, such default willbe deemed to have occurred on the Covenant Reversion Date.

 

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The Company filed its Annual Report on Form 10-K  for the year ended December 31, 2006 and itsQuarterly Report on Form 10-Q for the quarterly period ended September 30, 2006with the Securities and Exchange Commission on October 10, 2007.

On October 15, 2007, the Company received anadditional notice of default asserting that a default had occurred under theIndenture (as amended by the First Supplemental Indenture and the SecondSupplemental Indenture) with respect to the Notes.  The specific purported defaults referred toin the notice of default were (i) the Company’s failure to file with the SECand provide copies to the Trustee of its Quarterly Report on Form 10-Q for thefiscal quarter ended March 31, 2007 and its Quarterly Report on Form 10-Q forthe fiscal quarter ended June 30, 2007 and (ii) the Company’s failure todeliver to the Trustee the officer’s certificate of compliance of the Companyrequired by the Indenture.  The notice ofdefault provided that the Company has 60 consecutive days from October 15, 2007(the “Demand Date”) to cure the purported defaults before such defaults wouldconstitute an “Event of Default” under the Indenture.  The occurrence of an “Event of Default” underthe Indenture would afford the Trustee or holders of not less than 25% inaggregate principal amount of outstanding Notes the right to declare the fullprincipal amount of all outstanding Notes to be immediately due and payable. Asof the date of the filing of this Form 10-Q for the quarter ended June 30,2007, the Company has filed all required reports with the SEC prior to theDemand Date set forth in the October 15th notice of default, and, asa result, believes that no Event of Default under the Indenture occurred.

*Fiberxonmerger with MRV Communications*

On July1, 2007, Fiberxon, an investment in which the Company has a 7% ownershipinterest, completed a merger with MRV Communications (“MRV”).  In exchange for the Company’s investment inFiberxon, the Company will receive approximately $1.5 million in cash, 1.5million shares of MRV common stock and deferred consideration of approximately$2.7 million.  The deferred considerationbecomes payable upon the completion of certain milestones and may be reduced bylegitimate claims of MRV for certain matters related to the merger.

 

**ITEM 2—MANAGEMENT’S DISCUSSIONAND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**FORWARD-LOOKING STATEMENTS**

 

This Quarterly Report onForm 10-Q contains forward-looking statements within the meaning ofthe federal securities laws.  Thesestatements are based on information that is currently available tomanagement.  We intend such forward-lookingstatements to be covered by the safe harbor provisions of the PrivateSecurities Litigation Reform Act of 1995, and we are including this statementfor purposes of complying with those provisions.  The forward-looking statements include,without limitation, those concerning the following: our expectations regardingour compliance with SEC reporting requirements and NASDAQ listing requirements;our expectations as to the nature of possible market trends; our expectationsregarding continued growth in our business and operations; our expectationsregarding fluctuations in gross profit; our plans regarding payment of cashdividends; our expectations regarding recognition of certain compensation costs;our plans regarding legal proceedings; our expectations regarding the effect oflegal proceedings and government inquiries; our expectations regarding thefunctionality, performance and features of our products; our expectationregarding Softbank’s continued service of certain modems and modem rentalagreements; our expectations regarding possible transition in our management;our plans and expectations regarding relationships with vendors and suppliers,including Marvell and Cellon; our expectations regarding the future source andcosts of chipsets; our plan to fulfill the purchase commitment under variousorders from our suppliers; our expectations regarding the exchange rate riskswith respect to accountable receivables and payables in Renminbi, Japanese Yenand Euros; our plans regarding the use of financial instruments to hedgeagainst certain foreign currency exchange rate risks; our plans regarding theuse of derivative financial instruments for speculative trading purposes; ourplans regarding the discounting of certain bank notes and commercial notes; ourexpectations regarding our ability to raise funds, including the impact of latefiling of our reports with the SEC on our ability to raise funds; ourexpectations regarding the availability of funding under the account receivablefinancing program with Citibank, N.A. and our plan to continue service theaccount receivable; our expectations regarding our investment in Global AsiaPartners L.P.; our expectations regarding our right to intellectual propertyembedded in our products; our expectations regarding our ability to protect ourintellectual property; our expectations regarding the effect of market risks onour operating results; our plans to implement measures to remediate materialweaknesses; our expectations regarding the effectiveness of remediationmeasures; our plans to continue to review internal controls; our expectationsregarding competition and the competitive advantages of our competitors; ourexpectations regarding consolidation of the telecommunications industry; ourexpectations regarding the development and introduction of new and moreadvanced products; our expectations regarding deployment of our products; ourplans to reinvest cost savings derived from and expectations regarding ourworkforce restructurings; our expectations regarding future workforcerestructurings; our expectation regarding

 

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the adoption ofenvironmental, health and safety laws by countries world-wide; our expectationsregarding the effect of the Sarbanes-Oxley Act on our corporategovernance and disclosure practices; our expectation regarding the expensesassociated with compliance with the Sarbanes-Oxley Act; our expectationsregarding the impact of the restatement of our consolidated financialstatements; our expectations regarding the maturation of the PAS market andcorresponding decrease in PAS subscriber growth; our expectations regarding thelong-term demand for our PAS products; our expectations regarding our abilityto offset the decline in PAS sales through pursuing other products; ourexpectations regarding PAS system spending; our plan to pursue opportunitiesfor our wireless infrastructure products in multiple markets; our expectationsregarding our investment in and development of the IPTV market; ourexpectations regarding product margins; our expectations regarding the impactof our initiatives on our revenue plan; our expectations regarding our annualeffective tax rate; our expectations regarding the likelihood to realize thetax benefits in the U.S. and other countries; our expectations regarding theeffect of the China Corporate Income Tax Law on our future tax expenses; ourexpectations regarding valuation allowance on our net deferred tax assets andits impact; our expectations regarding the reporting of net losses throughout2007; our expectations regarding our level of capital expenditures in China;our plans to maintain adequate liquidity levels through at least the next 12months; our expectations regarding the availability and sufficiency of creditlines from our existing lenders; our plans to issue new debt instruments, sellinvestments and assets; our expectations regarding refinancing of theconvertible notes and access to cash in our China subsidiaries to meet ourliquidity requirements outside of China; our expectations regarding interestrates; our expectations regarding sufficiency of cash resources; ourexpectations regarding our ability to receive licenses for our products; ourexpectation that our business, financial condition and results of operationswill continue to be significantly influenced by the political, economic, legaland social environment in China and other international markets, includingJapan, India and Europe; our expectations regarding the nature of political,economic and legal reform in China; our expectations regarding the continuedimportance of the Chinese market for our technologies and development and theimportance of sales in China to our operating results; our expectationsregarding future sales generated from China as a percentage of total sales; ourexpectations regarding the impact of our receiving the license to sell GSM andCDMA handsets in China on our ability to meet future market demands; ourexpectations regarding subscriber growth in China; our expectations regardingglobal expansion of sales outside of China; our plan to extend our supplierbase by introducing more models of our own design and expanding relationshipswith more manufacturers; our plans to pursue opportunities to divest additionalnon-core assets; our expectation that research and development expenses will bestable; our expectations regarding future amortization expenses; ourexpectations regarding the impact of product defects or performance qualityissues; our expectations regarding the impact of international expansion on ourmanagement, operational, financial and other resources; our expectationsregarding the impact of legislation that restricts or prohibits the use ofwireless handsets while driving on our future sales; our expectations regardingimprovement to shorten days sales outstanding; our plans regarding improvementof our internal supply chain and inventory management processes; ourexpectations regarding the reliability of stock-based compensationvaluation models and the impact of SFAS 123R; and our expectationsregarding our ability to implement and enhance our administrativeinfrastructure. Additional forward-looking statements may be identifiedby the words “anticipate,” “expect,” “believe,” “intend,” “will,” “may,” andsimilar expressions, as they relate to us or our management, or by the words “designed,”“intended” and similar expressions, as they relate to our products andservices.  Investors are cautioned thatthese forward-looking statements are inherently uncertain.  These statements are subject to risks anduncertainties that may cause actual results and events to differmaterially.  For a detailed discussion ofthese risks and uncertainties, see Part II, Item 1A “Risk Factors” of thisForm 10-Q.  We do not guaranteefuture results and undertake no obligation to update the forward-lookingstatements to reflect events or circumstances occurring after the date of thisForm 10-Q.

 

**RESTATEMENT OF CONSOLIDATED FINANCIALSTATEMENTS**

 

Our consolidated financial statements and relatedfinancial information included in this Quarterly Report on Form 10-Q foraccounting periods prior to the third quarter of 2006 have been restated, asdescribed below.

 

***Summary***

 

In July 2007, the Company announced the AuditCommittee of the our Board of Directors (“Audit Committee”) was conducting anindependent investigation of historical sales with certain customers in Chinaand stated that it could not rule out the possibility that the outcome of theinvestigation could impact revenue recognized for certain of such contracts asrecorded in previously issued financial statements. In September 2007, theCompany announced the investigative phase of the Audit Committee’sinvestigation had been completed. After consultation with and upon therecommendation of management, the Audit Committee determined revenue in theCompany’s Western Region of China was recognized earlier than it should havebeen and that the financial statements for the affected periods should berestated. The Company also announced that itspreviously issued financial statements for each of thefiscal years ended December 31 in the period 2000 through 2005, the financialstatements for the interim periods contained in the Quarterly Reports on Form10-Q filed with respect to each of these years, and the quarterly reports onForm 10-Q filed with respect to each of the quarterly periods

 

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ended March 31 and June 30, 2006 should not be relied upon. In this Quarterly Reportwe have corrected for the effects of net sales and related costs of net sales thatwere recorded earlier than they should have been and have restated thefinancial statements for the three and six months ended June 30, 2006. The neteffects for the three and six months ended June 30, 2006 were to recognizepreviously deferred revenue and an increase (decrease) of gross profit of $2.4million and ($0.4) million, respectively, and $7.8 million and $1.0 million,respectively.

 

We also conducted a voluntary review of historical stock option practicesunder the direction of the Nominating and Corporate Governance Committee of ourBoard of Directors (“Governance Committee”). This review considered all optiongrant awards made in the period from February 29, 2000, shortly before theinitial public offering of our Common Stock, through August 2006 for compliancewith the various stock-based compensation accounting standards applicableduring this period as well as the rules of our stock option plans. We foundthat in a number of instances we did not use the proper date as the measurementdate in determining whether stock options had been issued with exercise pricesbelow the fair value of our common stock. Therefore, we have restated ourpreviously issued financial statements for the years ended December 31, 1998through 2005 to account for an additional $25.5 million of stock compensationexpense that should have been recognized over the period together with an equalincrease in additional paid-in capital to recognize the intrinsic valueassigned to these issuances of equity securities. Related adjustments ofpayroll and income taxes resulted in an additional $0.5 million of expensebeing recognized for the 1998 through 2005 period and total stockholders’equity being reduced by a total of $2.1 million at December 31, 2005. Duringthe first six months of 2006 an additional $1.2 million of stock compensationexpense was recognized, which reduced our previously reported operating resultsfor this period. We have restated the financial statements for the three andsix months ended June 30, 2006,  andduring that period incremental stock compensation expense totaling $0.5 millionand $1.2 million was recognized, respectively.

 

None of theserestatements had any effect on any of our cash balances, however cashequivalents were reduced at June 30, 2006 due to the correction inclassifications described below.

 

Additional informationabout these restatements and their effects on our financial statements ispresented below as well as in the Notes to Condensed Consolidated FinancialStatements.

 

***China Sales Investigation***

 

The Audit Committee engaged independent counsel toconduct an investigation of sales in China following a determination by theInternal Audit group that allegations of improper activities in a sales officein the Western Region were credible. The allegations were made by a Companyemployee using the Company’s whistle blower program. The independent counselengaged the assistance of forensic accountants, and this group is collectivelyreferred to as the Investigating Team in the rest of this discussion.

 

In conducting its procedures, the Investigating Teamfound instances where the customer contracts that evidenced the arrangementcontained obligations for the Company to deliver software upgrades when and ifmade available for the equipment sold for no additional consideration and foran unspecified period that could extend over the term of the contract. Thisadditional contract obligation is an element of “post contract support.” Inthese cases, the Investigating Team found that the contract documentation forthe same transaction submitted by the sales office to the Company’s Chinaheadquarters for accounting purposes and utilized by the Company in determiningthe amount of revenue recognized did not include evidence of such post contractsupport obligations.

 

Accounting standards governing revenue recognition forsystem sales require all revenue to be deferred while there are undeliveredelements under the arrangement unless the seller has established vendorspecific objective evidence (“VSOE”) of fair value for such contract elements.Because these arrangements included such undelivered elements, revenue shouldbe deferred based on the VSOE of the fair value of the underlying elements.VSOE of fair value represents the price charged when the same element is soldseparately. Since the Company does not sell this element separately, it has notestablished VSOE for such undelivered elements, and as such the revenue fromsuch contracts is required to be deferred and recognized over the period the Companyis obligated to provide the post contract support.

 

The China sales investigation covered each of theseven years in the period ended December 31, 2006 and included:  investigating approximately 1,200 contractsin all of our five regions in China; reviews of the electronic files of 45employees; and formal interviews of 96 employees in China. Additionally, theChina sales investigation included reviewing contract files, performing variousfinancial analyses including comparison of payments received per our accountingrecords to the contract terms, and computer forensic procedures wheredestruction of electronic documents was suspected. In the aggregate, theInvestigating Team expended approximately 25,000 hours in conducting thisinvestigation, which commenced

 

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in February 2007 and was completed in September 2007 when theindependent counsel and forensic accountants presented their final report tothe Audit Committee. In July 2007, we announced the Audit Committee wasconducting an independent investigation of historical sales with certaincustomers in China and we stated that we could not rule out the possibilitythat the outcome of the investigation could impact revenue recognized forcertain of such contracts as recorded in our previously issued financialstatements.

 

Upon completion of the investigative phase of theindependent investigation by the Audit Committee, our management:

 

•                  conducted follow-up procedures to attemptto locate any additional relevant information to ensure the China salesinvestigation considered all available information and documents;

 

•                  evaluated the accounting for identifiedsystem sales using the contract template and documentation found in the salescontract files from the Western Region offices. This included calculating thefinancial statement effects of correcting the accounting for all system saleswhere the contract template found at our sales offices contained post contractsupport obligations to recognize revenue and cost of net sales over estimatedperiod of post contract support; and

 

•                  concluded that as a result of theexistence of this undelivered post contract support obligation our previouslyissued financial statements should be restated to defer system sales contractrevenue and the related cost of net sales over the estimated period of postcontract support when a contract contained unspecified software upgrade rights.

 

The Audit Committee concurred with management’sdecisions.

 

The effect of correcting improperly recognized revenueand cost of net sales was to (reduce) increase previously reported net sales,gross profit and net income by the following amounts (in thousands of dollars):

 

| ** **                        | ** ** | **Net sales** | ** ** | **Gross profit** | ** ** | **Net income** | ** ** |
|-----------------------------------|------------|---------------|------------|------------------|------------|----------------|------------|
|                              |       |          |       |             |       |           |       |
| Year ended December 31,           |       |          |       |             |       |           |       |   |   |   |
| 2000                              |       | $             | (12,408    | )                | $          | (5,294         | )          | $ | (4,781 | ) |
|                              |       |          |       |             |       |           |       |
| 2001                              |       | (17,154       | )          | (6,330           | )          | (5,779         | )          |
|                              |       |          |       |             |       |           |       |
| 2002                              |       | (64,732       | )          | (22,924          | )          | (19,697        | )          |
|                              |       |          |       |             |       |           |       |
| 2003                              |       | (21,060       | )          | (8,014           | )          | (6,382         | )          |
|                              |       |          |       |             |       |           |       |
| Totals through December  31, 2003 |       | (115,354      | )          | (42,562          | )          | (36,639        | )          |
|                              |       |          |       |             |       |           |       |
| 2004                              |       | (104,965      | )          | (27,241          | )          | (18,594        | )          |
|                              |       |          |       |             |       |           |       |
| 2005                              |       | (58,232       | )          | (27,863          | )          | (42,433        | )          |
|                              |       |          |       |             |       |           |       |
| 2000 - 2005 Total                 |       | $             | (278,551   | )                | $          | (97,666        | )          | $ | (97,666 | ) |
|                              |       |          |       |             |       |           |       |
| 2006 quarter ended                |       |          |       |             |       |           |       |
|                              |       |          |       |             |       |           |       |
| March 31                          |       | 5,410         |       | 1,360            |       | 1,360          |       |
|                              |       |          |       |             |       |           |       |
| June 30                           |       | 2,379         |       | (371             | )          | (371           | )          |
|                              |       |          |       |             |       |           |       |
| Total China Sales  Restatement    |       | (270,762      | )          | (96,677          | )          | (96,677        | )          |
|                                   |            |               |            |                  |            |                |            |  |  |  |  |

 

The cumulative effect of allof the China sales restatement adjustments to our consolidated balance sheet asof December 31, 2003 resulted in a decrease in retained earnings of $36.6million, an increase in deferred revenue of $115.4 million to account forpreviously recognized sales, an increase in deferred costs of $72.8 million toaccount for previously recognized cost of net sales, and an increase indeferred tax assets and prepaid taxes of $5.9 million. In our consolidated balance sheet atDecember 31, 2006, deferred revenue is $275.7 million, of which $35.6 millionis classified as current and $240.1 million as non-current, and the deferredcosts balance is $176.6 million. These amounts will be recognized in ourconsolidated statements of operations over the estimated remaining period ofpost contract support.

 

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In our consolidated balance sheet at June 30, 2007 thenet reduction in previously recognized net sales is accounted for as deferredrevenue, of which $37.6 million is classified as current and $227.2 million asnon-current, and the related net reduction in cost of net sales of $169.7million is accounted for as deferred costs. These amounts will be recognized inour consolidated statements of operations over the estimated remaining periodof post contract support.   Due to thisrestatement, we increased(decreased) net sales, gross profit, and net income(in thousands) for the three and six month period ended June 30, 2006 asfollows: $2,379, ($371) and ($371), respectively, and $7,789, $989 and $989,respectively.

 

Upon completing its investigation, the Audit Committeeconcluded that the conditions and practices relating to systems contractsprevalent in the Western Region resulted primarily from the failure to preventor detect instances of override related to controls in China over customeragreements, lack of proper management oversight, unclear record retentionpolicies and procedures relating to systems contracts, and inadequate employeetraining.  The Investigating Team and theAudit Committee also concluded that with respect to four regions other than theWestern Region there was no evidence of fraud or misconduct or reason tosuspect such occurred. The Investigating Team and the Audit Committee alsoconcluded that there was no credible evidence of knowledge by senior managementin China or the United States of the conditions and practices related to theWestern Region of China that were discovered in the investigation. The AuditCommittee concluded that local management in several of the sales offices inthe Western Region of China did not submit appropriate information to theCompany’s senior management in China and the United States. Therefore, in prioryears, neither the Company’s management nor the Company’s independentregistered accounting firm were able to properly evaluate the effect of thatinformation on revenue recognition. The Audit Committee also concluded thatcertain members of management in China bear varying degrees of responsibilityfor inadequate oversight of activities. As a result, certain employees in Chinahave either been terminated or placed on suspension for failure to provideadequate oversight of activities.

 

We have restructured the management of the WesternRegion sales organization and are working to identify and implement changes toour policies and procedures and enhance employee training to improve internalcontrol consciousness and lessen the possibility of accounting errors occurringin the future.

 

***Stock Option Accounting***

 

In November 2006, we announced we had commenced avoluntary review of historical stock option practices under the leadership ofthe Governance Committee following a preliminary review by management whichidentified potential deficiencies and discrepancies in the documentation ofstock option grants. The review considered all option grant awards made in theperiod from February 29, 2000, shortly before the initial public offering ofour Common Stock, through August 2006 (“Review Period”) for compliance with thevarious stock-based compensation accounting standards applicable during theReview Period as well as the rules of our stock option plans. The GovernanceCommittee engaged independent outside legal counsel to assist in the reviewwho, in turn, engaged forensic accountants. (Separate law firms and separateforensic accounting firms were engaged by the Audit Committee and theGovernance Committee for the China sales investigation and the stock optionaccounting review.) In the rest of this discussion, this group collectively isreferred to as the Stock Option Review Team and their actions and activitiesare referred to as the Stock Option Review. The Stock Option Review Teammembers spent over 11,000 hours in this review, and the Governance Committeemet with the Stock Option Review Team on more than a dozen occasions toreceive, discuss, and consider the Stock Option Review Team’s information andfindings.

 

At the time the review commenced, the GovernanceCommittee consisted of three members of the Board of Directors, all of whom areindependent directors. The Committee decided to delegate supervision of thereview to Mr. Jeff Clarke, its Chairman, who joined our Board in 2005 and hadnot served on the Compensation Committee of the Board of Directors (“CompensationCommittee”) during the period under review. The Governance Committee alsoconsisted of two other independent directors, Mr. Larry D. Horner and Mr.Thomas Toy, who also serve on the Board’s Compensation Committee.  Mr. Allen Lenzmeier was appointed to theGovernance Committee on April 27, 2007.

Review proceduresincluded:

•                  interviews of individuals involved with granting,advising, administering, or accounting for stock options, including current andformer:  management, members of the Boardof Directors, employees, and non-employee professionals;

•                  review of relevant stock administration, humanresource, legal, and finance department files and records;

 

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•                  review of stock option grant information in selectemployee personnel files;

•                  review by at least 30 attorneys and 15 forensicaccountants of approximately 250,000 potentially relevant e-mails and documentsin electronic format selected through electronic discovery techniques from over1.8 million electronic documents processed;

•                  review of the electronic database of the Company’sstock option activity maintained by a third party along with communications toand from this service provider;

•                  reconciliation of grant activity from approvaldocuments executed by the Compensation Committee with the electronic database;

•                  reconciliation of stock option grant, exercise, andcancellation information from SEC filings with select employee personnel filesand the electronic database;

•                  statistical and judgmental pattern analysis;

•                  follow-up on matters raising questions about theoption granting process and its history, conduct of those involved withgranting, advising, administering, or accounting for stock options, or theaccounting treatment for stock options; and

•                  follow-up on items or issues requested or identifiedby management or the Company’s independent registered public accounting firm.

 

The Stock Option Review Team, management, and theGovernance Committee decided to group stock option grants into six awardcategories based on differences in what constituted substantive approval foreach category under our stock option granting practices as well as givingconsideration to the risk of intentional misstatement of the grant date.Guidance in a September 19, 2006 letter publicly issued by the SEC’s ChiefAccountant focuses on the concept that a measurement date under AccountingPrinciples Board Opinion No. 25 *Accounting for StockIssued to Employees*(“APB 25”), the accounting standard governingour stock option accounting through 2005, does not occur until the number ofshares an individual employee is entitled to receive and the exercise price isdetermined with finality (i.e., no longer subject to change). This is the dateon which substantive approval occurred, and depending on a company’s facts andcircumstances the guidance from the SEC discussed above recognizes a companymay determine that the measurement date for some stock option grants may occurbefore all required granting actions have occurred — such as final approval bythe Compensation Committee. This alternative is available only when a review ofall facts and circumstances supports a conclusion that substantive approvaloccurs earlier than when all required granting actions have occurred and thereis no evidence of fraudulent or manipulative conduct in the Company’s optiongranting practices.

 

In determining the measurement date to be used, theStock Option Review Team, management, and the Governance Committee agreed touse the following definitions as constituting the proper measurement date, andgenerally these dates were used in testing the stated grant dates orestablishing corrected measurement dates:

 

| **Discretionary Director and Officer Grants** |       | The date of a Compensation Committee meeting where  the grant was approved or the date the final Compensation Committee signer  approved the grant when approval occurred through unanimous written consent  documents (“UWC”).                                                                                                                                                   |
|-----------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **                                    | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                  |
| **Automatic Director Grants**                 |       | The date specified in the relevant stock option  plan.                                                                                                                                                                                                                                                                                                                                      |
| ** **                                    | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                  |
| **Broadbase**                                 |       | The date the grantee list, including the allocation  of shares to individual grantees, was complete. Compensation Committee  approval was considered perfunctory due to delegation of authority to  management.                                                                                                                                                                             |
| ** **                                    | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                  |
| **Acquisition**                               |       | The first Compensation Committee meeting following  the acquisition, provided grantees had received employment offer letters  stating the number of stock options to be granted before such date, because  this was the date at which the option exercise price was established.  Compensation Committee approval was considered perfunctory due to delegation  of authority to management. |

 

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| **New Hire**    |       | The first scheduled Compensation Committee meeting  following the first day of employment, because this was the date at which the  option exercise price was established. The number of options was based on  either grant amounts specified in an employment offer letter or, in some  cases, on a matrix that assigned grant amounts based on position and level  within the Company. Compensation Committee approval was considered  perfunctory due to delegation of authority to management. |
|-----------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **      | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| **Other Merit** |       | The date the grantee list, including the allocation  of shares to grantees, was substantially complete. Compensation Committee  approval was considered perfunctory due to delegation of authority to  management.                                                                                                                                                                                                                                                                                |

For 12 tested grant dateswhere a corrected measurement date was required, the Stock Option Review Teamand management were unable to locate sufficient evidence to establish acorrected measurement date using our established criteria for the applicable optiongrant type. In these situations alternative available evidence was used toestablish the corrected measurement date.

During the period coveredby the Stock Option Review, we granted stock options on approximately 34million shares of our Common Stock at 197 grant dates. The review specificallyexamined the appropriateness of the stated grant date for approximately 90% ofthe stock options granted, including all stock option grants made to directorsand officers, all broadbase grants and all option grants made in connectionwith business acquisitions.

 

The findings of this review are summarized as follows:

 
| ** **                           | ** ** | ** **            | ** ** | ** **         | ** ** | **Measurement date changed** |       |
|--------------------------------------|------------|-----------------------|------------|--------------------|------------|------------------------------|------------|
| **Grant  Type**                      | ** ** | **Number  of grants** | ** ** | **Grants  tested** | ** ** | **No  change required**      | ** ** | **additional  compensation  expense required** | ** ** | **no additional  compensation expense required (1)** |   |
|                                 |       |                  |       |               |       |                         |       |   |   |   |   |
| Discretionary Director & Officer |       | 16                    |       | 16                 |       | 8                            |       | 4 |   | 4 |   |
| Automatic Director                   |       | 5                     |       | 5                  |       | 5                            |       | — |   | — |   |
| Broadbase                            |       | 8                     |       | 8                  |       | —                       |       | 6 |   | 2 |   |
| Acquisition                          |       | 10                    |       | 10                 |       | 10                           |       | — |   | — |   |
| New Hire                             |       | 166                   |       | 48                 |       | 48                           |       | — |   | — |   |
| Other Merit                          |       | 96                    |       | 41                 |       | 4                            |       | 21 |   | 16 |   |
| Total                                |       | 301                   | (2)   | 128                |       | 75                           |       | 31 |   | 22 |   |

 

(1)          Under APB 25there is no expense adjustment arising from using the corrected measurementdate for these grants because the amount the employee would have to pay to exercisethese stock option grants exceeded the quoted market price of our Common Stockat the corrected measurement date, and therefore, these stock option grantscontained no intrinsic value at the corrected measurement date.

 

(2)          The number ofgrants exceeds the number of grant dates because on certain grant dates morethan one category of stock option grants were approved.

In late January 2007 theGovernance Committee reported its interim findings concerning the use ofincorrect measurement dates in our stock option accounting under APB 25 to ourBoard of Directors. On February 1, 2007, the Audit Committee of the Board ofDirectors then concluded, in consultation with and upon the recommendation ofmanagement, that we should correct for errors in previously reportedstock-based compensation expense through restatement of our previously issuedfinancial statements and that our previously issued financial statements forall periods should no longer be relied upon. We communicated this decision in aFebruary 1, 2007 public announcement.

 

A non-cash compensation charge, to be recognized as anexpense over a grantee’s service period, arises under APB 25 if a stock optionhas intrinsic value at its measurement date. This intrinsic value is measuredby the excess, if any, of the fair value at the date of grant of the underlyingcommon stock over the stock option’s exercise price. Our practice has been togrant stock options with exercise prices equal to the closing price of ourCommon Stock at each grant date, to use the grant date as the measurement datefor stock-based compensation purposes, and as such previously we had determinedthe granted stock options had no intrinsic value at their grant dates and nocompensation expense was recognized. However, APB 25 states the measurementdate does not occur until all essential actions necessary to grant the optionare completed, including the final determination of both the number of sharesto be granted to each employee or director and the exercise price, and theoption grant is approved by those with requisite authority. This is reinforcedby the September 19, 2006 letter issued by the SEC’s Chief Accountant whichfocuses on the need for the number of shares and exercise price of an award toan individual to be finalized to have a measurement date. This letter clarifiesthe SEC staff’s view that if it is possible that those terms could change, ameasurement date has not occurred, even if the award’s terms are not actuallychanged.

 

54

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Based on the available evidence, the review found thatthe number of shares an individual employee was entitled to receive and/or theexercise price was not determined with finality at the stated grant date on 53tested grant dates, and we should have used a later date as the measurementdate. The principal reasons for the stated grant date not qualifying as themeasurement date under APB 25 include:

•                  certainlistings of grantees, below officer level, were incomplete and added to ormodified by stock option administration personnel after the grant was approvedby the Compensation Committee;

•                  forcertain grants where Compensation Committee approval was not consideredperfunctory, the date a UWC document was sent to Compensation Committee membersfor approval was used as the stated grant date for some discretionary officerand director grants rather than the date the UWC was signed by all CompensationCommittee members and therefore became effective; and

•                  theStock Option Review Team was unable to locate contemporaneous documentation ofsome director and officer, broadbase, new hire, and other merit grants.

Duringthe review the Company also discovered a stock option grant to a former officerthat was modified in 1998 in connection with his termination of employment.This change was never included in the Company’s stock option grant records andthe additional compensation expense resulting from the change in the option’sterms  (approximately $1.2 million)  was not recorded previously. This discovery is consistent with theStock Option Review Team’s finding that in certain instances there was a lackof formal documentation in the stock option granting process and/or expecteddocumentation is missing from the stock option administration files. Inaddition, the Stock Option Review Team found that, in many instances, there wasa lack of self-authenticating evidence to corroborate that cash exercises werecontemporaneous. As a result, the findings on the issue of backdating of cashexercises were inconclusive.

 

We restated our consolidated financial statements torecognize additional non-cash stock-based compensation expense arising fromusing corrected measurement dates for certain stock option grants made duringthe years 2000 through 2005 and to reflect the modification of the 1998 grantdescribed above. Consistent with our historical accounting policy thisadditional stock-based compensation expense is being recognized on anaccelerated basis by treating each vesting tranche as a separate stock optiongrant (graded vesting).

 

Our accounting for stock-based compensation changed toa fair value based method in 2006 when, as required by accounting standards, weceased accounting for stock-based compensation under the intrinsic value methodpursuant to APB 25 and began accounting for stock-based compensation underStatement of Financial Accounting Standards 123(R) *Share-BasedPayments*(“SFAS 123(R)”). Under this method all stock option grantshave a fair value determined using an option pricing model, and such fair valueis used to recognize non-cash stock-based compensation expense. We restated ourunaudited condensed consolidated financial statement information for the firstand second fiscal quarters of 2006,included in Exhibit 99.1 in our AnnualReport on Form 10-K for the year ended December 31, 2006 (and as reflected inour results for the three and six months ended June 30, 2006 included in thisForm 10-Q), to recognize changes in non-cash stock-based compensation expensethat arose from a re-determination of the fair value of stock options grantedin 2005 and prior where the Governance Committee’s review resulted in acorrected measurement date. By January 1, 2006, of the 17.9 million optionsgranted in 2000 — 2005 where corrections were made to the measurement dates inthe Stock Option Review, 4.4 million options with corrected measurement datesgranted in 2000 and 2001 had fully vested. Therefore, the fair values of theoutstanding and unvested portion of the remaining 13.5 million stock optionsgranted in 2002-2005 with incorrect measurement dates were recalculated. Wealso recorded additional non-cash stock-based compensation expense in the firsttwo quarters of 2006 arising from correcting the measurement date for stockoption grants to three individuals in this period. We recognize stockcompensation expense on a straight-line basis under SFAS 123(R).

 

Those stock option grants with corrected measurementdates have also been restated using the fair value based measurement principlesof Statement of Financial Accounting Standards 123 *Accountingfor Stock-Based Compensation*(“SFAS 123”) to present, in Note 2, “Restatementof Financial Statements” of Notes to Consolidated Financial Statementscontained in Item 8 of this Annual Report, the pro forma effect on stock-basedcompensation expense, net income (loss), and earnings (loss) per share amountsin 2004 and 2005 of using the fair value based method to determine stock-basedcompensation expense rather than using APB 25’s intrinsic value method. Suchdisclosure is required in financial statements for periods prior to theadoption of SFAS 123(R).

 

In addition to restating the consolidated financialstatements in response to the Governance Committee’s findings, we recordedadditional non-cash adjustments to account for the modification in 1998 of astock option grant to a former officer in connection with his termination ofemployment and to record in the first two quarters of 2006 corrections relatingto accounting for performance related stock options and restricted stockgrants, all of which were previously identified and considered immaterial.

 

55

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Correcting the measurement date for previously grantedstock options in some cases results in additional taxable income to employeeson which additional payroll taxes are due from the employees as well as us. Wehave provided for all additional payroll taxes plus related penalties andinterest arising from the restatement of stock-based compensation, includingamounts otherwise payable by stock option recipients, and our restatedfinancial statements include an accrual in all affected years of approximately$1.5 million for all estimated payroll tax related expenses.

 

The corrections for the stock option restatement wereto increase (reduce) previously reported non-cash compensation expense, payrolltaxes, income taxes and net income by the following amounts (in thousands ofdollars):

 

 
|                              |   | **Non-cash stock** | ** ** | ** **        | ** ** | ** **       | ** ** | ** **     | ** ** |
|-----------------------------------|--------|--------------------|------------|-------------------|------------|------------------|------------|----------------|------------|
|                              |   | **compensation**   | ** ** | **Payroll taxes** | ** ** | **Income taxes** | ** ** | **Net income** | ** ** |
|                              |   |               |       |              |       |             |       |           |       |
| Year ended December 31,           |   |               |       |              |       |             |       |           |       |
| 1998                              |   | $                  | 1,244      |              | $          | —           |       | $              | (448       | ) | $ | (796 | ) |
| 1999                              |   | —             |       | —            |       | —           |       | —         |       |
| 2000                              |   | 556                |       | —            |       | (104             | )          | (452           | )          |
| 2001                              |   | 4,870              |       | —            |       | (942             | )          | (3,928         | )          |
| 2002                              |   | 8,110              |       | —            |       | (1,550           | )          | (6,560         | )          |
| 2003                              |   | 12,470             |       | 900               |       | (2,281           | )          | (11,089        | )          |
| Totals through December  31, 2003 |   | 27,250             |       | 900               |       | (5,325           | )          | (22,825        | )          |
| 2004                              |   | (410               | )          | 541               |       | 250              |       | (381           | )          |
| 2005                              |   | (1,290             | )          | 60                |       | 4,083            |       | (2,853         | )          |
| 2000-2005 Total                   |   | 25,550             |       | 1,501             |       | (992             | )          | (26,059        | )          |
|                              |   |               |       |              |       |             |       |           |       |
| 2006 quarter ended                |   |               |       |              |       |             |       |           |       |
| March 31                          |   | 662                |       | 9                 |       | —           |       | (671           | )          |
| June 30                           |   | 504                |       | 6                 |       | —           |       | (510           | )          |
|                              |   | $                  | 26,716     |              | $          | 1,516            |       | $              | (992       | ) | $ | (27,240 | ) |

 

The Governance Committee’s review found 17.9 millionstock options of the 28.8 million options granted on our Common Stock during2000 through 2005 had incorrect measurement dates. Using the correctedmeasurement dates, 7.6 million stock options had exercise prices that exceededthe closing price of our Common Stock and therefore had no intrinsic value tobe accounted for under APB 25, and 10.3 million stock options had intrinsicvalue because their exercise prices were below the closing price of our CommonStock. These 10.3 million stock options resulted in an increase in additionalnon-cash stock-based compensation expense of $24.3 million, and an additional$1.5 million of payroll tax related expenses during 2000-2005 partially offsetby $0.5 million of income tax benefit as shown in the above table. Of the 10.3million stock options resulting in additional non-cash stock-based compensationexpense, 2.0 million options were granted to officers and directors andresulted in $6.1 million of additional non-cash stock-based compensationexpense.

 

The total effect of the stock option restatement andthe amounts for 2006, as shown in the above table, have been reflected in theDecember 31, 2006 financial statements, as well as in the June 30, 2006financial statements. As a result of this restatement, net loss increased by$0.5 million and $1.2 million for the three and six months ended June 30, 2006,respectively.

 

56

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Upon completing its review, the Governance Committeeconcluded it found no evidence of intent to manipulate the Company’s operatingresults or financial statements. A key finding of the Governance Committee wasthat there were deficiencies with the process by which stock options weregranted during the period from our initial public offering in 2000 through atleast 2005, which resulted in accounting errors. The Governance Committeeconcluded that certain members of management bear varying degrees ofresponsibility for the deficiencies in the process by which options weregranted. The Governance Committee’s review also concluded that none of thecurrent or former employees or directors of the Company engaged in intentionalwrongdoing.

 

In determining the above restatement amounts,management used all reasonably available relevant information to formconclusions it believes are reasonable as to the most likely option grantingactions that occurred, the dates when such actions occurred, and thedetermination of grant dates for financial accounting purposes based on whenthe requirements of the accounting standards were met. In light of significantjudgment used in establishing revised measurement dates, alternative approachesto those used by the Stock Option Review Team and management could haveresulted in different compensation charges than those recorded in therestatement. The Stock Option Review Team and management considered variousalternatives throughout the course of the review and restatement, andmanagement believes the approaches used were the most appropriate in thecircumstances, and the choices of measurement dates used in our review of stockoption grant accounting and restatement of our financial statements werereasonable and appropriate in our circumstances.

 

***Summary of Restatement Amounts***

 

**               **The following table presents the decreasein net earnings from the restatement for each restated year:

 
| ** **                             | ** ** | **Net income (loss), as previously reported** | ** **      | **Restatement adjustments** | ** **        | **Net income (loss), as restated** | ** ** |
|----------------------------------------|------------|-----------------------------------------------|-----------------|-----------------------------|-------------------|------------------------------------|------------|
| ** **                             | ** ** | ** **                                    | **China Sales** | ** **                  | **Stock Options** | ** **                         | **Total**  | ** ** | ** ** |
| ** **                             | ** ** | ** **                                    | ** **      | **(in thousands)**          | ** **        | ** **                         | ** ** |
| ** **                             |       |                                          |            |                        |              |                               |       |   |   |   |   |
|                                   |       |                                          |            | **(Decrease) Increase**     |              |                               |       |
|                                   |       |                                          |            | ** **                  |              |                               |       |
| Year ended December 31,                |       |                                          |            | ** **                  |              |                               |       |
| 1998                                   |       |                                          |            | $                           | —            |                               | $          | (796 | ) | $ | (796 | )  |   |   |
| 1999                                   |       |                                          |            | —                      |              | —                             |       | — |   |   |   |
| 2000                                   |       |                                          |            | (4,781                      | )                 | (452                               | )          | (5,233 | )  |   |   |
| 2001                                   |       |                                          |            | (5,779                      | )                 | (3,928                             | )          | (9,707 | )  |   |   |
| 2002                                   |       | $                                             | 107,862         |                        | (19,697           | )                                  | (6,560     | ) | (26,257 | ) | $ | 81,605 |   |
| 2003                                   |       | $                                             | 209,856         |                        | (6,382            | )                                  | (11,089    | ) | (17,471 | ) | $ | 192,385 |   |
| Totals  through December 31, 2003 |       |                                          |            | (36,639                     | )                 | (22,825                            | )          | (59,464 | ) |   |   |
| 2004                                   |       | $                                             | 69,824          |                        | (18,594           | )                                  | (381       | ) | (18,975 | ) | $ | 50,849 |   |
| 2005                                   |       | $                                             | (487,359        | )                           | (42,433           | )                                  | (2,853     | ) | (45,286 | ) | $ | (532,645 | ) |
| 2000 -  2005 Total                     |       |                                          |            | (97,666                     | )                 | (26,059                            | )          | (123,725 | ) |   |   |
|                                   |       |                                          |            |                        |              |                               |       |   |   |   |   |
| 2006  quarter ended                    |       |                                          |            |                        |              |                               |       |   |   |   |   |
| March 31                               |       | $                                             | (10,635         | )                           | 1,360             |                               | (671       | ) | 689 |   | $ | (9,946 | ) |
| June 30                                |       | $                                             | (21,443         | )                           | (371              | )                                  | (510       | ) | (881 | ) | $ | (22,324 | ) |
|                                   |       |                                          |            | $                           | (96,677           | )                                  | $          | (27,240 | ) | $ | (123,917 | ) |   |   |
|                                        |            |                                               |                 |                             |                   |                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

 

 

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The cumulative effect onstockholders’ equity at December 31, 2003 from the above corrections was asfollows (in thousands):

 

| Increase (decrease) in paid-in capital and deferred stock  compensation:       |   |    |    |
|--------------------------------------------------------------------------------|--------|---------|---------|
|                                                                           |   |    |    |
|  Values assigned to stock  options                                        |   | $       | 27,250  |   |
|  Reduction of previously  recorded income tax benefits from stock options |   | (1,278  | )       |
|                                                                           |   |    |    |
|  Net increase in paid-in  capital and deferred stock compensation         |   | 25,972  |    |
|                                                                           |   |    |    |
| (Increase) decrease in accumulated deficit:                                    |   |    |    |
|                                                                           |   |    |    |
|  Revenue and related cost of  sales deferral for China system sales       |   | (36,639 | )       |
|  Additional non-cash  compensation expense from stock options             |   | (27,250 | )       |
|  Payroll taxes for values  assigned to stock options                      |   | (900    | )       |
|  Income tax benefit from  additional compensation and payroll tax expense |   | 5,325   |    |
|                                                                           |   |    |    |
|  Net increase in accumulated  deficit                                     |   | (59,464 | )       |
|                                                                           |   |    |    |
| Net decrease in stockholders' equity at December 31, 2003                      |   | $       | (33,492 | ) |
|                                                                                |        |         |         |  |  |

 

In restating thepreviously issued financial statements for the investigations discussed above,we also corrected other previously reported amounts. We corrected the reportingof  net sales to certain third partyresellers and associated cost of net sales for the three and six months endedJune 30, 2006 to classify these amounts as related party net sales and relatedparty cost of net sales classifications of $4.2 million and $3.0 million,respectively, and $12.9 million and $4.8 million, respectively, because in 2006we determined that sales to these entities were, in substance, sales to asignificant shareholder, SOFTBANK CORP. The classification of the accountsreceivable from these sales was similarly changed to include them in accountsreceivable from related parties in the June 30, 2006 consolidated balancesheet.   We also corrected ourreporting of $6.2 million of time deposits at June 30, 2006 because they didnot mature within three months. Formerly the time deposits had been reported inerror as cash equivalents, but now these amounts are included in short-terminvestments in the balance sheet and in the statement of cash flows for theJune 2006 reporting period.

**ALLAMOUNTS IN THE FOLLOWING SECTIONS OF THIS MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS, EXCEPT THOSE IDENTIFIED “ASPREVIOUSLY REPORTED” IN TABLES WITHIN THE QUARTERLY DATA (UNAUDITED), ASRESTATED CAPTION, REFLECT THE EFFECTS OF THE RESTATEMENT OF OUR FINANCIALSTATEMENTS TO CORRECT OUR REVENUE RECOGNITION FOR CERTAIN SALES CONTRACTS INCHINA AND OUR HISTORICAL STOCK OPTION ACCOUNTING AND THE CORRECTION OF THECLASSIFICATION OF A TIME DEPOSIT FROM CASH TO SHORT-TERM INVESTMENTS IN THEFIRST TWO QUARTERS OF 2006.**

 

**Late SEC Filings and NASDAQDelisting Proceedings**

As a result of the Nominating and Corporate Governance’sCommittee’s review of our historical stock option accounting and the resultingrestatements, we did not timely file our Quarterly Report on Form 10-Q for thequarter ended September 30, 2006 (“Q3 2006 Form 10-Q”), our Annual Report onForm 10-K for the fiscal year ended December 31, 2006 (“2006 Form 10-K”), andour Quarterly Report on Form 10-Q for the quarter ended March 31, 2007 (“Q12007 Form 10-Q”) with the Securities and Exchange Commission.  Inaddition, as a result of the Audit Committee’s review of certain historicalsales contracts in China, we did not timely file our Quarterly Report on Form10-Q for the quarter ended June 30, 2007 (“Q2 2007 Form 10-Q”) with theSecurities and Exchange Commission.

In connection with our failure to timely file ourperiodic reports, we received four NASDAQ Staff Determination letters, datedNovember 15, 2006, March 7, 2007, May 16, 2007 and August 13, 2007,respectively, stating that, as a result of each of these non-timely filings, wewere not in compliance with the requirements of Marketplace Rule 4310(c)(14)and, therefore, our stock was subject to delisting from the NASDAQ StockMarket. We appealed the November 15, 2006 determination to the NASDAQ ListingQualifications Panel (the “Panel”) and were granted a conditional extension toour request for continued listing until April 16, 2007. On April 17, 2007, thePanel extended the deadline for filing our Q3 2006 Form 10-Q to May 14,2007.  The Panel also extended the deadline for filing our 2006 Form 10-Kuntil July 16, 2007.

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On May 2, 2007, we asked the NASDAQ Listing andHearing Review Council (“Listing Council”) to review the April 17, 2007decision of the Panel.  On May 14, 2007, the Listing Council called thePanel’s decision for review and stayed the Panel’s decision that required us tofile our Q3 2006 Form 10-Q by May 14, 2007, and to file our 2006 Form 10-K byJuly 16, 2007.  On August 23, 2007, the Listing Council granted theCompany an extension until October 22, 2007 to file our delinquent periodicreports and restatements.

On October 9, 2007, we asked the NASDAQ Board ofDirectors (“NASDAQ Board”) to review the August 23, 2007 decision of theListing Council.  On October 17, 2007,the NASDAQ Board called the Listing Council’s decision for review and stayedthe Listing Council’s decision, which required us to file our delinquentperiodic reports and restatements by October 22, 2007, pending further reviewby the NASDAQ Board.

On October 10, 2007, we filed our Q3 2006 10-Q and our2006 Form 10-K, and on October 17, 2007 we filed our Q1 2007 Form 10-Q. As of the date of the filing of this Q2 2007 Form 10-Q, we are current with allpreviously overdue SEC filings.

**EXECUTIVE SUMMARY**

 

                We design, manufacture and selltelecommunications infrastructure, handsets and customer premise equipment andprovide services associated with their installation, operation, andmaintenance.  Our products are soldprimarily to telecommunications service providers or operators.  We sell an extensive range of products thatare designed to enable voice, data and video services for our operatorcustomers and consumers around the world. While historically the vast majority of our sales have been to serviceproviders in China, we have expanded our focus to build a global presence andcurrently sell our products in several other established and emerging growthmarkets, which include North America, Japan, India, Central and Latin America,Europe, the Middle East, Africa and Southeast and North Asia.

 

                We differentiate ourselves withproducts designed to reduce network complexity, integrate high performancecapabilities and allow a simple transition to next generation networks.  We design our products to facilitatecost-effective and efficient deployment, maintenance and upgrades.

 

Asof June 30, 2007, the Company was structured across four key operating units:

 

1.               NetworkSolutions:  Our Network Solutionsoperating unit provides its products and services through two reportingsegments; Wireless Infrastructure and Broadband Infrastructure.  Our Wireless Infrastructure segment designs,builds and sells software and hardware products that enable end users, orsubscribers, to send and receive voice and data communication in either a fixedor mobile environment by using wireless devices.  Our Broadband Infrastructure segment designs,builds and sells software and hardware products that enable end users to accesshigh-speed, cost effective fixed data, voice and media communication;

 

2.               PersonalCommunications Division: Our Personal Communications Division (“PCD”) markets,sells and supports handsets in markets other than China.  Most of our handset sales prior to 2006 weredesigned and built by other manufacturers, but beginning in 2006 and in thefuture, sales will include more of our UTStarcom branded products;

 

3.               Handsets: OurHandsets segment designs, builds and sells consumer devices that allowcustomers to access wireless services. Revenues from worldwide PAS handsets and all handset revenues withinChina are included in this segment; and

 

4.               Services: OurServices segment provides service and support for Wireless Infrastructure andBroadband Infrastructure customers in the areas of planning, deployment,operations and ongoing maintenance.

 

                Our products within each ofthese categories, excluding services, include multiple hardware and softwaresubsystems that can be offered in various combinations to suit individualcarrier needs. Our system products are based on widely adopted globalcommunications standards and are designed to allow service providers to quicklyand cost-efficiently integrate our systems into their existing networks anddeploy our systems in new broadband, Internet Protocol and wireless networkrollouts. Our products are also designed for quick and cost-effectivetransition to future network technologies, enabling our customers to make thebest use of their existing infrastructure.

 

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We  monitor our key business indicators on aregular basis, including net new bookings, collections, revenues, grossmargins, operating expenses, inventory and inventory turns, days salesoutstanding, cash flow from operations and cash balances. The inventory turnsand days sales outstanding for the handsets and PCD segments are different fromthe Network Solutions operating unit and tend to fluctuate because ofseasonality effects. Net new bookings and booking margins are good indicatorsof the health of the business and the aging distribution of accounts receivableindicates how well we are performing on our cash collections.

 

Ourlargest market for the six months ended June 30, 2007 and the year endedDecember 31, 2006 was the United States of America, representing 65% and55% of sales, respectively. Prior to 2005, the majority of our sales were toservice providers in China.

 

Westrive to develop products with more advanced features and to enhance thefeatures of our existing products, which, we believe, will enable us to offerour customers more advanced products at higher average selling prices thanotherwise would be possible in the future.

 

                China has been one of ourlargest markets and we believe that it will continue to be an important marketfor our current and future technologies and development for the foreseeablefuture. However, we have also experienced a maturation of our PAS market inChina resulting in our need to have a more diversified product and customerbase. The number of competitors for communications access and switching systemsand handsets in China has grown in line with China’s telecommunications marketexpansion.

 

                Over the past few years, we haveundertaken a significant globalization program and we intend to continue toexpand our global sales outside of China in the current year.  As we expand, we will continue to improve ourinternal supply chain and inventory management processes to ensure timelydeliveries.  We use subscriber growthstatistics to gauge future inventory purchasing requirements as well asforecast our anticipated revenue growth. We will also continue to implement and enhance our administrativeinfrastructure to assist with our growth and globalization transformation.

 

OnOctober 2, 2007, our Board of Directors approved a restructuring plan (the “Plan”)to reduce operating costs, which includes a worldwide reduction in force ofaproximately 11% of the Company’s headcount, or approximately 700 employees.The workforce reduction will be based primarily in the United States and Chinaand, to a lesser degree, other international locations. Management expects thePlan to be completed in the fourth quarter of fiscal year 2007. We expect toincur a restructuring charge in connection with the Plan of approximately $10million, comprised largely of cash payments associated with one-time severancebenefits, with the majority of the charge to be taken in the fourth quarter of2007. In addition, the Company expects to realize annual cost savings in salaryand compensation related expenses of approximately $21 million on an annualizedbasis.

 

               We strive to develop productswith more advanced features and to enhance the features of our existingproducts, which, we believe, will enable us to offer our customers moreadvanced products at higher average selling prices than otherwise would bepossible in the future.

 

**KEY TRANSACTIONS**

 

***Marvell Technology Group Ltd.***

 

                In February 2006, we soldsubstantially all of the assets and selected liabilities of our semiconductordesign business division, including the assets related to the prior acquisitionof Advanced Communications Devices Corporation, to Marvell. We received$20.0 million in cash in February 2006 and an additional$4.3 million in cash in August 2007. We received an additionalpayment of $16.0 million from Marvell in October 2006 as a result of achievingcertain defined milestones.

 

Inconnection with the sale of assets, we have entered into a supply agreementwith Marvell to purchase chipsets for our handset products over the next fiveyears. The value allocated to the supply agreement of $20.2 million is includedin other current and long-term liabilities, and is being amortized inproportion to the quantities of chipsets purchased under the supply agreementover the next five years.  As of June 30,2007, approximately $2.7 million has been amortized against cost of sales.

 

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**TRANSACTIONS WITH RELATED PARTIES AND OTHER INFORMATION**

 

                The following is a summary ofthe Company’s transactions with related parties and other information:

 

| ** **                    | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|-------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                    | ** ** | **Net sales**                   | ** ** | **Net sales**                 | ** ** |
| ** **                    | ** ** | **2007**                        | ** ** | **2006**                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                    | ** ** | ** **                      | ** ** | **(As  restated)**            | ** ** | ** ** | ** ** | **(As restated)** | ** ** |
| ** **                    | ** ** | **(in  thousands)**             | ** ** | **(in  thousands)**           | ** ** |
| Softbank                      |       | $                               | 15,383     |                          | $          | 36,027 |   | $ | 26,918 |   | $ | 79,053 |   |
| Japan Telecom, Ltd            |       | 4,848                           |       | 1,466                         |       | 6,429 |   | 3,256 |   |
| Total Softbank and affiliates |       | 20,231                          |       | 37,493                        |       | 33,347 |   | 82,309 |   |
| Xalted Networks, Inc.         |       | 224                             |       | —                        |       | 224 |   | — |   |
| ORG, Inc.                     |       | 429                             |       | 135                           |       | 641 |   | 263 |   |
| Total                         |       | $                               | 20,884     |                          | $          | 37,628 |   | $ | 34,212 |   | $ | 82,572 |   |

 

 

 

| ** **              | ** ** | **Accounts receivable** | ** ** | **Accounts payable** | ** ** |
|-------------------------|------------|-------------------------|------------|----------------------|------------|
| ** **              | ** ** | **June 30,**            | ** ** | **December 31,**     | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
| ** **              | ** ** | **2007**                | ** ** | **2006**             | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **              | ** ** | **(in thousands)**      | ** ** |
| Softbank and affiliates |       | $                       | 26,194     |                 | $          | 29,941 |   | $ | 582 |   | $ | 535 |   |
| MDC Holding, Ltd.       |       | 1,103                   |       | 1,300                |       | — |   | — |   |
| Fiberxon, Ltd.          |       | 10                      |       | 44                   |       | 1,320 |   | 368 |   |
| ORG, Inc.               |       | —                  |       | 1,025                |       | — |   | — |   |
| GCT Semiconductor, Inc. |       | —                  |       | —               |       | 49 |   | 1,051 |   |
| Acoustek Int'l, Inc.    |       | —                  |       | —               |       | 51 |   | 51 |   |
| Cortina/Immenstar       |       | —                  |       | —               |       | 18 |   | 345 |   |
| Other                   |       | 28                      |       | 8                    |       | 7 |   | 50 |   |
| Total                   |       | $                       | 27,335     |                 | $          | 32,318 |   | $ | 2,027 |   | $ | 2,400 |   |
|                         |            |                         |            |                      |            |  |  |  |  |  |  |  |  |  |  |

 

 

| ** **              | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|-------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **              | ** ** | **Purchases**                   | ** ** | **Purchases**                 | ** ** |
| ** **              | ** ** | **2007**                        | ** ** | **2006**                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **              | ** ** | **(in thousands)**              | ** ** | **(in thousands)**            | ** ** |
| Softbank and affiliates |       | $                               | 1,015      |                          | $          | — |   | $ | 1,499 |   | $ | — |   |
| Fiberxon, Ltd.          |       | 1,812                           |       | 72                            |       | 3,615 |   | 406 |   |
| GCT Semiconductor, Inc. |       | 576                             |       | 2,089                         |       | 1,753 |   | 4,374 |   |
| Cortina/Immenstar       |       | 1,389                           |       | 526                           |       | 1,402 |   | 543 |   |
| Audiovox Comm. Corp     |       | 353                             |       | 481                           |       | 758 |   | 715 |   |
| Total                   |       | $                               | 5,145      |                          | $          | 3,168 |   | $ | 9,027 |   | $ | 6,038 |   |

 

***Softbank and affiliates***

 

                We recognize revenue withrespect to sales of telecommunications equipment to affiliates of Softbank, asignificant stockholder of the Company. Softbank offers asynchronous digitalsubscriber line (“ADSL”) coverage throughout Japan, which is marketed under thename “YAHOO! BB.” We support Softbank’s fiber-to-the-home service through salesof our carrier class Gigabit Ethernet Passive Optical Network (“GEPON”) productas well as our multi-service optical transport product (“NetRingÔ”). Inaddition, the Company supports Softbank’s new IPTV, through sales of ourRollingStreamÔ product.Included in revenue for the six months ended June 30, 2006 are fees of$17.0 million and $10.1 million charged for the cancellation of orders forbroadband infrastructure and wireless infrastructure products, respectively.

 

                Sales to Softbank include athree year service period and a penalty clause if product failure rates exceeda certain level over a seven year period. As of June 30, 2007, our customeradvance balance related to Softbank agreements was $2.3 million compared to nobalance as of December 31, 2006.  Thecurrent deferred revenue balance related to Softbank was $9.8 million and $11.6million as of June 30, 2007 and December 31, 2006, respectively.  As of June 30, 2007, our noncurrent deferredrevenue balance related to Softbank was $9.3 million compared to $11.5 millionas of December 31, 2006.

 

61

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                During August 2004, weentered into several agreements with Japan Telecom Co., Ltd. (“JT”), a whollyowned subsidiary of Softbank. These agreements relate to the sale of *i*AN-8000 equipment with specified valueand delivery dates, as well as an oral agreement which subsequently convertedinto specific service contracts to manage a sales promotional program for JT.We  have determined that the serviceactivities revenue should be recorded net of expected promotional spending.

 

                On July 17, 2003, weentered into a Mezzanine Loan Agreement with BB Modem Rental PLC (“BB Modem”),an affiliate of Softbank. Under the terms of the agreement, we loaned BB Modem$10.1 million at an effective interest rate of 12.01% per annum, for thepurpose of investing in a portfolio of ADSL modems and associated modem rentalagreements, from Softbank. Softbank will continue to service such modems andmodem rental agreements. Our loan was subordinated to certain senior lenders ofBB Modem, and repayments were paid to us over a 42-month period throughJanuary 31, 2007, with a substantial portion of the principal amount ofthe loan schedule repaid during the last 16 months of this period.  During the three months ended June 30, 2007and 2006, we recorded zero and $0.2 million, respectively, in interestincome with respect to this loan.  Duringthe six months ended June 30, 2007 and 2006 we recorded an immaterial amountand $0.4 million, respectively, in interest income with respect to thisloan.  The loan receivable was fullysettled during the first quarter of 2007 and therefore a zero balance as ofJune 30, 2007 compared to a balance of approximately $1.0 million as ofDecember 31, 2006 which was included in prepaid and other current assets.

 

Asof June 30, 2007, Softbank beneficially owned approximately 12% of ouroutstanding stock.

 

***ORG, Inc.***

 

                We  have a 49% ownership in Global Asia PartnersL.P. which in turn is a significant shareholder in ORG, Inc., a resellerof infrastructure equipment for broadband access.  In January 2005, we entered into a reselleragreement with ORG, Inc., which was terminated in August 2006; however animmaterial amount of revenue for pre-August 2006 deliveries was recognized inthe three and six months ended June 30, 2007.

 

***MDC Holding, Ltd.***

 

We have an outstanding accounts receivable balancewith MDC Holding, Ltd. (“MDC”) related to a PAS system purchase, in whichcertain employees of us were shareholders of MDC.  MDC is in the business of providingvalue-added services, such as short message, voicemail or ring-tone servicesfor PAS telecom networks.

 

***Fiberxon, Ltd.***

 

                We  have an outstanding purchase commitment of$0.7 million as of June 30, 2007 with Fiberxon, Ltd. (“Fiberxon”) in which wehave a 7% ownership interest, to purchase component parts for opticalnetworking products. We had purchases from Fiberxon of  $1.8 million and $0.1 million for the threemonths ended June 30, 2007 and 2006, respectively; and $3.6 million and $0.4million for the six months ended June 30, 2007 and 2006, respectively.

 

On July 1, 2007, Fiberxoncompleted a merger with MRV Communications (“MRV”).  In exchange for our investment in Fiberxon,we will receive approximately $1.5 million in cash, 1.5 million shares of MRVcommon stock and deferred consideration of approximately $2.7 million.  The deferred consideration becomes payableupon the completion of certain milestones and may be reduced by legitimateclaims of MRV for certain matters related to the merger.  As a result of the merger, we recorded aninvestment in MRV of $4.5 million and a gain on the investment in Fiberxon of$2.9 million in the third quarter of 2007.

 

***GCT Semiconductor, Inc.***

 

                Wehave a 2% ownership interest in GCT Semiconductors, Inc., which designs,develops and markets integrated cost circuit products for the wirelesscommunications industry.

 

***Acoustek Int’l, Inc.***

 

                We have obtained consultingservices from Acoustek Int’l Inc. (“Acoustek”), which employed Minnie Huang,spouse of William Huang, our former Senior Vice President and Chief TechnologyOfficer.  Mr. Huang’s employment with theCompany terminated on December 31, 2006. We made no payments during the six months ended June 30, 2007 comparedto $0.1 million for the same period in 2006 to Acoustek for consulting services.

 

62

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***Cortina / Immenstar***

 

*               *Wehave an outstanding purchase commitment of $0.5 million as of June 30, 2007with Cortina Systems, Inc, in which the Company has a 1.3% ownership intereston a fully diluted basis, to purchase chips that are used in our product.

 

***Xalted Networks, Inc.***

 

                We received purchase orders fromXalted Networks (“Xalted”) totaling approximately $1.3 million in 2005 fortelecommunications equipment that is for product not typically sold by us toother customers. We are charging a ten percent procurement fee to Xalted forobtaining and reselling these products. The equipment was delivered during 2005but the revenue recognition process was not completed until the period endingJune 30, 2007, and as such the revenue was recognized in this quarter.

 

**RESULTS OF OPERATIONS**

 

                As mentioned in the ExecutiveSummary, we manage our business based principally upon product families of fouroperating units, (i) Network Solutions, which includes the BroadbandInfrastructure and Wireless Infrastructure reporting segments, (ii) PCD,(iii) Handsets, and (iv) Services. A summary of the financial resultsof each of the segments are as follows:

 

***Net Sales***

 
| ** **                       | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|----------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                       | ** ** | **2007**                        | ** ** | **% of net sales**            | ** ** | **2006** | ** ** | **% of net sales** | ** ** | **2007** | ** ** | **% of net sales** | ** ** | **2006** | ** ** | **% of net sales** | ** ** |
| ** **                       | ** ** | ** **                      | ** ** | ** **                    | ** ** | **(As restated)** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **(As restated)** | ** ** | ** ** | ** ** |
| *** ***                     | ** ** | **(in thousands)**              | ** ** | **(in thousands)**            | ** ** |
| *** Net Sales by Segment*** | ** ** | ** **                      | ** ** | ** **                    | ** ** |
|  Broadband Infrastructure   | * *   | $                               | 39,383     |                          | 7          | % | $ | 44,769 |   | 8 | % | $ | 70,605 |   | 7 | % | $ | 102,020 |   | 9 | % |
|  Wireless Infrastructure    | * *   | 63,091                          |       | 12                            | %          | 115,965 |   | 21 | % | 132,970 |   | 13 | % | 221,698 |   | 19 | % |
|  Network Solutions          | * *   | 102,474                         |       | 19                            | %          | 160,734 |   | 29 | % | 203,575 |   | 20 | % | 323,718 |   | 28 | % |
|  PCD                        | * *   | 357,797                         |       | 66                            | %          | 266,247 |   | 49 | % | 646,127 |   | 64 | % | 589,242 |   | 51 | % |
|  Handsets                   | * *   | 62,177                          |       | 12                            | %          | 107,069 |   | 19 | % | 131,896 |   | 13 | % | 206,103 |   | 18 | % |
|  Service                    | * *   | 15,797                          |       | 3                             | %          | 17,475 |   | 3 | % | 32,548 |   | 3 | % | 34,443 |   | 3 | % |
| Total Net Sales                  | * *   | $                               | 538,245    |                          | 100        | % | $ | 551,525 |   | 100 | % | $ | 1,014,146 |   | 100 | % | $ | 1,153,506 |   | 100 | % |

 

 
| ** **                       | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|----------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                       | ** ** | ** **                      | ** ** | **% of net**                  | ** ** | ** ** | ** ** | **% of net** | ** ** | ** ** | ** ** | **% of net** | ** ** | ** ** | ** ** | **% of net** | ** ** |
| ** **                       | ** ** | **2007**                        | ** ** | **sales**                     | ** ** | **2006** | ** ** | **sales** | ** ** | **2007** | ** ** | **sales** | ** ** | **2006** | ** ** | **sales** | ** ** |
| ** **                       | ** ** | ** **                      | ** ** | ** **                    | ** ** | **(As restated)** | ** ** | ** ** | ** ** | ** ** | ** ** | **(As restated)** | ** ** |
| *** ***                     |       | **(in  thousands )**            | ** ** | **(in  thousands)**           |       |
| *** Net Sales  by region*** |       | ** **                      | ** ** | ** **                    |       |
|  United States              |       | $                               | 361,334    |                          | 67         | % | $ | 266,352 |   | 48 | % | $ | 654,502 |   | 65 | % | $ | 596,116 |   | 52 | % |
|  China                      |       | 129,222                         |       | 24                            | %          | 205,316 |   | 37 | % | 265,956 |   | 26 | % | 405,126 |   | 35 | % |
|  Japan                      |       | 20,523                          |       | 4                             | %          | 38,071 |   | 7 | % | 34,838 |   | 3 | % | 85,731 |   | 7 | % |
|  Other                      |       | 27,166                          |       | 5                             | %          | 41,786 |   | 8 | % | 58,850 |   | 6 | % | 66,533 |   | 6 | % |
|  Total Net Sales            |       | $                               | 538,245    |                          | 100        | % | $ | 551,525 |   | 100 | % | $ | 1,014,146 |   | 100 | % | $ | 1,153,506 |   | 100 | % |

 

*Three months ended June 30, 2007 and 2006*

 

                Net sales decreased by 2% to$538.2 million during the quarter ended June 30, 2007 compared to the sameperiod in 2006. The decrease is primarily due to a decrease in sales in theNetwork Solutions segment by 36% for the three months ended June 30, 2007compared to the three months ended June 30, 2006. Broadband Infrastructure netsales decreased by $5.4 million, or 12% during the three months ended June 30,2007 compared to the same period in 2006.  Due to the customerconcentration in this segment, revenues fluctuate based upon the magnitude andtiming of revenue recognition on certain contracts.  Wireless net sales decreased by $52.9million, or 46%, for the three months ended June 30, 2007 compared to the sameperiod in 2006, mainly due to the continued weakening demand for our PASproducts.  Handset sales declined by$44.9 million, or 42%, in the second quarter of 2007 due primarily to volumedeclines when compared to the second quarter of 2006.  As we have been experiencing in recentquarters, increased competition and lower net subscriber growth of PAS haveresulted in lower demand for our handsets. Net sales for our Services segment decreased 10% due to a decrease inrevenue from external customers during the three months ended June 30, 2007compared to the same period in 2006.

 

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Netsales of PCD increased $91.6 million or 34% during the three months ended June30, 2007 as compared to the same period in 2006.  The increase in net sales is primarily due toan increase in the units sold and average selling price of our handsets.  For additional discussion see SegmentReporting.

 

*Six months ended June 30, 2007 and 2006*

 

                Net sales decreased by 12% to$1,014.1 million during the six months ended June 30, 2007 compared to the sameperiod in 2006. The decrease is primarily due to a decrease in sales in theNetwork Solutions segment by 37% during the six months ended June 30, 2007compared to the six months ended June 30, 2007. Broadband Infrastructure netsales decreased by $31.4 million, or 31%, during the six months ended June 30,2007 compared to the same period in 2006.  Higher BroadbandInfrastructure segment sales during the six months ended June 30, 2006 includedorder cancellation fees of $22.6 million, primarily for the GEPON and Netringproducts.  In addition, due to thecustomer concentration in this segment, revenues fluctuate based upon themagnitude and timing of revenue recognition on certain contracts.   Wireless Infrastructure net sales decreasedby $88.7 million, or 40%, during the six months ended June 30, 2007 compared tothe same period in 2006, mainly due to the continued weakening demand for ourPAS products.  Handset sales declined by$74.2 million, or 36%, during the six months ended June 30, 2007 due to bothprice and volume declines when compared to the same period in 2006.  As we have continued to experience in recentquarters, increased competition and lower net subscriber growth of PAS haveresulted in lower demand and average selling price for our handsets.  Net sales for our Services segment decreased6% due to a decrease in revenue from external customers during the six monthsended June 30, 2007 compared to the same period in 2006.

 

Netsales of PCD increased $56.9 million or 10% during the six months ended June30, 2007 as compared to the same period in 2006.  The increase in net sales is primarily due toan increase in the units sold of our handsets. For additional discussion see Segment Reporting.

 

***Gross Profit***

 
| ** **                           | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|--------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                           | ** ** | ** **                      | ** ** | **Gross**                     | ** ** | ** ** | ** ** | **Gross** | ** ** | ** ** | ** ** | **Gross** | ** ** | ** ** | ** ** | **Gross** | ** ** |
| ** **                           | ** ** | **2007**                        | ** ** | **Profit %**                  | ** ** | **2006** | ** ** | **Profit %** | ** ** | **2007** | ** ** | **Profit %** | ** ** | **2006** | ** ** | **Profit %** | ** ** |
| ** **                           | ** ** | ** **                      | ** ** | ** **                    | ** ** | **(As restated)** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **(As restated)** | ** ** | ** ** | ** ** |
| *** ***                         |       | **(in  thousands )**            | ** ** | **(in  thousands)**           |       |
| *** Gross  profit by Segment*** |       | ** **                      | ** ** | ** **                    |       |
|  Broadband Infrastructure       |       | $                               | 8,946      |                          | 23         | % | $ | 4,889 |   | 11 | % | $ | 13,947 |   | 20 | % | $ | 27,975 |   | 27 | % |
|  Wireless Infrastructure        |       | 28,572                          |       | 45                            | %          | 53,857 |   | 46 | % | 52,837 |   | 40 | % | 104,618 |   | 47 | % |
|  Network Solutions              |       | 37,518                          |       | 37                            | %          | 58,746 |   | 37 | % | 66,784 |   | 33 | % | 132,593 |   | 41 | % |
|  PCD                            |       | 15,922                          |       | 4                             | %          | 12,321 |   | 5 | % | 32,767 |   | 5 | % | 26,710 |   | 5 | % |
|  Handsets                       |       | 22,396                          |       | 36                            | %          | 32,896 |   | 31 | % | 47,443 |   | 36 | % | 64,509 |   | 31 | % |
|  Service                        |       | 3,894                           |       | 25                            | %          | 4,987 |   | 29 | % | 8,020 |   | 25 | % | 8,929 |   | 26 | % |
|                                 |       | $                               | 79,730     |                          | 15         | % | $ | 108,950 |   | 20 | % | $ | 155,014 |   | 15 | % | $ | 232,741 |   | 20 | % |

 

                Cost of sales consists primarilyof material and labor costs, including stock-based compensation, associatedwith manufacturing, assembly and testing of products, costs associated withinstallation and customer training, warranty costs, fees to agents, inventoryprovision and overhead. Cost of sales also includes import taxes and tariffs oncomponents and assemblies. Some components and materials used in our productsare purchased from a single supplier or a limited group of suppliers and, insome cases, are subject to obtaining Chinese import permits and approvals. Wealso rely on third party manufacturers to manufacture and assemble most of ourCDMA handsets.

 

                Our gross profit has beenaffected by average selling prices, material costs, product mix, the impact ofwarranty charges and contract loss provisions as well as inventory reserves andrelease of deferred revenues and related cost pertaining to prior years. Ourgross profit, as a percentage of net sales, varies among our product families.We expect that our overall gross profit, as a percentage of net sales, willfluctuate from period to period as a result of shifts in product mix, stage ofproduct life cycle, anticipated decreases in average selling prices and ourability to reduce cost of sales.

 

*Three months ended June 30, 2007 and 2006*

 

                Gross profit was$79.7 million, or 15% of net sales in the three months ended June 30,2007, compared to $109.0 million, or 20% of net sales in the correspondingperiod of 2006. The overall gross profit decrease is primarily due to a declinein sales in the Wireless Infrastructure and Handsets segments. The BroadbandInfrastructure segment gross profit percentage shows a sharp increase to 23%for the three months ended June 30, 2007 compared to 11% for the same period in2006.  The increase is largely due to achange in contract loss reserves of $8.1 million related primarily to onecontract in our

 

 

 

64

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Broadband Infrastructure segment, as well asimproved gross marginof our CPE product line. For additional discussion see Segment Reporting.

 

*Six months ended June 30, 2007 and 2006*

 

Grossprofit was $155.0 million, or 15% of net sales in the six months endedJune 30, 2007, compared to $232.7 million, or 20% of net sales in thecorresponding period of 2006. The overall gross profit decrease is primarilydue to a decline in sales and gross profit percentages in the Network Solutionssegment. Although the gross profit declined for the Handsets segment, grossprofit as a percentage of sales increased due to our continuous efforts to achieve costreductions, including lower inventory reserves, warranty cost and royalty cost.The gross profit improved in the PCD segment,primarily due to a change in the product mix to higher gross margin products. Foradditional discussion see Segment Reporting.

 

***Operating Expenses***

 

                Thefollowing table summarizes our operating expenses:

 
| ** **                           | ** **   | **Three months ended June 30,** | ** **   | **Six months ended June 30,** | ** **   |
|--------------------------------------|--------------|---------------------------------|--------------|-------------------------------|--------------|
| ** **                           | ** **   | **2007**                        | ** **   | **% of net sales**            | ** **   | **2006** | ** ** | **% of net sales** | ** ** | **2007** | ** ** | **% of net sales** | ** ** | **2006** | ** ** | **% of net sales** | ** ** |
| ** **                           | ** **   | ** **                      | ** **   | ** **                    | ** **   | **As restated** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **As restated** | ** ** | ** ** | ** ** |
| ** **                           | ** **   | **(in thousands)**              | ** **   | **(in thousands)**            | ** **   |
| ***Operating  expenses***            | *** *** | *** ***                    | *** *** | *** ***                  | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** |
| Selling, general  and administrative |         | $                               | 88,865       |                          | 17           | % | $ | 83,108 |   | 15 | % | $ | 168,701 |   | 17 | % | $ | 166,833 |   | 14 | % |
| Research and  development            |         | 42,158                          |         | 7                             | %            | 46,603 |   | 8 | % | 85,819 |   | 8 | % | 93,005 |   | 8 | % |
| Amortization of  intangible assets   |         | 4,046                           |         | 1                             | %            | 4,821 |   | 1 | % | 8,092 |   | 1 | % | 9,746 |   | 1 | % |
| Total operating expenses             |         | $                               | 135,069      |                          | 25           | % | $ | 134,532 |   | 24 | % | $ | 262,612 |   | 26 | % | $ | 269,584 |   | 23 | % |
|                                      |              |                                 |              |                               |              |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

                Selling,general and administrative expenses (“SG&A”) include compensation andbenefits, professional fees, sales commissions, provision for doubtful accountsreceivable and travel and entertainment costs. Research and development (“R&D”)expenses consist primarily of compensation and benefits of employees engaged inresearch, design and development activities, costs of parts for prototypes,equipment depreciation and third party development expenses. We believe thatcontinued and prudent investment in research and development is critical to ourlong-term success, and will aggressively evaluate appropriate investmentlevels. A portion of our costs are fixed and are difficult to quickly reduce inperiods of lower sales.

 

*Selling, general and administrative*

 

*Three months ended June 30, 2007 and2006*

 

SG&A expenses increased $5.8 million to 17% ofnet sales during the three months ended June 30, 2007 compared to 15%during the same period in 2006. The increase in SG&A expenses was primarilydue to a $5.8 million increase in our provision for doubtful accounts duringthe three months ended June 30, 2007 as compared to the same period in 2006.

 

S*ix months ended June30, 2007 and 2006*

 

SG&A expenses were $168.7 million and $166.8million in the six months ended June 30, 2007 and 2006, respectively.SG&A expenses as a percentage of net sales were 17% and 14% during the sixmonths ended June 30, 2007 and 2006, respectively.

 

The increase in SG&A expenses was primarily due to ahigher labor related costs and legal fees. The increase in labor costs isrelated to the addition of administrative staff in accounting, informationtechnology and legal to handle the increasingly complex accounting and legalissues we are facing as part of the remediation program to correct materialweaknesses in our internal controls over financial reporting. Legal costsincreased as a result of independent investigations.

 

*Research and development*

 

*Three months ended June 30, 2007 and2006*

 

                R&Dexpenses were $42.2 million, or 7% of net sales, in the three months endedJune 30, 2007, compared to $46.6 million, or 8% of net sales, in thethree months ended June 30, 2006. The decrease of $4.4 million in absolutedollars of R&D expenses is primarily due to a decrease in employeeheadcount. Personnel related expenses decreased by $1.1 million and facilityand depreciation cost decreased by $1.9 million as a result of ouron-going reorganization of R&D activities and the disposal of R&Dequipment in prior periods. Additionally, parts, equipment and tools costsdecreased by $1.0 million due to on-going cost reduction measures.

 

65

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*Six months ended June 30, 2007 and 2006*

 

                R&Dexpenses were $85.8 million and $93.0 million, or 8% and 8% of netsales, in the six months ended June 30, 2007 and 2006, respectively. Inabsolute dollars, R&D expenses decreased by $7.2 million, primarily due toa decrease in depreciation costs of $3.7 million as a result of our on-goingreorganization of R&D activities and the disposal of R&D equipment inprior periods. There was a decrease in personnel expenses, including payroll,payroll taxes and benefits totaling $1.8 million due to a decrease inemployee headcount. In addition, the decrease in R&D expenses can beattributed to a decrease in professional costs of $1.6 million associatedwith decreased use of consultants.

 

*Amortization of intangible assets*

 

*Three and six months ended June 30,2007 and 2006*

 

                Amortizationof intangible assets decreased by $0.8 million in the three months ended June30, 2007 compared to the same quarter last year, and $1.7 million in the sixmonths ended June 30, 2007 compared to the same period last year. Amortizationof intangible assets declined as several intangible assets became fullyamortized during the preceding twelve months.

 

***Interest income***

 

*Three months ended June 30, 2007 and2006*

 

                Interestincome was $3.4 million and $3.9 million for the three months ended June 30,2007 and 2006, respectively. Interest income decreased primarily due to thelower average balance of cash and restricted cash during the three months endedJune 30, 2007 as compared to the same period ended June 30, 2006.

 

*Six months ended June 30, 2007 and 2006*

 

                Interestincome was $8.3 million and $7.5 million for the six months ended June 30, 2007and 2006, respectively. Interest income increased primarily due to a higheraverage interest rate on investments during the six months ended June 30, 2007compared to at the same period ended June 30, 2006.

 

***Interest expense***

 

*Three months ended June 30, 2007 and2006*

 

Interest expense was $7.3 million and$3.2 million for the three months ended June 30, 2007 and 2006,respectively. The increase in interest expense for the three months endedJune 30, 2007 compared to the same period in 2006 was primarilyattributable to the incremental interest expense of $4.6 million resulting fromthe First Supplemental Indenture. The stated interest rate of our convertiblesubordinated notes was 7.625% from January 9, 2007 through June 30, 2007. Priorto January 9, 2007, our convertible subordinated notes accrued interest at 7/8%per annum.

 

*Six months ended June 30, 2007 and 2006*

 

Interest expense was $14.0 million and$6.7 million for the six months ended June 30, 2007 and 2006,respectively. The increase in interest expense for the six months endedJune 30, 2007 compared to the same period in 2006 was primarilyattributable to the incremental interest expense of $8.9 million resulting fromthe First Supplemental Indenture. The stated interest rate of our convertiblesubordinated notes was 7.625% from January 9, 2007 through June 30, 2007. Priorto January 9, 2007, our convertible subordinated notes accrued interest at 7/8%per annum.

 

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***Other income (expense)****, **net***

 

*Three months ended June 30, 2007 and2006*

 

                Otherincome (expense), net was net income of $0.2 million and $6.9  millionfor the three months ended June 30, 2007 and 2006, respectively. Other income(expense), net for the three months ended June 30, 2006 included a $2.9million gain on foreign currency revaluation, and a $2.5 million gain on salesof assets.

 

*Six months ended June 30, 2007 and 2006*

 

                Otherincome (expense), net was income of $4.1 million and $10.5 million for thesix months ended June 30, 2007 and 2006, respectively. Other income (expense),net for the six months ended June 30, 2007 included a $2.8 million gain on thesale of our Immenstar investment and a $0.8 million gain on foreign currencyrevaluation. Other income (expense), net for the six months ended June 30,2006 included a $5.7 million gain on foreign currency revaluation and $2.5million for a gain on sales of assets.

 

***Income tax expense***

 

Income tax expense is based upon a blended effective taxrate based upon our expectation of the amount of income to be earned in eachtax jurisdiction and is accounted under the liability method. Deferred incometaxes are recognized for the differences between the tax bases of assets andliabilities and their financial statement amounts based on enacted tax rates.Valuation allowances are established when necessary to reduce deferred taxassets to the amount expected to be realized. We will maintain a full valuationallowance on our net deferred tax assets in China, the United States, and othercountries until an appropriate level of profitability that generates taxableincome is sustained or until we are able to develop tax strategies that would enableus to conclude that it is more likely than not that a portion of our deferredtax assets will be realizable. Any reversal of valuation allowances willfavorably impact our results of operations in the period of the reversal.

 

The Company adopted theprovisions of FASB Interpretation No. 48, “Accounting for Uncertainty in IncomeTaxes-an interpretation of FASB Statement No. 109” (“FIN 48”) on January 1,2007. As a result of the implementation of FIN 48, the Company recognized a$1.4 million increase in the liability for unrecognized tax benefits which, asrequired, was accounted for as a reduction to the January 1, 2007 balance ofretained earnings. FIN 48 established criteria for recognizing or continuing torecognize only more-likely-than tax positions, which may result in income taxexpense volatility in future periods. While the Company believes that it hasadequately provided for all tax positions, amounts asserted by taxingauthorities could be greater than our accrued position. Accordingly, additionalprovisions on income tax related matters could be recorded in the future asrevised estimates are made or the underlying matters are settled or otherwiseresolved.

 

*Three months ended June 30, 2007 and2006*

 

       Income taxexpense was $3.3 million and $4.7 million for the three months ended June30, 2007 and 2006, respectively. There are two primary reasons why the Companyhas tax expense while the Company has pretax losses. First, the Company has notprovided any tax benefit on the forecasted current year losses incurred and taxcredits generated in the United States and other countries, because managementbelieves that it is more likely than not that the tax benefit associated withthese losses will not be realized. Second, the Company continues to accrue taxexpense in jurisdictions where the Company has been historically profitable.Estimates of the annual effective tax rate at the end of the interim periodsare based on evaluations of possible future events and transactions and may besubject to subsequent refinement or revision.

 

*Six monthsended June 30, 2007 and 2006*

 

Incometax expense was $7.6 million and $7.5 million for the six months endedJune 30, 2007 and 2006, respectively.

 

 

**SEGMENT REPORTING**

 

We offer products and services through four operatingunits, namely Network Solutions, PCD, Handsets and Services. The NetworkSolutions operating unit provides its products and services through tworeporting segments; Broadband Infrastructure and Wireless Infrastructure. Eachreporting segment and operating unit is responsible for managing its ownperformance.

 

                Wecurrently evaluate operating performance of and allocate resources to thereporting segments based on segment gross profit. Cost of sales and directexpenses in relation to production are assigned to the reporting segments. Theaccounting policies used in measuring segment assets and operating performanceare the same as those used by corporate and are consistently applied across allsegments.

 

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                Summarizedbelow are our segment sales revenue and gross profit for the three and sixmonths ended June 30, 2007 and 2006, respectively.

 

***Network Solutions***

 

*Broadband Infrastructure*

 
| ** **                            | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|---------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                            | ** ** | **2007**                        | ** ** | **2006**                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                            | ** ** | ** **                      | ** ** | **(As restated)**             | ** ** | ** ** | ** ** | **(As restated)** | ** ** |
| ** **                            | ** ** | **(in thousands)**              | ** ** | **(in thousands)**            | ** ** |
| Sales                                 |       | $                               | 39,383     |                          | $          | 44,769 |   | $ | 70,605 |   | $ | 102,020 |   |
| Gross profit                          |       | $                               | 8,946      |                          | $          | 4,889 |   | $ | 13,947 |   | $ | 27,975 |   |
| Gross profit as a percentage of sales |       | 23                              | %          | 11                            | %          | 20 | % | 27 | % |
|                                       |            |                                 |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

Our largest Broadband Infrastructure customer isSoftbank in Japan, representing approximately 42% and 44% of total broadbandsales during the three months ended June 30, 2007 and 2006, respectively, and37% and 53% during the six months ended June 30, 2007 and 2006, respectively.Due to the customer concentration in this segment, revenues are subject tofluctuations based upon the magnitude and timing of revenue recognitionregarding certain contracts.

 

Gross profit as apercentage of sales showed a sharp increase to 23% during the three monthsended June 30, 2007 compared to the same period in 2006 largely due to changein contract loss reserves of $8.1 million relatedprimarily to one contract in our Broadband Infrastructure segment, as well as improved gross margin of ourCPE product line.

 

Gross profit declined for the six months ended June30, 2007 compared to the corresponding period in 2006 primarily becauseBroadband Infrastructure net sales during the six months ended June 30, 2006included $22.6 million revenue for order cancellation fees; this revenue had no associated costof sales related to it.

 

*Wireless Infrastructure*

 
| ** **                            | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|---------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                            | ** ** | **2007**                        | ** ** | **2006**                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                            | ** ** | ** **                      | ** ** | **(As restated)**             | ** ** | ** ** | ** ** | **(As restated)** | ** ** |
|                                  |       | **(in  thousands)**             |       | **(in  thousands)**           |       |
| Sales                                 |       | $                               | 63,091     |                          | $          | 115,965 |   | $ | 132,970 |   | $ | 221,698 |   |
| Gross profit                          |       | $                               | 28,572     |                          | $          | 53,857 |   | $ | 52,837 |   | $ | 104,618 |   |
| Gross profit as a percentage of sales |       | 45                              | %          | 46                            | %          | 40 | % | 47 | % |
|                                       |            |                                 |            |                               |            |  |  |  |  |  |  |  |  |  |

 

During the three months ended June 30, 2007, sales ofWireless Infrastructure products declined by 46% compared to the same period in2006. PAS systems sales declined 36% and comprise approximately 94% of ourWireless Infrastructure sales compared to 80% during the same period in 2006.The decrease in PAS systems sales was primarily the result of our customers inChina transitioning from new system installations to system expansions.Included in Wireless Infrastructure sales for the three months ended June 30,2006 is a one-time compensation from a customer of $10.1 million for the cancellation ofprevious purchase orders.

 

During the six months ended June 30, 2007, WirelessInfrastructure sales declined by 40% compared to the same period in 2006. Salesin China, which is predominately a PAS market for us, decreased by 37% as Chinacarriers continued the transition to system expansions. The decline in salesoutside of China is mainly due to a one-time compensation from a customer of $10.1million for the cancellation of previous purchase orders for the six monthsended June 30, 2006.

 

We plan to aggressively pursue opportunities for ourother technology products in multiple markets, though we do not anticipate thatthese sales will fully offset the decline in PAS sales.

 

Gross profit decreased by47% and 49% in the three and six months ended June 30, 2007, respectively, ascompared to the corresponding period in 2006 due to lower sales. Gross profitas a percentage of sales was constant in the three months period when comparedto the same period in 2006. Gross profit as a percentage of sales was lower forthe six month period ending June 30, 2007 as compared with the same period in2006 mainly due to higher margin software related sales in the prior year.

 

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***PCD***

 
| ** **                            | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|---------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                            | ** ** | **2007**                        | ** ** | **2006**                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                            | ** ** | ** **                      | ** ** | **(As restated)**             | ** ** | ** ** | ** ** | **(As restated)** | ** ** |
| ** **                            | ** ** | **(in thousands)**              | ** ** | **(in thousands)**            | ** ** |
| Sales                                 |       | $                               | 357,797    |                          | $          | 266,247 |   | $ | 646,127 |   | $ | 589,242 |   |
| Gross profit                          |       | $                               | 15,922     |                          | $          | 12,321 |   | $ | 32,767 |   | $ | 26,710 |   |
| Gross profit as a percentage of sales |       | 4                               | %          | 5                             | %          | 5 | % | 5 | % |
|                                       |            |                                 |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

Revenue for the PCD segment increased 34% during thethree months ended June 30, 2007 as compared to the same period in 2006. Thenumber of units sold during the three months ended June 30, 2007 increased byapproximately 351,000 units, and the overall average selling price increased15% when compared to the same period in 2006. The increase in the number ofunits sold and the overall average selling price resulted in a $91.6 millionincrease to revenue for the three months ended June 30, 2007 as compared to thesame period in 2006. Revenue increased 10% during the six months ended June 30,2007, as compared to the same period in 2006, primarily due to a 600,000increase in the number of units sold, partially offset by a 5% decline in theoverall average selling price.

 

                Historically,PCD has relied upon a limited number of manufacturers to supply its handsetproducts. During the three months ended June 30, 2007 and 2006, sales ofUTStarcom branded devices accounted for approximately 40% of the total unitssold in both of the periods. During the six months ended June 30, 2007 sales ofUTStarcom branded devices account for 46% of the total units sold, compared to30% of the total units sold for the comparable period in 2006. We have focusedon increasing our sales of UTStarcom branded devices as we earn a higher grossmargin on these handsets. We expect this trend to continue in the future.

 

                Grossprofit as a percentage of sales was consistent for the three and six monthsended June 30, 2007 compared to the same periods in 2006.

 

***Handsets***

 

 

 
| ** **                            | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|---------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                            | ** ** | **2007**                        | ** ** | **2006**                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                            | ** ** | ** **                      | ** ** | **(As restated)**             | ** ** | ** ** | ** ** | **(As restated)** | ** ** |
| ** **                            | ** ** | **(in  thousands)**             | ** ** | **(in  thousands)**           | ** ** |
| Sales                                 |       | $                               | 62,177     |                          | $          | 107,069 |   | $ | 131,896 |   | $ | 206,103 |   |
| Gross profit                          |       | $                               | 22,396     |                          | $          | 32,896 |   | $ | 47,443 |   | $ | 64,509 |   |
| Gross profit as a percentage of sales |       | 36                              | %          | 31                            | %          | 36 | % | 31 | % |
|                                       |            |                                 |            |                               |            |  |  |  |  |  |  |  |  |  |

 

Handsets revenue declined 42% for the three monthsended June 30, 2007 compared to the same period in 2006. Nearly all our handsetsales are in China, where we have experienced a decline in volume for our PAShandsets. The units sold declined to 1.2 million during the three months endedJune 30, 2007 compared to 2.2 million in the same period last year. We believethat the 45% volume decline was primarily attributed to lower demand for ourPAS handsets resulting from slower subscriber growth. During the three monthsended June 30, 2007, the PAS net subscriber growth in China decreased comparedto the same period in 2006 because of competition from GSM and CDMA carriers asa result of the implementation of one-way charge in February 2007. In addition,PAS service providers reduced marketing efforts for PAS handsets in anticipationof next generation technology networks. PAS subscribers have declined in recentperiods.

 

Handset sales declined 36% for the six months endedJune 30, 2007 compared to the same period in 2006. As noted above, the decreasein net sales was primarily attributable to deteriorating PAS subscriber growth.Unit sales declined to 2.6 million for the six months ended June 30, 2007compared to 4.4 million units in the prior comparable period of 2006. Theaverage selling price per unit remained relatively stable due to the offset ofcompetitive pricing pressures in the PAS market with a shift in product mix tosales of higher end models including our new dual mode model.

 

Gross profit as a percentage of sales for our handsetssegment showed slight improvement in the three and six months ended June 30,2007, as compared to the corresponding periods in 2006, due to our continuouseffort on cost reduction, including lower inventory reserves, warranty cost androyalty cost.

 

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***Services***

 
| ** **                            | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|---------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                            | ** ** | **2007**                        | ** ** | **2006**                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                            | ** ** | ** **                      | ** ** | **(As restated)**             | ** ** | ** ** | ** ** | **(As restated)** | ** ** |
| ** **                            | ** ** | **(in thousands)**              | ** ** | **(in thousands)**            | ** ** |
| Sales                                 |       | $                               | 15,797     |                          | $          | 17,475 |   | $ | 32,548 |   | $ | 34,443 |   |
| Gross profit                          |       | $                               | 3,894      |                          | $          | 4,987 |   | $ | 8,020 |   | $ | 8,929 |   |
| Gross profit as a percentage of sales |       | 25                              | %          | 29                            | %          | 25 | % | 26 | % |

 

Our Services segment revenue from external customersdecreased by $1.7 million or 10% for the three months ended June 30, 2007 ascompared to the corresponding quarter last year. Our Services segment revenuefrom external customers declined by $1.9 million, or 6%, for the six monthsended June 30, 2007 as compared to the corresponding period last year.

 

The decline in service revenue as well as gross marginis mainly caused by the lower allocated revenue from both WirelessInfrastructure and Broadband Infrastructure segments. Revenues of $1.6 millionand $3.0 million from Wireless Infrastructure and $0.1 million and $0.2 millionfrom Broadband Infrastructure sales in China were allocated to the Servicessegment during the three and six months ended June 30, 2007, respectively.During the three and six months ended June 30, 2006, the allocated amounts fromWireless Infrastructure was $2.7 million and $5.3 million and from BroadbandInfrastructure was $0.2 million and $0.4 million, respectively. The lowerallocated amount are a result of lower sales from both the Wireless andBroadband segments during the three and six months ended June 30, 2007.

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

***Operating Activities***

 

*2007*

 

                Netcash used in operating activities for the six months ended June 30, 2007 was$149.3 million. Operating cash was negatively affected by the net loss of$115.7 million and changes in accounts payable and inventories offset bychanges in accounts receivable and customer advances, as discussed below.

 

                Duringthe first six months of 2007, accounts payable decreased $89.5 million, due toour decision to change the timing of payments to vendors in the first quarterof 2007 to comply with vendor payment terms. In addition, inventories increased$19.4 million primarily due to inventory purchases related to an infrastructuredeployment contract that we entered into in the fourth quarter of 2006

 

The cash used in operating activities was partiallyoffset by a reduction in accounts receivable of $84.7 million as a result ofstrong cash collections and the high percentage of revenue in the first half of2007 from our PCD segment which generally has experienced a shorter collectionperiod on related receivables. Customer advances increased by $27.1 million forthe six months ended June 30, 2007. Customer advances represents cash depositswe have received from our customers for orders that have not yet received finalacceptance. Upon subsequent receipt of final acceptances and revenuerecognition, customer advances are reduced and revenue and cost of sales isrecorded. The reduction in other current liabilities is primarily due todecreases in compensation and warranty related accruals.

 

*2006*

 

                Netcash provided by operating activities for the six months ended June 30,2006 was $79.2 million. Operating cash was affected by changes in accountsreceivable, customer advances, and accounts payable, and offset by the net lossas well as changes in other current liabilities and inventories.

 

                The$97.6 million decrease in accounts receivable was attributable to adecline in sales preceding the end of the June 30, 2006 quarter ascompared to sales preceding December 31, 2005. Days sales outstanding,when calculated using the preceding quarterly sales, remained constant at70 days at June 30, 2006 and December 31, 2005. Days salesoutstanding lengthened in the Broadband and PCD segments and shortened in theHandset and Wireless segments.

 

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                Customeradvances increased by $69.3 million for the six months ended June 30,2006. Customer advances represent cash deposits we have received from ourcustomers for orders that have not yet received final acceptance. Uponsubsequent receipt of final acceptances and revenue recognition, customeradvances are reduced and revenue and cost of sales is recorded.

 

                Accountspayable increased by $39.7 million, other current liabilities decreased by$89.5 million and inventory increased by $36.9 million. The decreasein other current liabilities is primarily the result of a decrease in othertaxes payable of approximately $19.1 million, a decrease in compensationrelated costs of approximately $10.2 million, a decrease in accruedwarranty costs of approximately $12.6 million, a decrease in accruedcontract costs, which relate to purchase of goods and services for whichinvoices have not been received of approximately $13.5 million and adecrease of approximately $34.1 million in other liabilities.

 

                Non-cashcharges for the six months ended June 30, 2006 included $34.7 millionof depreciation and amortization, $7.5 million of stock compensationexpense and $6.0 million in recovery of deferred costs reserves.

 

***Investing Activities***

 

*2007*

 

                Netcash used in investing activities for the six months ended June 30, 2007totaled $15.5 million. Cash of $15.3 million was received from thedisposition of long-term investments and proceeds from the sale of short-terminvestments, and $6.6 million was a decrease in restricted cash. Cashoutflows from investing activities included $21.7 million for the purchase ofshort-term investments as well as $15.4 million for the purchase ofproperty, plant and equipment.

 

*2006*

 

                Netcash used in investing activities for the six months ended June 30, 2006totaled $13.4 million. Cash outflows for investing activities, including$12.3 million of additions to property, plant and equipment,$28.0 million of purchases of short-term investments, and $20.0 millionin changes to restricted cash. Cash inflows from investing activities included$20.0 million received from the sale of the semiconductor design assets toMarvell Technology Group, Ltd., and $25.6 million of proceeds of thesale of short-term investments.

 

***Financing Activities***

 

*2007*

 

                Netcash provided by financing activities was $4.6 million, primarilyconsisting of a change in cash overdrafts for the six months ended June 30,2007.

 

*2006*

 

                Netcash used in financing activities was $75.5 million, primarily consistingof a net repayment of short-term borrowings in excess of new borrowings of$77.5 million.

 

***Liquidity***

 

Wereported net losses in each quarter in the period beginning April 1, 2005 andcontinuing through June 30, 2007, which have resulted in an accumulated deficitof $611.3 million and total stockholders’ equity being reduced to $722.4million at June 30, 2007. Additionally, at June 30, 2007, we had short-termdebt in China under lines of credit to our China subsidiaries of $105.1 millionmaturing in 2007 and the first quarter of 2008, and short-term debt outside ofChina in the form of convertible subordinated notes with a principal balance of$274.6 million that matures in March 2008.

 

Ourworking capital was $424.7 million and $835.4 million at June 30, 2007 and2006, respectively, and included cash on hand of $509.4 million and$641.0 million and short term investments of $18.2 million in and $16.6million, respectively in 2007 and 2006. Planned capital expenditures include anincrease in the level of our capital expenditures in China in 2007 byapproximately $40 million to support wire line telephone carriers in China whoutilize our products and services to provide television service to theircustomers using the IPTV protocol.

 

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Credit facilities in Chinaat June 30, 2007 totaled $702.8 million, with $358.6 million of this amountavailable for working capital purposes, of which we had drawn $105.1 million inoutstanding borrowings, with interest rates ranging from 5.51% to 5.57%, and$344.2 million was available for use in support of letters of credit andcorporate guarantees. These facilities expireprimarily in November and December of 2007. We believe that based uponour recent financial performance and financial position our lenders may reducethe total available credit when it negotiates renewals of these lines.Furthermore, each borrowing under the credit facilities is subject to the bank’scurrent favorable opinion of the credit worthiness of the Company’s Chinasubsidiaries, as well as the bank having funds available for lending and otherChinese banking regulations. However, we believe the amounts of credit ourlenders may make available and the borrowings made under the renewed lines ofcredit will be sufficient to meet planned uses of these credit facilities.

 

As of September 30, 2007 our outstanding borrowings underthe credit facilities in China totaled $140.1 million, with interest rates ofup to 6.67%, with varying maturity dates through September 2008. The Company’spractice in China is to draw new loans under the credit facilities prior toeither the maturity of our borrowings or expiration of our facilities to ensurewe maintain adequate liquidity to re-pay the existing borrowings at maturity,or to effectively lengthen the credit facility period to the latest maturitydate of the underlying borrowings.

 

Of our total cash andshort-term investments at June 30, 2007 of $527.6million, a total of $415.5 million was held in China. To meet liquidityneeds outside of China, our subsidiaries in China have the ability to transfercash to the Company in the United States under China’s current exchange controlregulations. The amount of cash available for transfer from the China subsidiariesis limited both by liquidity needs of the subsidiaries in China and by Chinesegovernment requirements that the China subsidiaries retain adequate capitallevels in China to protect creditors and to have funds available for mandatedemployee benefits. During the nine months ended September 30, 2007 our Chinasubsidiaries have made such transfers of funds out of China to the Companytotaling $150 million.

 

Although management believeswe now have a sufficient amount of cash resources to finance our anticipatedworking capital and capital expenditure requirements for the next 12 months, wedo not have enough cash outside of China to repay the convertible notes due onMarch 1, 2008. Management’s liquidity plans include a partial or completerefinancing of the convertible notes, renewal of the lines of credit in China,transfers of more cash from its subsidiaries in China to the extent necessary,and, if needed, liquidation of certain investments and/or seeking new financingarrangements. Our ability to maintain sufficient liquidity is also dependent onachieving projected sales and operating margin forecasts.

 

The convertible notes were issued in March 2003 whenwe completed an offering of $402.5 million of 7/8% convertiblesubordinated notes due March 1, 2008 to qualified institutional buyers.The notes are convertible into our common stock at a conversion price of $23.79per share and are subordinated to all of our present and future senior debt.Concurrent with the issuance of the convertible notes, we entered into aconvertible bond hedge and a call option transaction with respect to our commonstock. Both the bond hedge and call option transactions may be settled at ouroption either in cash or net shares and expire on March 1, 2008. During 2005,we completed exchanges of approximately 5.0 million shares of our commonstock and approximately $57.1 million in cash for $127.9 millionaggregate principal amount of outstanding notes. As a result of the earlyextinguishment, we also amended the convertible bond hedge and call optiontransactions to reflect the change in principal amount of the underlying notes.

 

Ifan event of default were to occur and be continuing, the Trustee or the holdersof at least 25% in aggregate principal amount of the notes then outstandingcould declare all unpaid principal and accrued interest on the Notes thenoutstanding to be immediately due and payable. Therefore as a result of ourinability to timely file our Quarterly Report on Form 10-Q for the period endedSeptember 30, 2006, because the independent review by the Governance Committeeof the Company’s historic stock option accounting was not completed, afterreceiving a purported notice of default from the trustee for the notes (the “Trustee”)asserting that the delay in filing and a failure to comply with certaincovenants had caused a default under the indenture, we solicited and receivedthe requisite consents from the holders of the notes to a waiver of anydefaults which may have occurred to and including January 9, 2007, caused by adelay in filing certain reports required to be filed pursuant to the ExchangeAct (the “SEC Reports”) with the Securities and Exchange Commission (the “SEC”)and entered into a First Supplemental Indenture with the Trustee, dated January9, 2007, which provided that any failure by us to comply with certainprovisions of the original agreement will not result in a default or an eventof default through May 31, 2007. After receiving a notice of default from theTrustee asserting that our inability to timely file SEC Reports and comply withcertain covenants as of May 31, 2007 had caused a default under the indenture,we solicited and received the requisite consents from the holders of the notesto a waiver of any defaults which may have occurred to and including July 26,2007 and entered into a Second Supplemental Indenture with the Trustee, afterreceiving consent from holders of more than 50% 

 

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ofthe outstanding aggregate principal amount of the convertible subordinatednotes in connection with our consent solicitation announced July 19, 2007. TheSecond Supplemental Indenture provided that (i) during the period from andincluding July 26, 2007 to and including October 15, 2007 (“Covenant ReversionDate”), any failure by us to comply with the covenants contained in theoriginal indenture agreement related to the required filing of reports with theSEC, and the furnishing of copies of the SEC reports and certain compliancecertificates to the Trustee, will not constitute a default, and that (ii) if,but for the Second Supplemental Indenture, a default would be deemed to haveoccurred as a result of a failure to comply with such covenants and suchdefault remains uncured and is continuing as of the Covenant Reversion Date,such default will be deemed to have occurred on the Covenant Reversion Date.

 

On October 15, 2007, wereceived an additional notice of default asserting that a default had occurredunder the Indenture (as amended by the First Supplemental Indenture and theSecond Supplemental Indenture) with respect to the Notes. The specificpurported defaults referred to in the notice of default were (i) our failure tofile with the SEC and provide copies to the Trustee of our Quarterly Report onForm 10-Q for the fiscal quarter ended March 31, 2007 and our Quarterly Reporton Form 10-Q for the fiscal quarter ended June 30, 2007 and (ii) our failure todeliver to the Trustee the officer’s certificate of compliance required by theIndenture. The notice of default provides that we have 60 consecutive days fromOctober 15, 2007 (the “Demand Date”) to cure the purported defaults before suchdefaults would constitute an “Event of Default” under the Indenture. Theoccurrence of an “Event of Default” under the Indenture would afford theTrustee or holders of not less than 25% in aggregate principal amount ofoutstanding Notes the right to declare the full principal amount of alloutstanding Notes to be immediately due and payable. As of the date of the filingof this Quarterly Report on Form 10-Q for the quarter ended June 30, 2007, theCompany has filed all required reports with the SEC prior to the Demand Dateset forth in the October 15th notice of default, and, as a result,believes that no Event of Default under the Indenture occurred.

 

Under the Second Supplemental Indenture, theconvertible subordinated notes accrue an additional 6.75% per annum in specialinterest from and after January 9, 2007 to and including July 25, 2007, and anadditional 10% per annum in special interest from and after July 26, 2007 tothe date the notes are paid, prepaid, redeemed, converted or otherwise cease tobe outstanding. The special interest rate accruing on the notes after July 26,2007 represents an increase of 3.25% per annum over the previous specialinterest rate of 6.75% per annum provided by the First Supplemental Indenture.As a result of the Second Supplemental Indenture, the convertible subordinatednotes now bear a stated interest rate of 10.875%. Accordingly, we will have $22.0 million of additional annual interestexpense in 2007 while the convertible subordinated notes are outstanding.Payments ofspecial interest will be made in addition to, and at the same time and in thesame manner as, regularly scheduled payments of interest to holders entitled tosuch regularly scheduled payments of interest.

 

If additional sources ofliquidity were needed, the Company would consider new debt or equity offeringsor obtaining cash from asset sales, but there is no assurance that suchtransactions could be consummated on acceptable terms or at all. Failure toraise sufficient capital when needed could have a material adverse effect onthe business, results of operations and financial position of the Company.

 

Our China sales are generally denominated in localcurrency, and we accept commercial notes receivable with maturity dates ofbetween three and six months from our customers in China in the normalcourse of business. Notes receivable available for sale was $4.1 millionand $5.1 million at June 30, 2007 and December 31, 2006, respectively. We maydiscount these notes with banking institutions in China. Any notes that havebeen sold are not included in our consolidated balance sheets as the criteriafor sale treatment established by Statement of Financial Accounting StandardsNo. 140, “Accounting for Transfers and Servicing of Financial Assets andExtinguishment of Liabilities” (“SFAS 140”) have been met.

 

Due to the limitations on converting Renminbi, we arelimited in our ability to engage in foreign currency hedging activities inChina. We cannot guarantee that fluctuations in foreign currency exchange ratesin the future will not have a material adverse effect on revenues frominternational sales and, correspondingly, on our business, financial condition,results of operations and cash flows. We have contracts negotiated in JapaneseYen and we maintain bank accounts in Japanese Yen for purchasing portions ofour inventories and supplies. The balance of these Japanese Yen accounts atJune 30, 2007 was approximately $8.5 million.

 

On August 1, 2005, we entered into a 364-day$100.0 million committed receivables purchase facility with a financialinstitution. In March 2007, the agreement was amended and restated to reflectthat the purchase of trade receivables shall be at the sole discretion of thefinancial institution. The agreement was also extended to the earlier of(i) March 28, 2008 or (ii) upon 90 days written notice by thefinancial institution. Pursuant to the terms of the receivable purchasefacility, we may sell certain receivables arising from the sale oftelecommunications equipment to this financial institution. No receivables hadbeen sold pursuant to this arrangement.

 

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We havenot guaranteed any debt that is not included in the consolidated balance sheet.

 

***Income taxes***

 

Certain subsidiaries andjoint ventures located in China enjoy tax benefits in China which are generallyavailable to foreign investment enterprises, including full exemption fromnational enterprise income tax for two years starting from the first profit-makingyear and/or a 50% reduction in national income tax rate for the following threeyears. In addition, local enterprise income tax is often waived or reducedduring this tax holiday/incentive period. Under current regulations in China,foreign investment enterprises that have been accredited as technologicallyadvanced enterprises are entitled to additional tax incentives. These taxincentives vary in different locales and could include preferential nationalenterprise income tax treatment at 50% of the usual rates for different periodsof time. The tax holidays discussed above are applicable or potentiallyapplicable to UTStarcom Chongqing Telecom Co. Ltd. (“CUTS”), UTStarcom TelecomCo., Ltd. (“HUTS”), Hangzhou UTStarcom Telecom Co., Ltd. (“HSTC”) and UTStarcomChina Co., Ltd. (“UTSC”), our active subsidiaries in China, as those entitiesmay qualify as accredited technologically advanced enterprises.

OnMarch 16, 2007, China’s top legislature, the National People’s Congress, passedthe China Corporate Income Tax Law (“CIT Law”). CIT Law will be effective on January 1, 2008.  Under the CIT Law, China’s dual tax systemfor domestic enterprises and foreign investment enterprises (“FIEs”) would beeffectively replaced by a unified system. The new law establishes a tax rate of 25% for most enterprises and areduced tax rate of 15% for certain qualified high technology enterprises.

Priorto this change in tax law, certain subsidiaries and joint ventures located inChina enjoy tax benefits in China which are generally available to FIEs.   The tax holidays/incentives for FIEs wereapplicable or potentially applicable to CUTS,, HUTS, HSTC and UTSC, our activesubsidiaries in China, as those entities may qualify as accreditedtechnologically advanced enterprises.

CIT Lawtargets certain industries for the reduced 15% tax rate for certain qualifiedhigh technology enterprises.    For FIEsestablished before the promulgation of the new law who currently enjoy lowertax rates, any increase in their tax rates would be gradually phased in overfive years.  Significant regulationsregarding the interpretation and implementation of the new tax law are stillpending.  There is potential risk thatour subsidiaries may not qualify for the reduced 15% tax rate.  Therefore, the new law may have an adverseimpact on our future tax expense in China.

Moreover, the Chinese central government may review andaudit tax benefits granted by local or provincial authorities and coulddetermine to disallow such benefits. Certain of our subsidiaries and jointventures located in China enjoy tax benefits in China that are generallyavailable to foreign investment enterprises. If these tax benefits are reduced,disallowed or repealed due to changes in tax laws or determination by theChinese government, our business could suffer.

 

***Off balance sheet arrangements***

 

                OnAugust 1, 2005, we entered into a 364-day committed receivables purchasefacility with Citibank, N.A., which provides for the sale of up to$100.0 million of trade accounts receivable of our PCD segment. On March30, 2007, the agreement was amended and restated to reflect that the purchaseof trade receivables shall be at the sole discretion of Citibank, N.A.  Sales of the accounts receivables toCitibank, N.A. under this program will result in a reduction of total accountsreceivable in our consolidated balance sheet. The remaining accounts receivablesnot sold to Citibank, N.A. will be carried at their net realizable value,including an allowance for doubtful accounts. We have not sold any receivablespursuant to this facility during 2006 or the first six months of 2007. Webelieve that available funding under our accounts receivable financing programprovides us increased flexibility to manage working capital requirements, andthat there are sufficient trade accounts receivable to support the U.S.financing programs. Under the program, we will continue to service the accountsreceivable.

 

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***Contractual obligations and other commitments***

 

                Ourobligations under contractual obligations and commercial commitments are asfollows:

 

 
| ** **                         | ** **   | **Payments due by period** | ** **   |
|------------------------------------|--------------|----------------------------|--------------|
| ** **                         | ** **   | ** **                 | ** **   | **Less than  1 year** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                         | ** **   | **Total**                  | ** **   | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **over 5 years** | ** ** |
| ** **                         | ** **   | **(in thousands)**         | ** **   |
| ***Contractual Obligations***      | *** *** | *** ***               | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** |
| Bank loans                         |         | $                          | 105,098      |   | $ | 105,098 |   | $ | — |   | $ | — |   | $ | — |   |
| Convertible subordinated notes     |         | $                          | 274,600      |   | $ | 274,600 |   | $ | — |   | $ | — |   | $ | — |   |
| Interest payable on debt           |         | $                          | 21,730       |   | $ | 21,730 |   | $ | — |   | $ | — |   | $ | — |   |
| Lease obligations                  |         | $                          | 32,427       |   | $ | 14,306 |   | $ | 15,776 |   | $ | 1,141 |   | $ | 1,204 |   |
| ***Other Commercial Commitments*** | *** *** | *** ***               | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** |
| Standby letters of credit          |         | $                          | 43,012       |   | $ | 26,284 |   | $ | 16,728 |   | $ | — |   | $ | — |   |
| Purchase commitments               |         | $                          | 126,830      |   | $ | 120,223 |   | $ | 6,607 |   | $ | — |   | $ | — |   |
|                                    |              |                            |              |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

*Bank loans*

 

                AtJune 30, 2007, we had loans with various banks totaling $105.1 millionwith interest rates ranging from 5.51% to 5.75% per annum. These bank loansmature during the fourth quarter of 2007 and the first quarter of 2008 and areincluded in short-term debt.

 

*Convertiblesubordinated notes*

 

                Ourconvertible subordinated notes, due March 1, 2008, are convertible intoour common stock at a conversion price of $23.79 per share and are subordinatedto all our present and future senior debt. The principal is due only atmaturity of the notes.

 

Effective January 9, 2007, the Company and the holders ofthe remaining $274.6 million of convertible subordinated notes entered into aFirst Supplemental Indenture, providing that any failure by us to comply withcertain provisions of the original agreement will not result in a default or anevent of default through May 31, 2007.  Theconvertible subordinated notes accrue an additional 6.75% per annum in specialinterest from and after January 9, 2007 to the March 1, 2008 maturity date ofthe notes, unless the notes are earlier repurchased or converted. OnJuly 26, 2007, we entered into a Second Supplemental Indenture providing that the convertible subordinated notes willaccrue an additional 10% per annum in special interest from and after July 26,2007 to the March 31, 2008 maturity date of the notes unless the notes areearlier repurchased or converted.  Thespecial interest rate represents an increase of 3.25% per annum over theprevious special interest rate of 6.75% per annum in the First SupplementalIndenture.  As a result of the SecondSupplemental Indenture, the convertible subordinated notes now bear a statedinterest rate of 10.875%. Interest is payable semiannually on March 1and September 1, and payments of the special interest are made in addition toand at the same time and in the same manner as regularly scheduled payments ofinterest to holders entitled to such regularly scheduled payments ofinterest.  For more information regardingthe notice of default on May 31, 2007, the notice of default on October 15,2007 and the Company’s Second Supplemental Indenture see the “Liquidity”section of this Quarterly Report.

 

*Operatingleases*

 

                Welease certain facilities under non-cancelable operating leases that expire atvarious dates through 2013.

 

*Letters ofcredit*

 

                Weissue standby letters of credit primarily to support international salesactivities outside of China. When we submit a bid for a sale, often thepotential customer will require that we issue a bid bond or a standby letter ofcredit to demonstrate our commitment through the bid process. In addition, wemay be required to issue standby letters of credit as guarantees for advancecustomer payments upon contract signing or performance guarantees. The standbyletters of credit usually expire six to twelve months from date of issuancewithout being drawn by the beneficiary thereof.

 

*Purchasecommitments*

 

                Weare obligated to purchase raw materials and work-in-process inventory undervarious orders from various suppliers, all of which should be fulfilled withoutadverse consequences material to our operations or financial condition.Purchase commitments exclude agreements that are cancelable withoutpenalty.  As of June 30, 2007 total opencommitments under these purchase orders extending beyond one year wereapproximately $6.6 million. Additionally, we have agreed to purchase fromMarvell certain chip-sets that will be included in 50% to 100% of our PAShandsets, through 2011.

 

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*Intellectualproperty*

 

                Certainsales contracts include provisions under which customers would be indemnifiedby us in the event of, among other things, a third-party claim againstthe customer for intellectual property rights infringement related to ourproducts. There are no limitations on the maximum potential future paymentsunder these guarantees. We have not accrued any amounts in relation to theseprovisions as no such claims have been made and we believe we have validenforceable rights to the intellectual property embedded in our products.

 

*Income Tax Obligations*

 

Effective January 1, 2007, the Company adopted theprovisions of FIN 48.  As of June 30, 2007,the Company had $74.0 million of liabilities for unrecognizedtax benefits. If recognized, the portion of liabilities for unrecognized taxbenefits that would decrease the provision for income taxes and increase theCompany’s net income is $7.1 million. The impact on net income reflects theliabilities for unrecognized tax benefits net of certain deferred tax assetsand the federal tax benefit of state income tax items totaling $66.9 million.The Company is not updating the disclosures in its contractual obligations andcommercial commitments table because of the difficulty in making reasonablyreliable estimates of the timing of cash settlements with the respective taxingauthorities.

 

 

 

**RECENT ACCOUNTING PRONOUNCEMENTS**

 

See Note 22, “RecentAccounting Pronouncements,” in the Notes to Condensed Consolidated FinancialStatements in Item 1 of this Quarterly Report for a full description of recentaccounting pronouncements, including the expected dates of adoption andestimated effects on results of operations and financial condition, which isincorporated herein by reference.

 

**ITEM 3—QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISKS**

 

                Weare exposed to the impact of interest rate changes, changes in foreign currencyexchange rates and changes in the stock market.

 

***Interest Rate Risk***

 

                Ourexposure to market risk for changes in interest rates relates primarily to ourinvestment portfolio.  The fair value ofour investment portfolio would not be significantly affected by either a 10%increase or decrease in interest rates due mainly to the short-term nature ofmost of our investment portfolio. However, our interest income can be sensitive to changes in the generallevel of U.S. interest rates since the majority of our funds are invested ininstruments with maturities less than one year. Our policy is to ensure the safety of invested funds by generallyattempting to limit market risk.  Fundsin excess of current operating requirements are mostly invested in government-backednotes, commercial paper, floating rate corporate bonds, fixed income corporatebonds and tax-exempt instruments.  Inaccordance with our investment policy, all short-term investments are investedin “investment grade” rated securities with minimum A or better ratings.  Currently, most of our short-term investmentshave AA or better ratings.

 

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                Thetable below represents carrying amounts and related weighted-averageinterest rates of our investment portfolio at June 30, 2007:

 
| ** **                                              | ** ** | **(in thousands, except interest rates)** | ** ** |
|---------------------------------------------------------|------------|-------------------------------------------|------------|
| Cash and cash equivalents                               |       | $                                         | 509,423    |   |
| Average interest rate                                   |       | 2.10                                      | %          |
|                                                    |       |                                      |       |
| Restricted cash                                         |       | $                                         | 9,797      |   |
| Average interest rate                                   |       | 4.80                                      | %          |
|                                                    |       |                                      |       |
| Short-term investments                                  |       | $                                         | 18,156     |   |
| Average interest rate                                   |       | 1.75                                      | %          |
|                                                    |       |                                      |       |
| Restricted cash - long-term                             |       | $                                         | 16,728     |   |
| Average interest rate                                   |       | 4.95                                      | %          |
|                                                    |       |                                      |       |
| Total cash, cash  equivalents and investment securities |       | $                                         | 554,104    |   |
| Average interest rate                                   |       | 2.22                                      | %          |

 

 

***Equity Investment Risk***

 

                Ourinvestment portfolio includes equity investments in publicly traded companies,the values of which are subject to market price volatility.  Economic events could adversely affect thepublic equities market and general economic conditions may worsen.  Should the fair value of our publicly tradedequity investments decline below their cost basis in a manner deemed to beother-than-temporary, our earnings may be adversely affected.  We have also invested in several privatelyheld companies as well as investment funds which invest primarily in privatelyheld companies, many of which can still be considered in the start-up ordevelopment stages.  These investmentsare inherently risky, as the market for the technologies or products they haveunder development are typically in the early stages and may never materialize.

 

***Foreign Exchange Rate Risk***

 

                Weare exposed to foreign currency exchange rate risk because most of our sales inChina are denominated in Renminbi and portions of our accounts receivable andpayable are denominated in Japanese Yen. Due to the limitations on converting Renminbi, we are limited in ourability to engage in foreign currency hedging activities in China.  Although the impact of currency fluctuationsof Renminbi to date has been slight, fluctuations in currency exchange rates inthe future may have a material adverse effect on our results ofoperations.  The balance of cash andshort-term investment balance held in China was $415.5 million at June 30,2007.  In July 2005, China uncoupledthe Renminbi from the U.S. dollar and let it float in a narrow band against abasket of foreign currencies.  The moverevalued the Renminbi by 2.1% against the U.S. dollar.  Additionally, during 2006 and the first sixmonths of 2007 we made significant sales in both Japanese Yen and inEuros.  We maintain Japanese Yen bankaccounts for purchasing portions of our inventories and supplies.

 

                Ourrevenues, earnings and cash flows are subject to fluctuations due to changes inforeign currency exchange rates.  We mayhedge currency exposures associated with certain assets and liabilitiesdenominated in nonfunctional currencies and certain anticipated nonfunctionalcurrency transactions using forward foreign currency exchange ratecontracts.  We have not hedged any suchtransactions, and due to the limitations on converting Renminbi, we are limitedin our ability to engage in currency hedging activities in China.  As a global concern, we face exposure toadverse movements in foreign currency exchange rates.

 

                Wehave performed a sensitivity analysis as of June 30, 2007, using a modelingtechnique that measures the change in the fair values arising from ahypothetical 10% positive or adverse movement in the levels of foreign currencyexchange rates relative to the U.S. Dollar, with all other variables heldconstant.  The analysis covers all of ourforeign currency contracts offset by the underlying exposures.  The foreign currency exchange rates used werebased on market rates in effect at June 30, 2007.  The sensitivity analysis indicated that ahypothetical 10% movement in foreign currency exchange rates would result in again or loss in the fair values of our foreign exchange financial instrumentsof $7.6 million at June 30, 2007.

 

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**ITEM 4—CONTROLS AND PROCEDURES**

 

**Evaluation of Disclosure Controls and Procedures**

 

                UTStarcom, Inc. (“UTStarcom”or the “Company”) maintains disclosure controls and procedures that aredesigned to ensure that information required to be disclosed in the reports theCompany files or submits under the Securities Exchange Act of 1934, as amended(“Exchange Act”), is recorded, processed, summarized and reported within thetime periods specified in the Securities and Exchange Commission’s (“SEC”)rules and forms, and that such information is accumulated and communicated tothe Company’s management, including its chief executive officer (“CEO”) andchief financial officer (“CFO”), as appropriate, to allow timely decisionsregarding required financial disclosure.

 

                In connection with thepreparation of this Quarterly Report on Form 10-Q (“Form 10-Q”), theCompany carried out an evaluation as of June 30, 2007 under the supervision andwith the participation of the Company’s management, including the CEO and CFO,of the effectiveness of the design and operation of the Company’s disclosurecontrols and procedures, as such term is defined in Rules 13a-15(e) and15d-15(e) under the Exchange Act. Based upon this evaluation, managementconcluded that as of June 30, 2007 the Company’s disclosure controls andprocedures were not effective because of the material weaknesses described in “Management’sAnnual Report on Internal Control over Financial Reporting,” included in “ITEM9A**—**CONTROLS AND PROCEDURES” in the Company’s Annual Report on Form10-K for the fiscal year ended December 31, 2006 (the “Item 9A in the 2006Annual Report”), which have not yet been fully remediated. Investors are directed to Item 9A in the2006 Annual Report for the description of these weaknesses.

 

A “materialweakness” is a control deficiency in internal control over financial reporting,or a combination of deficiencies in internal control over financial reporting,that results in more than a remote likelihood that a material misstatement ofthe annual or interim consolidated financial statements will not be preventedor detected. To address these material weaknesses in internal control overfinancial reporting noted above, the Company performed additional analyses andother procedures (as further described below under “Management’s PlannedRemediation Initiatives and Interim Measures”) to ensure that the Company’sconsolidated financial statements are prepared in accordance with generallyaccepted accounting principles in the United States (“GAAP”). Accordingly, theCompany’s management believes that the consolidated financial statementsincluded in this Form 10-Q fairly present in all material respects the Company’sfinancial condition, results of operations and cash flows for the periodspresented and that this Form 10-Q does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the periods covered by this report.

 

**Management’s Planned Remediation Initiatives and InterimMeasures**

 

                The Company plans to makenecessary changes and improvements to the overall design of its controlenvironment to address the material weaknesses in internal control overfinancial reporting described in Item 9A in the 2006 Annual Report  In particular, the Company has implementedduring 2006 and the first two quarters of 2007, and plans to continue toimplement during 2007, the specific measures described below.  In addition, in connection with the June 30,2007 quarter-end reporting process, the Company has undertaken additionalmeasures described under the subheading “Interim Measures” below to providereasonable assurance regarding the reliability of financial reporting and thepreparation of the Company’s consolidated financial statements included in thisForm 10-Q and to ensure that material information relating to the Company andits consolidated subsidiaries was made known to management in connection withthe preparation of this Form 10-Q.

 

***Remediation Initiatives***

 

1.             Toremediate the materialweakness described in Item 9A in the 2006 Annual Report, in “1.*The Company did not maintain aneffective control environment*,”the Company has implemented or plans to implement the measures describedbelow, and will continue to evaluate and may in the future implement additionalmeasures. These measures include the following:

 

a)             *Effective financial reporting process, including policies andprocedures*—In the fourth quarter of 2006, the Company’s financedepartment commenced an initiative to update its finance and accountingpolicies and procedures. Through this initiative, which was ongoing through thefirst nine months of 2007 and will be ongoing through the rest of 2007, theCompany’s financial policies and procedures will be reviewed for completeness,accuracy and adequacy, updated and brought current, and standardized globallyas necessary and appropriate. A communication plan will also be developed toensure updated policies and procedures are publicized and understood, andappropriate employees are trained in their application, as necessary. TheCompany expects this initiative will form the foundation for the process tomaintain and keep current its finance and accounting policies and procedures ona go-forward basis. In addition, starting in the fourth quarter of 2006, theCompany commenced internal audits of, and in the remainder of 2007 and 2008plans to continue to expand and increase the scope of its efforts to monitor,controls at the Company’s decentralized and remote operations globally, throughreviews and audits of employee compliance with applicable policies andprocedures at business units, subsidiaries and other locations.

 

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b)            *Non-compliance with established policies and procedures intendedto ensure compliance with laws and regulations*—During the secondquarter of 2006, the Company launched a formal investigation at the directionof the Audit Committee of the Company’s Board of Directors (“Audit Committee”)to review alleged violations of the FCPA; refer to “*GovernmentalInvestigations*” under “ITEM3—LEGAL PROCEEDINGS” for additional information. Throughout the courseof this investigation, the Company took and plans to continue to take allappropriate actions including changes to its training, processes and proceduresrelated to its code of business conduct and ethics, its payment controlsparticularly in outlying regions, and its due diligence evaluation of businesspartnerships. Upon conclusion of this investigation, the Company will reviewand, as necessary, further enhance its procedures to reduce the risk of ongoingcontrol deficiencies in this area. In addition, in the third and fourthquarters of 2006 and 2007 to date, the Company provided training to personnelin offices in various regions including North America, Europe, and China and,in the remainder of 2007 and in 2008, plans to continue to provide training andexpand its coverage of personnel employed in other regions and countries. In addition,the Company’s internal audit staff commenced audits and plans to continue toexpand and increase the scope of the Company’s efforts to monitor controls atcompany operations globally, through reviews and audits of employee compliancewith applicable policies and procedures at business units, subsidiaries andother locations.

 

c)             Inaddition to the specific measures described above to address this materialweakness in the control environment, the Company’s planned remediation measuresinclude the following:

 

i.              InNovember, 2006, the Company hired an assistant controller and a shared servicesmanager at its U.S. headquarters whose responsibilities include overseeing thecorporate accounting and SEC external financial reporting functions. In thefirst quarter of 2007, the Company hired a vice president of financialoperations and a vice president of financial planning and analysis to provideadditional finance personnel at its U.S. headquarters. These personnel haveappropriate qualifications, considerable technical experience and training inareas including accounting and SEC reporting, and in the utilization of theOracle financial system modules. The Company believes the addition of thesepersonnel improves and strengthens the capabilities of this function.

 

ii.             InApril 2007, the Company created the position of and hired a new chief ethicsofficer, to provide focused executive leadership in the area of corporateethics and integrity.

 

iii.            TheCompany retained and intends to continue to retain the services of outsideconsultants with relevant accounting experience, skills and knowledge in theapplication of GAAP, working under the supervision and direction of the Company’smanagement, to supplement the Company’s existing corporate accounting andexternal financial reporting personnel.

 

iv.            TheCompany will continue to hire, and has allocated resources to hire, additionalfinance personnel as needs arise and to replace departures, in the areas ofcompliance, corporate accounting, external financial reporting, internal audit,revenue accounting and tax, with relevant accounting experience, skills andknowledge in the application of GAAP.

 

v.             Inthe first quarter of 2007, the Company implemented a new “management byobjectives” system which is being used globally to capture corporate andexecutive management goals and articulate them throughout the organization, andto cascade and align each employee’s goals to support corporate objectives. Thegoal setting, monitoring and evaluation process will incorporate capturingemployee’s training and development requirements, including training to staycurrent with the application of GAAP and the company’s code of business conductand ethics.

 

vi.            During2007 to date, the Company’s CFO, with assistance from senior financial staffand outside consultants, reviewed and in the remainder of 2007 will continue toreview and adapt the overall design of the Company’s financial reportingorganization and structure, including the roles and responsibilities of eachfunctional group within the Company.

 

2.             Inaddition to the remediation measures described above, the Company hasimplemented or plans to implement the measures described below, and willcontinue to evaluate and may in the future implement additional measures.

 

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a)             To remediate the materialweaknesses described in Item 9A in the 2006 Annual Report  in section 2. a) over “*instances of overriderelated to controls in China over customer agreements*,” the Company’s planned remediation measures areintended to address material weakness in China that has the potential ofmisstating these balances in the financial statements in future financialperiods. These measures include the following:

 

i.             In the period from January to May2007, the Company effected personnel changes in the sales force in China’swestern sales region, as well as certain associated sales offices. The Companybelieves that these changes will enable effective management of the Chinawestern sales region’s sales operations and enhance compliance with the Company’spolicies and procedures, including the Company’s Code of Business Conduct andEthics.

 

ii.             The Company plans to reviseits  policies and procedures related toentering into sales contracts, document retention, as well the Code of BusinessConduct and Ethics to provide for details around the standards for enteringinto sales agreements and breaches to the Code of Business Conduct and Ethics.

 

iii.            The Company plans to implementmandatory training to employees in China’s sales organization around controlconsciousness and ongoing training to Sales, Contract Management and Finance inChina around the Company’s policies and procedures, including revenuerecognition.

 

iv.            The Company plans to review and makeimprovements to the sales databases to capture relevant contract informationand current status information.

 

v.             The Company plans to establish a process aroundorganizing visits by business operations and the regional sales managers to thevarious sales offices in China to enhance the awareness and compliance with theCompany’s polices and procedures.

 

b)            Toremediate the material weaknesses described in Item 9A in the 2006 Annual Reportin section 2. b) over “*inventory,including finished goods at customer sites, inventory reserves and deferredcosts accounts and associated cost of sales,*” section 2. c) over “*inventory reserves for losses on customer contracts and associated costof sales*,” and section 2. d) over “*accountingfor warranty reserves and associated cost of sales*”, the Company’splanned remediation measures are intended to address material weaknesses at itsU.S. headquarters that have the potential of misstating these balances in thefinancial statements in future financial periods. These measures include thefollowing:

 

i.              InNovember 2006, the Company hired an assistant controller and a shared servicesmanager at its U.S. headquarters whose responsibilities include overseeing theinternational cost accounting function. These personnel have considerableexperience and training in cost accounting and utilization of the relevantOracle financial system modules. The Company believes the addition of thesepersonnel improves and strengthens the capabilities for the manual analyses andmanagement review required of this function.

 

ii.             TheCompany plans in the remainder of  2007,to enhance its processes and procedures related to properly tracking andconfirming inventory movements to ensure the proper classification ofinventory, including finished goods at customer sites, and deferred costs (andassociated accounts such as purchase price variances), and to ensure thecompleteness and accuracy of the recording of the cost of sales when revenue isrecognized. The revised processes will include involving and obtaining detailedand timely input from business unit, operations and sales operations personnelto enhance the information available for finance to analyze these accounts. Newreports have been developed and reports and procedures will continue to be enhancedas necessary to facilitate the accuracy of accounting for these processes. Inaddition, finance management has placed increased attention on reviewing indetail the accounting in this area.

 

c)             Toremediate the material weaknesses described in Item 9A in the 2006 Annual Reportin section 2. e) over “*accountingfor and disclosure of stock-based compensation expense,*” the Company’splanned remediation measures are intended to address material weaknesses thathave the potential of misstating these balances in the financial statements infuture financial periods. These measures include the following:

 

i.              In November 2006, the Company announced avoluntary review of its historical equity award grant practices under thedirection of the nominating and corporate governance committee of the board ofdirectors. Upon this announcement, theCompany immediately suspended granting of equity awards and no new equityawards have been granted through the date of filing of this Form 10-Q.

 

ii.             Further, in November2006, the Company migrated to a new vendor’s system for stock options andequity awards administration, selected inpart for its improved processes, systems and controls.

 

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iii.            In April 2007, the Company’s compensationcommittee of the board of directors approved an equity award grant policy andprocedures (“Awards Policy”). Under this Awards Policy, the Company has adoptedthe following equity awards grant processes:

 

•              Equity awards will be made only ongrant dates pre-determined in accordance with the Awards Policy.

 

•              The awards committee (a committeeas defined in the Awards Policy consisting of human resources, legal andfinance personnel, duly formed and authorized by the compensation committee,with specific, limited authority to approve certain grants of equity awards)will ensure completeness and accuracy of the final equity awards grant list.

 

•              All equity awards will be approvedmonthly, at a meeting of the awards committee, the compensation committee orthe board of directors, as applicable.

 

•              Internal audit will conductperiodic review of the accounting records and equity awards grant process.

 

iv.            Relevant personnel at the Companywill be provided training in the equity awards granting andaccounting process.

 

v.             In April 2007, the Company created the position ofand hired a new chief ethics officer, to provide focused executive leadershipin the area of corporate ethics and integrity.

 

vi.            Duringthe remainder of 2007, the Company will update its record retention policy tospecify retention of equity award records.

 

 

d)            Toremediate the material weaknesses described in Item 9A in the 2006 Annual Reportin section 2. f) over “*its processto ensure the complete, accurate and timely preparation and review of itsconsolidated financial statements in accordance with GAAP*”, theCompany’s planned remediation measures are intended to address materialweaknesses at its U.S. headquarters that have the potential of preventing thecomplete, accurate and timely preparation and review of the Company’sconsolidated financial statements in future financial periods. In addition tothe measures described above, these measures include the following:

 

i.              Duringthe fourth quarter of 2006 and 2007 to date, the Company implemented and in theremainder of 2007 and in 2008, the Company plans to continue to enhance andimprove month and quarter-end closing procedures within its corporateaccounting function to standardize its processes for financial review to ensurethat reviewers at its U.S. headquarters analyze and monitor financialinformation in a consistent and thorough manner. In addition, the Companyimplemented and plans to continue to improve new and enhanced procedures withinits corporate accounting function to ensure that non-routine transactions areidentified and escalated to senior financial management during the closeprocess to help ensure proper accounting treatment.

 

ii.             Duringthe fourth quarter of 2006 and 2007 to date, the Company implemented and in theremainder of 2007 and in 2008, the Company plans to continue to enhance andimprove the documentation and review of required information associated withthe preparation of its quarterly and annual filings under the Exchange Act.

 

***Interim Measures***

 

Managementhas not yet implemented and/or tested all of the measures described above underthe heading “*Remediation Initiatives.*” Nevertheless, management believesthe measures identified above (to the extent these have been implemented),together with other measures undertaken by the Company in connection withpreparation of the consolidated financial statements included in thisForm 10-Q and described below, address the material weaknesses in internalcontrol over financial reporting described in Item 9A in the 2006 Annual Reportand that remain material weaknesses as of June 30, 2007. These other measuresinclude the following:

 

1.             The Companyretained on an interim basis outside consultants with relevant accountingexperience, skills and knowledge, working under the supervision and directionof the Company’s management, to assist with its review in a number of areasincluding inventory and reserves, equity award pricing and accounting, and SECexternal financial reporting.

 

2.             The Companyimplemented and performed a number of additional detailed procedures and acomprehensive review of its accounting in various areas, including:

 

a)             Inventory cyclecounts at a majority of its International inventorylocations.

 

b)            Reconciliation ofinventories at customer sites to outstanding customer contracts as of quarterend and consideration and analysis of this inventory for recoverability andpotential impairment.

 

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c)             Review of contractanalysis reports and consolidated revenue schedules from the second quarter of2007 to determine the proper recording and classification of inventory anddeferred costs and the related cost of goods sold (including associatedaccounts such as purchase price variance).

 

d)            Analysis of the backlogreport, gross margin report and contract analysis report, enhanced discussionswith business unit, operations and sales and services personnel to enhance theinformation available for finance to analyze, and thorough review of relatedsales and cost information to determine the reserves for losses on customercontracts and associated cost of sales.

 

e)             Analysis of actualcost reports associated with specific warranty reserves, and discussions withbusiness unit, operations and sales and services personnel to enhance theinformation available for finance to analyze and determine the adequacy ofliability reserves for warranty and associated cost of sales.

 

f)             A variety of manualreview procedures, such as an extensive review of journal entry postings intothe Oracle system, a thorough review of account reconciliations, and a detailedreview at its U.S. headquarters of trial balances including those issued fromdecentralized locations, to ensure the completeness and accuracy of theunderlying financial information used to generate the consolidated financialstatements included in this Form 10-Q.

 

3.             As part of the investigation ofhistorical sales in China**,**the AuditCommittee retained independent outside counsel and forensic accountants toconduct an investigation of sales in China. The investigation was expanded toconsider sales contracts entered into in the period 2000 to 2006 in China,beyond the Western Region in order to provide adequate coverage percentage ofthe value of sales contracts entered into during the period. The investigationencompassed different procedures depending on the contract type, date andregion in which the contracts were executed. In addition, the accounting andreporting process for the consolidated financial statements for the quarterended June 30, 2007 was extended, thereby allowing the Company time to conductadditional procedures and analyses, to assess the adequacy and accuracy of therelated balances, and to make additional adjustments and disclosures asnecessary to ensure the accuracy of financial reporting.  Additionally, the Company conducted a review of a portion ofcontracts recognized in revenue during the quarter ended June 30, 2007, fromthe Western Region in China, for compliance with revenue recognition criteria.As part of this review, the Company matched the contract copies at the Chinaheadquarters, regional office and the relevant sales office, and analyzed themfor terms that might affect revenue recognition.

 

***Management’s Conclusion***

 

Managementbelieves the remediation measures described under “Management’s Planned Remediation Initiatives and Interim Measures”above will strengthen the Company’s internal control over financial reportingand remediate the material weaknesses identified in “Management’s Annual Reporton Internal Control over Financial Reporting.” However, management has not yetimplemented all of these measures and/or tested them.  Management believes that the interim measuresdescribed under “Management’s Planned Remediation Initiatives and InterimMeasures” above provide reasonable assurance regarding the reliability offinancial reporting and the preparation of the Company’s financial statementsincluded in this Form 10-Q and has discussed this with the Company’s AuditCommittee.

 

TheCompany is committed to continuing to improve its internal control processesand will continue to diligently and vigorously review its disclosure controlsand procedures and its internal control over financial reporting in order toensure compliance with the requirements of Section 404 of the Sarbanes-OxleyAct of 2002. However, any control system, regardless of how well designed,operated and evaluated, can provide only reasonable, not absolute, assurancethat its objectives will be met. As management continues to evaluate and workto improve the Company’s internal control over financial reporting, it maydetermine to take additional or alternate measures to address controldeficiencies, and it may determine not to complete certain of the measuresdescribed under “Management’s PlannedRemediation Initiatives and Interim Measures” above.

 

**Changes in Internal Control over Financial Reporting**

 

                The discussion above under “Management’s Planned Remediation Initiativesand Interim Measures” includes adescription of the material changes to the Company’s internal controlover financial reporting during the second quarter of 2007 and subsequent toJune 30, 2007 that materially affected, or are reasonably likely to materiallyaffect, the Company’s internal control over financial reporting.

 

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**PART II—OTHER INFORMATION**

 

**ITEM 1—LEGAL PROCEEDINGS**

 

*Securities Class Action Litigation*

                Beginning in October 2004,several shareholder class actions alleging federal securities violations werefiled against us and various officers and directors ofour company.  The actions have beenconsolidated in United States District Court for the Northern District ofCalifornia under the caption*In reUTStarcom, Inc. Securities Litigation*, Master File No.C-04-4908-JW(PVT).  The lead plaintiffsin the case filed a First Amended Consolidated Complaint on July 26,2005.  The First Amended Complaintalleged violations of the Securities Exchange Act of 1934, and was brought onbehalf of a putative class of shareholders who purchased our stock afterApril 16, 2003 and before September 20, 2004.  On April 13, 2006, the lead plaintiffsfiled a Second Amended Complaint adding new allegations and extending the endof the class period to October 6, 2005. In addition to the Company defendants,the plaintiffs are also suing Softbank. Plaintiffs’ complaint seeks recovery of damages in an unspecifiedamount.

                On June 2, 2006, we and theindividual defendants filed a motion to dismiss the Second AmendedComplaint.  On March 21, 2007, the Courtgranted defendants’ motion and dismissed plaintiffs’ Second AmendedComplaint.  The Court granted plaintiffsleave to file a Third Amended Complaint, which plaintiffs filed on May 25,2007. On July 13, 2007, we and the individual defendants filed a motion todismiss and a motion to strike the Third Amended Complaint.

                On September 4, 2007, a second shareholder classaction complaint captioned *Peter Rudolph v.UTStarcom, et al.*, Case No. C-07-4578 SI, was filed in the UnitedStates District Court for the Northern District of California against us andsome of our current and former directors and officers. The complaint allegesviolations of the Securities Exchange Act of 1934 through undisclosed improperaccounting practices concerning our historical equity award grants.  Plaintiff seeks unspecified damages on behalfof a purported class of purchasers of our common stock between July 24, 2002and September 4, 2007.

                Dueto the preliminary status of these lawsuits and uncertainties related tolitigation, we are unable to evaluate the likelihood of either a favorable orunfavorable outcome.  Accordingly, we areunable at this time to estimate the effects of these complaints on ourfinancial position, results of operations, or cash flows.

 

*Governmental Investigations*

                InSeptember 2005, we have received notice of a formal inquiry by the staff ofthe Securities & Exchange Commission (“SEC”) into certain aspects of ourfinancial disclosures during priorreporting periods and certain other issues. In addition, in December 2005, the U.S. Embassy in Mongolia informed usthat it had forwarded to the Department of Justice (“DOJ”) allegations that anagent of our Mongolia joint venture had offered payments to a Mongoliangovernment official in possible violation of the Foreign Corrupt Practices Act(the “FCPA”).  We, through our AuditCommittee, authorized an independent investigation into possible violations ofthe FCPA, and we have been in contact with the DOJ and SEC regarding theinvestigation.  The investigation hasidentified possible FCPA violations in Mongolia, Southeast Asia, India, andChina, as well as possible violations of U.S. immigration laws.  The DOJ has requested that wevoluntarily produce documents related to the investigation and the SEC hassubpoenaed us for documents.  We have executed tolling agreementsextending the statute of limitations for the FCPA issues under investigation bythe SEC and DOJ and the immigration issues under investigation by the DOJ. At this time, we cannot predict when anyinquiry will be completed or what the outcome of any inquiry will be.

 

*ShareholderLitigation*

OnNovember 17, 2006, a shareholder derivative complaint captioned *Ernesto Espinoza v. Ying Wu et al.*, CaseNo. RG06298775, was filed against certain of our current and former officersand directors in the Superior Court of the County of Alameda, California.  The complaint alleges that the individualdefendants, among other things, breached their duties, were unjustly enriched,and violated the California Corporations Code in connection with the timing ofstock option grants.  The complaint namesus as a nominal defendant and seeks unspecified monetary damages against theindividual defendants and various forms of injunctive relief.  On February 2, 2007, we and the individualdefendants filed demurrers against the complaint.  On April 11, 2007, the Court sustained the individualdefendants’ demurrer, overruled our demurrer, ordered the plaintiff to file anamended complaint, and ordered us to answer the original complaint.  The plaintiff filed an amended complaint andwehave filed ananswer to the amended complaint.  OnAugust 21, 2007, the individual defendants filed demurrers against the amendedcomplaint.  The Court sustained theindividual defendants’ demurrers and ordered the plaintiff to file a secondamended complaint.

 

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Due to the preliminary status of thiscomplaint and uncertainties related to litigation, we are unable to evaluatethe likelihood of either a favorable or unfavorable outcome.  Accordingly, we are unable at this time toestimate the effects of this complaint on our financial position, results ofoperations, or cash flows.

 

*IPOAllocation*

 

                OnOctober 31, 2001, a complaint was filed in United States District Courtfor the Southern District of New York against us, some of ourdirectors and officers and various underwriters for our initial publicoffering.  Substantially similar actionswere filed concerning the initial public offerings for more than 300 differentissuers, and the cases were coordinated as *Inre Initial Public Offering Securities Litigation*, 21 MC 92 forpretrial purposes.  In April 2002, aconsolidated amended complaint was filed in the matter against us, captioned *In re UTStarcom, Initial Public Offering SecuritiesLitigation*, Civil Action No. 01-CV-9604.  Plaintiffs allege violations of the SecuritiesAct of 1933 and the Securities Exchange Act of 1934 through undisclosedimproper underwriting practices concerning the allocation of IPO shares inexchange for excessive brokerage commissions, agreements to purchase shares athigher prices in the aftermarket and misleading analyst reports.  Plaintiffs seek unspecified damages on behalfof a purported class of purchasers of our common stock between March 2,2000 and December 6, 2000.  Ourdirectors and officers have been dismissed without prejudice pursuant to astipulation.  On February 19, 2003,the Court granted in part and denied in part a motion to dismiss broughtby defendants including us.  The orderdismissed all claims against us except for a claim brought underSection 11 of the Securities Act of 1933, which alleges that theregistration statement filed in accordance with the IPO was misleading.  In June 2004, a stipulation ofsettlement and release of claims against the issuer defendants, including us,was submitted to the court for approval. The terms of the settlement, if approved, would have dismissed andreleased all claims against the participating defendants (including us).  In August 2005, the Court preliminarilyapproved the settlement.  In December2006, the Court of Appeals for the Second Circuit reversed the Court’s October2004 order certifying a class in six test cases that were selected by theunderwriter defendants and plaintiffs in the coordinated proceedings.  Ourcase is not one of the test cases. Because class certification was a conditionof the settlement, it was unlikely that the settlement would receive finalCourt approval.  On June 25, 2007, theCourt entered an order terminating the proposed settlement based on astipulation among the parties to the settlement.  Plaintiffs have filed amended masterallegations and amended complaints in the six test cases.  It is unclear whether there will be anyrevised or future settlement.  If thelitigation proceeds, we believe that we have meritorious defenses and intend todefend the action vigorously.  The totalamount of the loss associated with the above litigation is not determinable atthis time.  Therefore, we are unable tocurrently estimate the loss, if any, associated with the litigation.

 

*Passave Litigation*

* *

In November 2005, the Company filed suit inthe Superior Court of California, County of Santa Clara, againstPassave, Inc. (“Passave”) for breaches of contract and warranties inconnection with a semiconductor device sold by Passave, Ltd. (Passave’s wholly-­owned subsidiary) to the Company. The Company’s complaintalleges that the Passave device, known as the PAS5001M3 chip, has exhibitedcertain operational malfunctions within some of our Fiber-to-the-Home productline, and has thereby caused damage to the Company. The parties entered into asettlement agreement in favor of the Company, dated August 7, 2007, andhave since dismissed all claims with prejudice.

 

*UTStarcom,Inc. v. Starent Patent Infringement Litigations*

 

On February 16,2005, we filed a suit against Starent for patent infringement in the U.S.District Court for the Northern District of California.  In the Complaint, we assert that Starentinfringes UTStarcom patent U.S. Reg. No. 6,829,473 (“the ‘473 patent”) through Starent’s development and testingof a software upgrade for its customer’s installed ST-16 Intelligent MobileGateways.  We seek declaratory andinjunctive relief.  Starent subsequentlyfiled its answer and counterclaims, denying our allegations and seeking adeclaration that the patent-in-suit is not infringed, is invalid, and isunenforceable.  On June 16, 2005, wefiled a motion to strike Starent’s affirmative defense and dismiss Starent’scounterclaim alleging inequitable conduct. On July 19, 2005, the parties stipulated that Starent would file anamended answer and counterclaim by July 27, 2005 and that we would withdraw ourmotion to strike.  On August 10, 2005, weresponded to Starent’s amended counterclaim filed on July 27, 2005.  In earlyDecember 2006, we filed a reissue application for the ‘473 patent with theUnited States Patent and Trademark Office. Starent has also filed for reexamination of the ‘473 patent.  The reexamination and reissue are currentlycopending.  The litigation is still in apreliminary stage and its outcome cannot be predicted, although we believe thelitigation has merit.  Nonetheless, webelieve that any adverse judgment on Starent’s counterclaims will not have amaterial adverse effect on our business, financial condition, or results ofoperations.

 

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On May 8, 2007, we filed an additional suit againstStarent and sixteen individual defendants (who were all former employees of3Com’s CommWorks division which we acquired certain assets of in May of 2003) inthe Northern District of Illinois.  Thecauses of action include claims for patent infringement, misappropriation oftrade secrets, intentional interference with business relations and prospectiveeconomic advantage and declarations of ownership of certain patent rights.  In its Complaint, we assert that Starentinfringes UTStarcom patents U. S. Reg. Nos. 7,173,905; 6,978,128; 6,963,582;6,975,900; and 6,684,256 through the manufacture, use, offer, for sale, and saleof Starent’s ST16 Intelligent Mobile Gateway and ST40 multimedia code platform,that the individual Defendants and Starent have misappropriated valuableCompany trade secrets by improperly taking and using  our confidential and proprietary informationfor the benefit of Starent, that the individual defendants and Starent haveinterfered with our business relations and prospective economic advantage byusing the misappropriated information to obtain and enhance sales of Starent’sproducts, and that several of Starent’s patent applications and one issuedpatent are based on information obtained by the former employees while at theCompany (CommWorks) and on that basis belong to UTStarcom.  We seek compensatory damages, punitivedamages and injunctive relief.  After thecourt denied the defendants motion to dismiss the misappropriation of tradesecrets claims, onAugust 30, 2007, Starent answered our complaint, denying our allegations andasserting a number of affirmative defenses and counterclaims, includingnon-infringement of the subject patents and alleged tortious interference withprospective economic advantage.  We havefiled a motion to dismiss most of the counterclaims and the court has orderedappointment of a special master to handle discovery, which is justbeginning.  We believe that any adversejudgment on Starent’s counterclaims will not have a material adverse effect onour business, financial condition or results of operations.

 

*Telemetrix, Inc. Arbitration*

 

OnOctober 19, 2006, Telemetrix, Inc. (“Telemetrix”) filed a formalRequest for Arbitration against us to the World Intellectual PropertyOrganization (“WIPO”) in Geneva, Switzerland. The Request for Arbitration sought unspecified damagesarising from a contract between Telemetrix and Telos Technology, Inc., datedOctober 22, 2003.  We assumed Telos’rights and obligations under this contract pursuant to ourpurchase of Telos’ assets on May 19, 2004.  Telemetrix alleged nine causes of action,including breach of contract, fraud, negligent misrepresentation, interferencewith contractual relations, and interference with prospective economicadvantage.  In December 2006, we filed aformal response to the Request for Arbitration, denying all material factualallegations asserted by Telemetrix.  Anarbitrator was selected by the parties, and, on August 2, 2007, the arbitrator granted apleading motion in favor of us due to Telemetrix’s failure to allege sufficientfacts in support of a majority of its causes of action.  On August 17, 2007, Telemetrix filed anAmended Statement of Claim, alleging six causes of action, including breach ofcontract, fraud, interference with contractual relations and interference withprospective economic advantage.  Theprevious hearing date of December 11-13 has been vacated.  No hearing date has been rescheduled.  Discovery has begun.

 

*Telos Technology, Inc.Litigation*

* *

On November 22, 2005, plaintiffs TelosTechnology, Inc., Telos Technology (Canada), Inc., Telos Technology(Bermuda) Ltd., and Telos Engineering Limited (collectively, the “TelosPlaintiffs”) filed a Complaint against the Company in the Superior Court ofCalifornia, County of Santa Clara. The Complaint alleges five causes of action,including breach of contract, breach of the implied covenant of good faith andfair dealing, fraudulent inducement, intentional misrepresentation andnegligent misrepresentation, all of which arise from the Asset PurchaseAgreement between the parties dated April 21, 2004. The Telos Plaintiffsassert that the Company breached the express and implied terms of the AssetPurchase Agreement and made representations to the Telos Plaintiffs duringnegotiations that it never intended to fulfill. The Telos Plaintiffs sought atleast $19 million in damages, unspecified punitive damages and attorneys’fees. The parties executed a settlement agreement in the amount of $4.5 millionon August 20, 2007 and the case was dismissed on September 26, 2007with prejudice.

 

*Other Litigation*

 

                We are a party to otherlitigation matters and claims that are normal in the course of operations, andwhile the results of such litigation matters and claims cannot be predictedwith certainty, we believe that the final outcome of such matters will not havea material adverse impact on our financial position or results of operations.

 

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**ITEM 1A—RISK FACTORS**

 

**FACTORS AFFECTING FUTURE OPERATINGRESULTS**

 

**RISKS RELATED TO OUR COMPANY**

 

*Therestatement of our consolidated financial statements following the**Nominating and CorporateGovernance Committee’s**andmanagement’s review of our past stock option granting practices and the AuditCommittee’s and management’s review of certain sales in China has resulted inexpanded litigation and regulatory proceedings and may result in futurelitigation which could harm our financial results*

 

Our review of our historic option granting practicesand certain sales in China has required us to incur substantial expenses forlegal, accounting, tax and other professional services, has diverted ourmanagement’s attention from our business, and could in the future harm ourbusiness, financial condition, results of operations and cash flows.

 

TheAudit Committee of our Board of Directors (“Audit Committee”) engagedindependent counsel to conduct an investigation of sales in China. The independent counsel engaged forensicaccountants. The China sales investigation, which commenced in February 2007and was completed in September 2007, covered each of the seven years in theperiod ended December 31, 2006.  As aresult of the review, management concluded and recommended to the AuditCommittee that our previously issued financial statements should be restated todefer the system sales contract revenue and the related cost of net sales forcertain sales arrangements in one region of China found to containpost-contract support obligations and recognize such amounts in ourconsolidated statements of operations over the estimated period ofpost-contract support. The Audit Committee concurred with management’srecommendation.

 

In November 2006 we announced that the Nominating andCorporate Governance Committee of our Board of Directors (“Governance Committee”),comprised of independent directors, was conducting a voluntary review, with theassistance of independent legal counsel and forensic accounting experts (the “OptionGrant Review Team”), of our historic option granting practices, the timing ofoption grants and related accounting matters. The review considered alloption grant awards made in the period from February 29, 2000, shortly beforethe initial public offering of our Common Stock, through August 2006 forcompliance with the various stock-based compensation accounting standardsapplicable as well as the rules of our stock option plans.Upon completion of the review, managementconcluded the adjustments to correct errors in stock option accounting in ourpreviously issued financial statements for the years ended December 31, 1998and 2000 through 2005, and the quarterly periods of 2005, as well as in thequarterly periods ended March 31 and June 30, 2006 that are reflected in ourconsolidated financial statement information included in Exhibit 99.1 in ourAnnual Report on Form 10-K for the year ended December 31, 2006 should be made.

 

In determining the restatement adjustments in connectionwith the review of our historical option granting practices, management usedall reasonably available relevant information to form conclusions it believesare reasonable as to the most likely option granting actions that occurred, thedates when such actions occurred, and the determination of grant dates forfinancial accounting purposes based on when the requirements of the accountingstandards were met. The Option Grant Review Team and management consideredvarious alternatives throughout the course of the review and restatement;management believes the  adjustments tomeasurement dates used in our restatement of our financial statements arereasonable and appropriate in our circumstances.

 

Our restatement of previously issued financialstatements to correct revenue recognition for certain sales in China and forthe effects of past stock options granting practices has exposed us to greaterrisks associated with litigation and regulatory proceedings. We havevoluntarily provided information about the conduct of our independentinvestigation and review, the findings of the reviews, and our conclusions tothe staff of the Securities and Exchange Commission (“SEC”), and arecooperating, and will continue to cooperate fully with the SEC. In addition, asdescribed in Part II, Item 1, “Legal Proceedings,” of this Form 10-Q,several derivative complaints have been filed against certain of our current and former officers and directors pertainingto allegations relating to stock option grants. However, our judgments may bechallenged in legal proceedings or regulatory reviews, and we could be subjectto adverse findings that could require us to again restate our financialstatements, to pay damages or penalties, or have other remedies imposed upon usthat could harm our business, financial condition, results of operations andcash flows.  We may also be exposed tolegal proceedings in connection with the results of our investigation ofcertain sales in China.  We cannotguarantee that new lawsuits related to the matters resulting in therestatements will not be filed, and we cannot predict the outcome of anycurrent or potential future litigation or regulatory proceeding against theCompany or our current and former directors or officers.

 

*Thematters relating to the Audit Committee’s investigation of revenue recognitionin China, the Governance Committee’s review of our past stock option grantingpractice, and the restatement of our consolidated financial statements mayotherwise adversely impact our business.*

 

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As a result of our delayed filing of our QuarterlyReports on Form 10-Q for the quarters ended September 30, 2006, March 31, 2007and June 30, 2007, as well as our Form 10-K for the fiscal year ended December31, 2006, we will be ineligible to register our securities on Form S-3 for saleby us or resale by others until we have been current in our SEC filings for 12calendar months.  We may use Form S-1 toraise capital, but doing so could increase transaction costs and the timerequired to complete such transactions.

 

Employees who were awarded options at a discount fromfair market value and were totally or partially unvested as ofDecember 31, 2004, may be subject to a penalty tax under Internal RevenueCode Section 409A (“Section 409A”) and corresponding states taxes uponexercise of these stock options. We are considering certain actions, which webelieve would be in the best interests of our stockholders and employees thatmight substantially reduce or eliminate the federal and state penalty taxes.However, there is no guarantee that we will be successful in developingeffective measures to address employees’ adverse tax consequences, and any suchmeasures may cause us to incur additional cash or noncash compensation expense.Furthermore, such measures, or the failure of such measures, may require theCompany to incur substantial expenses for legal, accounting, tax and otherprofessional services and may divert management’s attention from our business,which could in the future harm our business, financial condition, results ofoperations and cash flows.

 

*Our future product sales areunpredictable and, as a result, our operating results are likely to fluctuatefrom quarter to quarter.*

 

                Ourquarterly and annual operating results have fluctuated in the past and arelikely to fluctuate in the future due to a variety of factors, some of whichare outside of our control.  Factors thatmay affect our future operating results include:

 

•             the timing and size of the orders for our products;

 

•             consumer acceptance of new products we may introduce to market;

 

•             changes in the growth rate of customer purchases of communicationsservices;

 

•             the lengthy and unpredictable sales cycles associated with sales of ourproducts;

 

•             revenue recognition, which is based primarily on customer acceptance ofdelivered products, is unpredictable;

 

•             cancellation, deferment or delay in implementation of large contracts;

 

•             quality issues resulting from the design or manufacture of the products,or from the software used in the product;

 

•             cash collection cycles in China and other emerging markets;

 

•             reliance on product, software and component suppliers who may constitutea sole source of supply or may have going concern issues;

 

•             the decline in business activity we typically experience during theChinese Lunar New Year, which leads to decreased sales and collections duringour first fiscal quarter;

 

•             issues that might arise from the integration of acquired entities or theinability to achieve expected results from such acquisitions; and

 

•             shifts in our product mix or market focus.

 

                As aresult of these and other factors, period-to-period comparisons of ouroperating results are not necessarily meaningful or indicative of futureperformance.  In addition, the factorsnoted above may make it difficult for us to forecast and provide in a timelymanner public guidance (including updates to prior guidance) related to ourprojected financial performance. Furthermore, it is possible that in some future quarters our operatingresults will fall below the expectations of securities analysts orinvestors.  If this occurs, the tradingprice of our common stock could decline.

 

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*Competition in our markets may lead toreduced prices, revenues and market share.*

 

                Wehave experienced intense competition in the past years, and we believe that wewill continue to face intense competition from both domestic and internationalcompanies in our target markets, many of which may operate under lower coststructures or may be given preferential treatment by applicable governmentalregulators and policies and have much larger sales forces than we do.  Additionally, other companies not presentlyoffering competing products may also enter our target markets.  Many of our competitors have significantlygreater financial, technical, product development, sales, marketing and otherresources than we do.  As a result, ourcompetitors may be able to respond more quickly to new or emerging technologiesand changes in service provider requirements. Our competitors may also be able to devote greater resources than we canto the development, promotion and sale of new products.  These competitors may be able to offersignificant financing arrangements to service providers, which may give them acompetitive advantage in selling systems to service providers with limitedfinancial resources.  In many of thedeveloping markets in which we operate or intend to operate, relationships withlocal governmental telecommunications agencies are important to establish andmaintain.  In many such markets, ourcompetitors may have or be able to establish better relationships with localgovernmental telecommunications agencies than we have, which could result intheir ability to influence governmental policy formation and interpretation totheir advantage.  Additionally, ourcompetitors might have better relationships with their third party suppliersand obtain component parts at a reduced rate, allowing them to offer their endproducts at reduced prices.  Moreover,the telecommunications and data transmission industries have experiencedsignificant consolidation, and we expect this trend to continue.  If we have fewer significant customers, wemay be more reliant on such large customers and our bargaining position andprofit margins may suffer.  Increasedcompetition is likely to result in price reductions, reduced gross profit as apercentage of net sales and loss of market share, any one of which couldmaterially harm our business, cash flows and financial condition, includingpotential impairment in value of our tangible and intangible assets andgoodwill if extended losses were incurred.

 

*We have**incurred netlosses in the past and will need to renew our lines of credit in China,refinance our convertible subordinated notes, and transfer cash from oursubsidiaries in China to have sufficient cash resources and liquidity. Ourability to accomplish these actions is not assured, and our ability to raisefunds for other purposes is uncertain.*

 

At June30 2007, we had cash and short-term investments of $527.6 million to meet ourliquidity requirements of which $415.5 million was held by our subsidiaries inChina. China imposes currency exchange controls on transfers of funds outsideof China; such controls limit transfers of approximately $200 million of ournet assets outside of China without first obtaining the consent of the Chinesegovernment. While we believed the China subsidiaries could freely transfer atleast $200 million as of June 30, 2007, the amount of cash available fortransfer from the China subsidiaries is limited both by the liquidity needs ofthe subsidiaries in China and by the Chinese government requirements that theChina subsidiaries retain adequate capital levels in China to protect creditorsand to have funds available for mandated employee benefits.  Additionally, available credit facilities inChina at June 30, 2007 totaled $702.8 million, of which $358.6 million wasavailable for working capital purposes and $344.2 million was available for usein support of letters of credit and corporate guarantees. These creditfacilities expire principally in November and December 2007, and we hadborrowed $105.1 million at June 30, 2007 under the working capital portion ofthe available credit lines and such borrowings increased to $140.1 million atSeptember 30, 2007. We also have outstanding long-term debt outside of China inthe form of our convertible subordinated notes with a principal balance of$274.6 million that mature in March 2008 (the “Notes”).

 

During the nine months endedSeptember 30, 2007 our China subsidiaries made transfers of funds out of Chinato the Company totaling $150 million. Although we believe the Company now hassufficient amount of cash resources to finance the Company’s anticipatedworking capital and capital expenditure requirements for the next 12 months, wedo not have enough cash outside of China to repay the convertible notesmaturing in March 2008, and we expect our recent financial performance and financial position will cause the lenders toreduce the total available credit facilities when we negotiate renewals of thelines of credit in China in late 2007. Management’s liquidity plans include a partial or complete refinancingof the convertible notes, renewal of the lines of credit in China, transfers ofadditional cash from its subsidiaries in China to the extent necessary, and, ifneeded, liquidation of certain investments and/or seeking new financing arrangements.  In addition, it may be necessary for us tomake significant changes to our business plan to maintain adequate liquidityfor at least the next 12 months in the event of various matters, such as:

 

•                  changes in financial market conditions or our business condition thatcould limit our access to existing credit facilities or make plannedre-financings more costly or even unfeasible;

•                  changes in China’s currency exchange control regulations that couldlimit our ability to access cash in China to meet liquidity requirementsoutside of China; and

•                  inability to achieve planned operating results that could increaseliquidity requirements beyond those considered in our financial plans.

 

We may desire to raise additional funds for purposes notpresently included in our financial plans such as to develop new or enhancedproducts, respond to competitive pressures, take advantage of acquisitionopportunities or raise capital for strategic purposes. There is no assurancethat additional financing for these or other purposes would be available onacceptable terms or at all. If we raise additional funds through the issuanceof equity securities, our stockholders will experience dilution of 

 

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their ownership interest, and the newly issued securitiesmay have rights superior to those of common stock.  If we raise additional funds by issuing debt,our ability to meet our debt service obligations will be dependent upon ourfuture performance, which will be subject to financial, business and otherfactors affecting our operations, many of which are beyond our control, we maybe subject to limitations on our operations, and our leverage mayincrease.  The degree to which we areleveraged could materially and adversely affect our ability to obtain financingfor working capital, acquisitions or other purposes and could make us morevulnerable to industry downturns and competitive pressures.

 

*Our ability to meet our obligationsunder the terms of our outstanding convertible notes and to continue operationsmay be compromised if we are unable to transfer funds from our China operationsas needed.*

 

Duringthe nine months ended September 30, 2007 our China subsidiaries made transfersof funds out of China to the Company totaling $150 million.  Although we believe the Company now hassufficient amount of cash resources to finance the Company’s anticipatedworking capital and capital expenditure requirements for the next 12 months, we do not have enough cash outside ofChina to also repay the convertible notes, aggregating $274.6 million andmaturing on March 1, 2008.  Because we are limitedby the Chinese government’s imposition of currency controls on transfer offunds outside of China, it may be time-consuming, difficult and /or expensivefor us to transfer funds from China to repay the Notes.  As a result, if an Event of Default on theNotes were to occur, we may not have sufficient cash resources to repay theNotes and to continue operations without seeking new financing arrangements.  We cannot be certain that additionalfinancing for these purposes would be available on acceptable terms or at all,and if such financing is not available, our business could be seriously harmed.  See the risk factor entitled “*We face a variety of risks related to our convertiblesubordinated notes”*for a further description of our obligationsunder the Notes, our recent consent solicitation of the noteholders and ourcompliance with certain covenants under the Indenture.

 

*Sales in China have historicallyaccounted for a material portion of our total sales, and our business,financial condition and results of operations are to a significant degreesubject to economic, political and social events, and the performance of oursenior management team  in China.*

 

Approximately $785.5 million, or 32%,$870.6 million, or 30%, and $2,028.2 million, or 79%, of our netsales for fiscal years 2006, 2005 and 2004, respectively, occurred inChina.  While we have expanded into othermarkets, we have made substantial investments in China and, therefore, ourbusiness, financial condition and results of operations are to a significantdegree subject to economic, political, legal and social developments and otherevents in China.  In addition, we havehad significant changes within our senior management team in China recently,and our current senior management team as a whole does not have the same degreeof experience in China as our senior management team had in the past. (See therisk factor entitled “*Our success is dependenton continuing to hire and retain qualified personnel, including for seniormanagement positions, and if we are not successful in attracting and retainingthese personnel and in managing key employee turnover, our business will suffer”)*.  If our current senior management in Chinacannot maintain and /or establish key relationships with customers,governmental entities and others in China, our business in China may declinesignificantly. If our business in China declines, our financial condition and resultsof operations may be significantly harmed.

 

*The average selling prices of ourproducts may decrease, which may reduce our revenues and our gross profit.  As a result, we must introduce new productsand reduce our costs in order to maintain profitability.*

 

The average selling prices for communications access andswitching systems and handsets have historically declined as a result of anumber of factors, including:

 

•             increased competition;

 

•             aggressive price reductions by competitors;

 

•             rapid technological change; and

 

•             constant change in customer buying behavior and market trends.

 

                Theaverage selling prices of our products may continue to decrease in the futurein response to product introductions by us or our competitors or other factors,including price pressures from customers. Certain of our products, including wireless handsets, have historicallyhad low gross profit margins, and any further deterioration of our profitmargins on such products could result in losses with respect to such products.  Therefore, we must continue to develop,source and introduce new products and enhancements to existing products thatincorporate features that can be sold at higher average selling prices.  Failure to do so or the failure of consumersor our direct customers to accept such new products could cause our revenuesand gross profit to decline.

 

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                Ourcost reduction efforts initiated in 2005 and our subsequent efforts in theremainder of 2007 and early 2008 may not allow us to keep pace with competitivepricing pressures or lead to improved gross profit, as a percentage of netsales.  In order to be competitive, wemust continually reduce the cost of manufacturing our products through designand engineering changes.  We may not besuccessful in these efforts or in delivering our products to market in a timelymanner.  In addition, any redesign maynot result in sufficient cost reductions to allow us to reduce the prices ofour products to remain competitive or to improve or maintain our gross profit,as a percentage of net sales, which would cause our financial results tosuffer.

 

*Our market is subject to rapidtechnological change, and to compete effectively, we must continually introducenew products and product enhancements that achieve market acceptance.*

 

The market for communications equipment is characterizedby rapid technological developments, frequent new product introductions,changes in consumer preferences and evolving industry and regulatory standards.  Our success will depend in large part on ourability to enhance our technologies and develop and introduce new products andproduct enhancements that anticipate changing service provider requirements,technological developments and evolving consumer preferences.  We may need to make substantial capitalexpenditures and incur significant research and development costs to developand introduce new products and enhancements. If we fail to develop and introduce new products or enhancements toexisting products that effectively respond to technological change on a timelybasis, our business, financial condition and results of operations could bematerially adversely affected.  Certainof our products, including wireless handsets, have a short product life.  Moreover, from time to time, our competitorsor we may announce new products or product enhancements, technologies orservices that have the potential to replace or shorten the life cycles of ourproducts and that may cause customers to defer purchasing our existingproducts, resulting in charges for inventory obsolescence reserves.  Future technological advances in thecommunications industry may diminish or inhibit market acceptance of ourexisting or future products or render our products obsolete.  Even if we are able to develop and introducenew products, they may not gain market acceptance.  Market acceptance of our products will dependon various factors, including:

 

•             our ability to obtain necessary approvals from regulatory organizationswithin the countries in which we operate and for any new technologies that weintroduce;

 

•             the length of time it takes service providers to evaluate our products,causing the timing of purchases to be unpredictable;

 

•             the compatibility of our products with legacy technologies and standardsexisting in previously deployed network equipment;

 

•             our ability to attract customers who may have pre-existing relationshipswith our competitors;

 

•             product pricing relative to performance;

 

•             the level of customer service available to support new products; and

 

•             the timing of new product introductions meeting demand patterns.

 

                Ifour products fail to obtain market acceptance in a timely manner, our businessand results of operations could suffer.

 

*We depend on some sole source and keysuppliers for handsets, base stations, components and materials used in ourproducts.  If we cannot secure adequatesupplies of high quality products at competitive prices or in a timely mannerfrom these suppliers or sources, or if the suppliers successfully market theirproducts directly to our customers, our competitive position, reputation andbusiness could be harmed.*

 

We have contracts with a limited group of suppliers topurchase some components and materials used in our products.  If any supplier is unwilling or unable toprovide us with high-quality components and materials in the quantitiesrequired and at the costs specified by us, we may not be able to findalternative sources on favorable terms, in a timely manner, or at all.  Further, a supplier could market its productsdirectly to our customers.  Thepossibility of a supplier marketing its own products would create directcompetition and may affect our ability to obtain adequate supplies.  Our inability to obtain or to develop alternativesources if and as required could result in delays or reductions inmanufacturing or product shipments.  Fromtime to 

 

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time, there could be shortages of certain products orcomponents.  Moreover, our suppliers maysupply us with inferior quality products. If an inferior product supplied by a third party is embedded in our endproduct and causes a problem, it might be difficult to identify the source ofthe problem as being due to the component parts.  If any of these events occur, our competitiveposition, reputation and business could suffer.

 

                Ourability to source a sufficient quantity of high-quality, cost-effectivecomponents used in our products may also be limited by import restrictions andduties in the foreign countries in which we manufacture our products.  We require a significant number of importedcomponents to manufacture our products, and imported electronic components andother imported goods used in the operation of our business may be limited by avariety of permit requirements, approval procedures, patent infringementclaims, import duties and licensing requirements.  As an example, a recent court case between athird party and one of our suppliers involved a patent dispute potentiallyrestricting the importation of handsets into the U.S.  While this case has been resolved in thesupplier’s favor at the trial court level, our supply of products could beaffected by similar cases in the future. Moreover, import duties on such components increase the cost of ourproducts and may make them less competitive.

 

*Product defects or performance qualityissues could cause us to lose customers and revenue or to incur unexpectedexpenses.*

 

Many ofour products are highly complex and may have quality deficiencies resultingfrom the design or manufacture of such product, or from the software orcomponents used in the product.  Forexample, during 2005 we recorded warranty charges of $70.6 million, includingspecial warranty charges of $11.7 million for certain asynchronous digitalsubscriber line (“ADSL”) products, $4.0 million for NetRingTM equipment and$14.9 million for GEPON equipment sold to SBBC, an affiliate of SOFTBANKCORP and SOFTBANK America Inc., during 2003 and 2004.  Often these issues are identified prior tothe shipment of the products and may cause delays in market acceptance of ourproducts, delays in shipping products to customers, or the cancellation oforders.  In other cases, we may identifythe quality issues after the shipment of products.  In such cases, we may incur unexpected expensesand diversion of resources to replace defective products or correctproblems.  Such pre-shipment andpost-shipment quality issues could result in delays in the recognition ofrevenue, loss of revenue or future orders, and damage to our reputation and customerrelationships.  In addition, we may berequired to pay damages for failed performance under certain customer contracts, and may receive claims from customersrelated to the performance of our products. Such pre-shipment and post-shipment quality issues could result indelays in the recognition of revenue, loss of revenue or future orders, anddamage to our reputation and customer relationships.  In addition, we may be required to paydamages for failed performance under certain customer contracts and may receiveclaims from customers related to the performance of our products.

 

*Our global diversification strategy andgrowth has strained our resources, adversely affected our reported grossmargins, and if we are unable to manage this growth, our future operatingresults will be further negatively affected.*

 

Over the last four years we have experienced a rapidexpansion of our international operations and anticipate that we must continueto transform our operations to address market demands and potential marketopportunities globally.

 

Competition in international markets for new serviceprovider customers and for new infrastructure deployments is particularlyintense and increasingly focused on price. To meet competitive offerings we mayaccept contracts with low profitability or even enter into contracts withanticipated losses if we believe it is necessary to establish a relationshipwith a customer or a presence in a market that we consider important to ourinternational expansion strategy. We believe these decisions will facilitatethe development of our international business, but we can provide no assurancethat they will. Accepting a contract with an anticipated loss requires us torecognize a provision for the entire loss in the period in which it becomesevident rather than in later periods in which contract performance occurs.Accepting contracts with low gross margins adversely affects our reportedresults when the revenues from such contracts are recognized; in some casesrevenue recognition must be deferred until all revenue recognition criteriahave been met, and this would result in recognizing the adverse effects of lowgross margin contracts in periods subsequent to when contract performanceoccurred.

 

Our transformation to a global focus will place asignificant strain on our management, operational, financial and otherresources.  To manage this transformationeffectively, we will need to take various actions, including:

 

•             enhancing management information systems, including forecasting procedures;

 

•             further developing our operating, administrative, financial andaccounting systems and controls;

 

•             managing our working capital and sources of financing;

 

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•             maintaining close coordination among our engineering, accounting,finance, marketing, sales and operations organizations;

 

•             retaining, training and managing our employee base;

 

•             enhancing human resource operations and improving employee hiring andtraining programs;

 

•             reorganizing our business structure to more effectively allocate andutilize our internal resources;

 

•             improving and sustaining our supply chain capability; and

 

•             managing both our direct and indirect sales channels in a cost-efficientand competitive manner.

 

                Ifwe fail to implement or improve systems or controls or to manage any futuregrowth and transformation effectively, our business could suffer.

 

*Any failure by us to execute plannedcost reductions successfully could result in total costs and expenses that aregreater than expected.*

 

From time to time we have undertaken restructuring plansto bring operational expenses to appropriate levels for each of our businesses,while simultaneously implementing extensive new company-wide expense-controlprograms.  For example, in 2005, weannounced workforce restructurings. These programs resulted in the termination of approximately 1,595employees worldwide through December 31, 2005.  We anticipate making further workforcereductions and taking additional rebalancing actions in the future.  In October 2007, our Board of Directors approved arestructuring plan which includes a worldwide reduction in force ofapproximately 11% of the Company’s headcount, or approximately 700employees.  Weexpect cost savings from planned restructuring activities to be used to offsetmarket forces or to be reinvested in our businesses to strengthen ourcompetitiveness, but we cannot be certain that we will be successful in theseefforts.  Significant risks associatedwith these actions and other workforce management issues that may impair ourability to achieve anticipated cost reductions or may otherwise harm ourbusiness include delays in implementation of anticipated workforce reductionsin highly regulated locations outside of the United States, particularly inEurope and Asia, redundancies among restructuring programs, decreases inemployee morale and the failure to meet operational targets due to the loss ofemployees, particularly sales employees.

 

*Our success is dependent on continuing tohire and retain qualified personnel, including for senior management positions,and if we are not successful in attracting and retaining these personnel and inmanaging key employee turnover, our business will suffer.*

 

The success of our business depends in significant partupon the continued contributions of key technical and senior managementpersonnel, many of whom would be difficult to replace.  In particular, our success depends in largepart on the knowledge, expertise and services of Hong Liang Lu, our ChiefExecutive Officer, Peter Blackmore, our President and Chief Operating Officer,Francis P. Barton, Executive Vice President and Chief Financial Officer andPhilip Christopher, President and Chief Executive Officer of our PersonalCommunications Division.  The loss of anykey employee, the failure of any key employee to perform satisfactorily in hisor her current position or our failure to attract and retain other keytechnical and senior management employees could have a significant negative impacton our operations.  We have hadsignificant changes within our senior management team recently, and our currentsenior management team as a whole does not have the same degree of experiencein China as our senior management  had inthe past.  If our current seniormanagement cannot maintain and/or establish key relationships with customers,governmental entities and others in China, our business in China may declinesignificantly and our financial condition and results of operations may besignificantly harmed.

 

Notwithstanding our workforce restructurings, toeffectively manage our operations, we will need to recruit, train, assimilate,motivate and retain qualified employees both locally and internationally.  Competition for qualified employees is intense,and the process of recruiting personnel in all fields, including technology,research and development, sales and marketing, administration and managementwith the combination of skills and attributes required to execute our businessstrategy can be difficult, time-consuming and expensive.  As we grow globally, we must implement hiringand training processes that are capable of quickly deploying qualified localresidents to knowledgeably support our products and services.  Alternatively, if there is an insufficientnumber of qualified local residents available, we might incur substantial costsimporting expatriates to service new global markets.  For example, we have historically experienceddifficulty finding qualified accounting personnel knowledgeable in both U.S.and Chinese accounting standards who are Chinese residents.  If we fail to attract, hire, assimilate orretain qualified personnel, our business would be harmed.  Competitors and others have in the past, andmay in the 

 

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future, attempt to recruit our employees.  In addition, companies in thetelecommunications industry whose employees accept positions with competitorsfrequently claim that the competitors have engaged in unfair hiring practices.  We may be the subject of these types ofclaims in the future as we seek to hire qualified personnel.  Some of these claims may result in materiallitigation and disruption to our operations. We could incur substantial costs in defending ourselves against theseclaims, regardless of their merit.

 

*Any acquisitions and divestitures thatwe undertake could be difficult to integrate, disrupt our business, dilute ourstockholders and harm our operating results.*

 

We have acquired and divested certain businesses,products and technologies.  Anticipatedbenefits of these acquisitions and divestitures may not be realized.  We have in the past and will continue toevaluate acquisition prospects that would complement our existing productofferings, augment our market coverage, enhance our technological capabilities,or that may otherwise offer growth opportunities.  Acquisitions may result in dilutive issuancesof equity securities, use of our cash resources, the incurrence of debt and theamortization of expenses related to intangible assets.  In addition, acquisitions involve numerousrisks, including difficulties in the assimilation of operations, technologies,products and personnel of the acquired company, diversion of management’sattention from other business concerns, risks of entering markets in which wehave no direct or limited prior experience, the potential loss of key employeesof the acquired company, unanticipated costs and, in the case of theacquisition of financially troubled businesses, challenges as to the validityof such acquisitions from third party creditors of such businesses. Forexample, in the fourth quarter 2004, we encountered difficulties in integratingHyundai Syscomm, Inc. (“HSI”) legacy operations into our operations anddetermined to abandon a substantial amount of HSI’s legacy operations.  As a result, in the fourth quarter 2004, wewrote off the entire goodwill and intangibles associated with HSI.

 

*We may be unable to adequately protectthe loss or misappropriation of our intellectual property, which couldsubstantially harm our business.*

 

We rely on a combination of patents, copyrights,trademarks, trade secret laws and contractual obligations to protect ourtechnology.  We have applied for patentsin the United States and internationally. Additional patents may not be issued from our pending patentapplications, and our issued patents may not be upheld.  In addition, we have, from time to time,chosen to abandon previously filed patent and trademark applications.  Moreover, we may face difficulties inregistering our existing trademarks in new jurisdictions in which we operate,and we may be forced to abandon or change product or service trademarks becauseof the unavailability of our existing trademarks or because of oppositions filedor legal challenges to our trademark filings. We cannot guarantee that the intellectual property protection measuresthat we have taken will be sufficient to prevent misappropriation of ourtechnology or trademarks or that our competitors will not independently developtechnologies that are substantially equivalent or superior to ours.  In addition, the legal systems of manyforeign countries do not protect or honor intellectual property rights to thesame extent as the legal system of the United States.  For example, in China, the legal system ingeneral, and the intellectual property regime in particular, are still in thedevelopment stage.  It may be verydifficult, time-consuming and costly for us to attempt to enforce ourintellectual property rights in these jurisdictions.

 

*We may be subject to claims that weinfringe the intellectual property rights of others, which could substantiallyharm our business.*

 

The industry in which we compete is moving towardsaggressive assertion, licensing, and litigation of patents and otherintellectual property rights.  From timeto time, we have become aware of the possibility or have been notified that wemay be infringing certain patents or other intellectual property rights ofothers.  Regardless of their merit,responding to such claims could be time consuming, divert management’sattention and resources and cause us to incur significant expenses.  In addition, although some of our suppliercontracts provide for indemnification from the supplier with respect to lossesor expenses incurred in connection with any infringement claim, certaincontracts with our key suppliers do not provide for such protection.  Moreover, certain of our sales contractsprovide that we must indemnify our customers against claims by third partiesfor intellectual property rights infringement related to our products.  There are no limitations on the maximumpotential future payments under these guarantees.  Therefore, we may incur substantial costsrelated to any infringement claim, which may substantially harm our results ofoperations and financial condition.

 

                Wehave been and may in the future become subject to litigation to defend againstclaimed infringements of the rights of others or to determine the scope andvalidity of the proprietary rights of others. Future litigation may also be necessary to enforce and protect ourpatents, trade secrets and other intellectual property rights.  Any intellectual property litigation orthreatened intellectual property litigation could be costly, and adversedeterminations or settlements could result in the loss of our proprietaryrights, subject us to significant liabilities, require us to seek licenses fromor pay royalties to third parties which may not be available on commerciallyreasonable terms, if at all, and/or prevent us from manufacturing or sellingour products, which could cause disruptions to our operations.

 

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                Inthe event that there is a successful claim of infringement against us and wefail to develop non-infringing technology or license the proprietary rights oncommercially reasonable terms and conditions, our business, results ofoperations and financial condition could be materially and adversely impacted.

 

*Our multinational operations subject usto various economic, political, regulatory and legal risks.*

 

We market and sell our products globally, with asignificant portion of our sales made in China. The expansion of our existing multinational operations and entry intonew markets will require significant management attention and financialresources.  Multinational operations aresubject to a variety of risks, such as:

 

•             the burden of complying with a variety of foreign laws and regulations;

 

•             the burden of complying with United States laws and regulations forforeign operations, including the Foreign Corrupt Practices Act;

 

•             difficulty complying with continually evolving and changing globalproduct and communications standards and regulations for both our end productsand their component technology;

 

•             market acceptance of our new products, including longer productacceptance periods in new markets into which we enter;

 

•             reliance on local original equipment manufacturers (“OEMs”), third partydistributors and agents to effectively market and sell our products;

 

•             unusual contract terms required by customers in developing markets;

 

•             changes in local governmental control or influence over our customers;

 

•             changes to import and export regulations, including quotas, tariffs,licensing restrictions and other trade barriers;

 

•             the burden of compliance with complex and varying taxation requirementsof multiple jurisdictions;

 

•             evolving and unpredictable nature of the economic, regulatory,competitive and political environments;

 

•             reduced protection for intellectual property rights in some countries;

 

•             unproven business operation models developed or operated in specificcountries or regions;

 

•             longer accounts receivable collection periods; and

 

•             difficulties and costs of staffing, monitoring and managingmultinational operations, including but not limited to internal controls andcompliance.

 

*We do business in markets that are notfully developed, which subjects us to various economic, political, regulatoryand legal risks unique to developing economies.*

 

Less developed markets present additional risks, such asthe following:

 

•             customers that may be unable to pay for our products in a timely manneror at all;

 

•             new and unproven markets for our products and the telecommunicationsservices that our products enable;

 

•             lack of a large, highly trained workforce;

 

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•             difficulty in controlling local operations from our headquarters;

 

•             variable ethical standards and an increased potential for fraud;

 

•             unstable political and economic environments; and

 

•             lack of a secure environment for our personnel, facilities and equipment.

 

                Inparticular, these factors create the potential for physical loss of inventoryand misappropriation of operating assets. We have in the past experienced cases of vandalism and armed theft ofour equipment that had been or was being installed in the field.  If disruptions for any of these reasonsbecome too severe in any particular market, it may become necessary for us toterminate contracts and withdraw from that market and suffer the associatedcosts and lost revenue.

 

*Our wireless handset products aresubject to a wide range of environmental, health and safety laws, and mayexpose us to potential health and environmental liability claims.*

 

Our handset products are subject to a wide range ofenvironmental, health and safety laws, including laws relating to the use,disposal and clean up of, and human exposure to hazardous substances.  In the United States, these laws oftenrequire parties to fund remedial action regardless of fault.  Factors such as the discovery of additionalcontaminants, the extent of remediation and compliance expenses, and theimposition of additional clean up obligations could cause us to incursubstantial costs relating to remediation activities.  Compliance with existing or futureenvironmental, health and safety laws could also cause us to incur substantialcosts relating to such compliance, including the expense of modifying productdesigns and manufacturing processes.  Inaddition, restrictions on the use of certain materials in our facilities orproducts in the future could have a negative impact on our operations.

 

                Additionally,there have been claims made alleging a link between the use of wirelesshandsets and the development or aggravation of certain cancers, including braincancer. The scientific community is divided on whether there is a risk fromwireless handset use, and if so, the magnitude of the risk.  Even if there is no link established betweenwireless handset use and cancer, the negative publicity and possible litigationcould have a material adverse effect on our business.  In the past, several plaintiffs’ groups havebrought class actions against wireless handset manufacturers and distributors,alleging that wireless handsets have caused cancer.  To date, we have not been named in any ofthese actions and none of these actions has been successful.  In the future we could incur substantialcosts in defending ourselves against similar claims, regardless of theirmerit.  Also, claims may be successful inthe future and may have a material adverse effect on our business.

 

Furthermore, there have been claims made alleging a linkbetween the use of Bluetooth enabled mobile phone handsets and noise-inducedhearing loss.  To date, we have not beennamed in any of these actions.  In thefuture we could incur substantial costs in defending ourselves against similarclaims, regardless of their merit.  Also,claims may be successful in the future and may have a material adverse effecton our business.

 

*We are subject to a wide range ofenvironmental, health and safety laws and efforts to comply with such laws maybe costly and may adversely impact our financial performance.*

 

Our operations and the products we manufacture and/orsell are subject to a wide range of global environmental, health and safetylaws.  Compliance with existing or futureenvironmental, health and safety laws could subject us to future costs,liabilities, impact our production capabilities, constrict our ability to sell,expand or acquire facilities and generally impact our financial performance.  Some of these laws relate to the use,disposal, clean up of, and exposure to hazardous substances.  In the United States, laws often requireparties to fund remedial studies or action regardless of fault.  Over the last several years, the EuropeanUnion (the “EU”) countries have enacted environmental laws regulatingelectronic products.  For example,beginning July 1, 2006, our products have been subject to laws thatmandate the recycling of waste in electronic products sold in the EU and thatlimit or prohibit the use of certain substances in electronic products.  Other countries outside of Europe areexpected to adopt similar laws.  We mayincur additional expenses to comply with these laws.

 

*Currency rate fluctuations and exchangecontrols may adversely affect our cash flow and operating results.*

 

Because a significant percentage of our sales are made inforeign countries and denominated in local currency, we are exposed to marketrisk for changes in foreign exchange rates on our foreign currency denominatedaccounts and notes receivable balances. Historically, the majority of our sales have been made in China anddenominated in Renminbi.  Prior toJuly 2005, the impact of currency fluctuations of Renminbi wereinsignificant as it was fixed to the U.S. dollar.  However, in July 2005, China 

 

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uncoupled the Renminbi from the U.S. dollar and let itfloat in a narrow band against a basket of foreign currencies.  The move revalued the Renminbi by 2.1% againstthe U.S. dollar; however, it is uncertain what further adjustments may be madein the future.  The Renminbi-U.S. dollarexchange rate could float, and the Renminbi could appreciate relative to theU.S. dollar.  For example, theRenminbi-U.S. dollar exchange rate was 8.28 to the U.S. dollar prior to thefloat of the Renminbi in July 2005 and 7.63 Renminbi to the U.S. dollar atJune 30, 2007.  Any significantrevaluation of the Renminbi may materially and adversely affect our cash flows,revenues, operating results and financial position.

 

                Outsideof China, our primary foreign currency exposures have related to non-dollardenominated sales and purchases in Japan, Europe and Canada.  Additionally, we have exposures to emergingmarket currencies, which can have extreme currency volatility.  We have experienced material adverse impactson our results of operations from fluctuations in currency exchange rates andmay continue to do so in the future.

 

                Wemay, from time to time, enter into foreign exchange forward contracts tominimize the short-term impact of foreign currency fluctuations on certainforeign currency receivables and payables. Our attempts to hedge against these risks may not be successful,resulting in an adverse impact on our results of operations.  Moreover, some of the foreign countries inwhich we do business might impose currency restrictions that may limit theability of our subsidiaries and joint ventures in such countries to obtain andremit foreign currency necessary for the purchase of imported components andmay limit our ability to obtain and remit foreign currency in exchange forforeign earnings.  For example, Chinaemploys currency controls restricting Renminbi conversion, limiting our abilityto engage in currency hedging activities in China.  Various foreign exchange controls may alsomake it difficult for us to repatriate earnings, which could have a materialadverse effect on our ability to conduct business globally.

 

*Business interruptions could adverselyaffect our business.*

 

                Ouroperations are vulnerable to interruption by fire, earthquake, power loss,telecommunications failure, external interference with our informationtechnology systems, incidents of terrorism and other events beyond our control.  For example, our Hangzhou manufacturingfacility’s ability to produce sufficient products is dependent upon acontinuous power supply.  However, theHangzhou facility has in the past been subject to power shortages, which hasaffected our ability to produce and ship sufficient products.  Also, our operations in Alameda, Californiaare located in an area prone to earthquakes. We do not have a detailed disaster recovery plan, and the occurrence ofany events like these that disrupt our business could harm our business andoperating results.

 

*We may suffer losses with respect toequipment held at customer sites, which could harm our business.*

 

We face the risk of loss relating to our equipment heldat customer sites.  In some cases, ourequipment held at customer sites is under contract, pending final acceptance bythe customer.  We generally do not holdtitle or risk of loss on such equipment, as title and risk of loss aretypically transferred to the customer upon delivery of our equipment.  However, we do not recognize revenue andaccounts receivable with respect to the sale of such equipment until we obtainacceptance from the customer.  If we donot obtain final acceptance, we may not be able to collect the contract priceand recover this equipment or its associated costs.  In other cases, particularly in China, wheregovernmental approval is required to finalize certain contracts, inventory notunder contract may be held at customer sites. We hold title and risk of loss on this inventory until the contracts arefinalized and, as such, are subject to any losses incurred resulting from anydamage to or loss of this inventory.

 

                Ifour contract negotiations fail or if the government of China otherwise delaysapproving contracts, we may not recover or receive payment for this inventory.  Moreover, our insurance may not cover alllosses incurred if our inventory at customer sites not under contract isdamaged prior to contract finalization. If we incur a loss relating to inventory for any of the above reasons,our financial condition, cash flows, and operating results could be harmed.

 

*Restrictions on the use of handsetswhile driving could affect our future growth.*

 

Several foreign governments and U.S. state and localgovernments have adopted or are considering adopting legislation that wouldrestrict or prohibit the use of wireless handsets while driving.  Widespread legislation that restricts orprohibits the use of wireless handsets while driving could negatively affectour future growth.

 

*We have been named as a defendant insecurities litigation and other lawsuits, as well as lawsuits in the ordinarycourse of business.*

 

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Currently, we are a defendant in securities litigationclass action lawsuits, as well as other lawsuits.  Additionally, from time to time we areplaintiffs or defendants in other lawsuits including lawsuits in the ordinarycourse of our business.  The pursuit ordefense of these lawsuits may divert our management’s attention, and we mayincur significant expenses in pursuing or defending these lawsuits.  In addition, we may be required to payjudgments or settlements that could have a material adverse effect on ourresults of operations, financial condition and liquidity.

 

*We face risks related to pendinggovernmental inquiries.*

 

                InSeptember 2005, we received notice of a formal inquiry by the staff of theSecurities & Exchange Commission (“SEC”) into certain aspects of ourfinancial disclosures during prior reporting periods and certain otherissues.  In addition, inDecember 2005, the U.S. Embassy in Mongolia informed us that it hadforwarded to the Department of Justice (“DOJ”) allegations that an agent of ourMongolia joint venture had offered payments to a Mongolian government officialin possible violation of the Foreign Corrupt Practices Act (the “FCPA”).  We, through our Audit Committee, authorizedan independent investigation into possible violations of the FCPA, and we havebeen in contact with the DOJ and SEC regarding the investigation.  The investigation has identified possibleFCPA violations in Mongolia, Southeast Asia, India and China, as well aspossible violations of U.S. immigration laws. The DOJ has requested that the Company voluntarily produce documents relatedto the investigation and the SEC has subpoenaed the Company fordocuments.  The Company has executed tolling agreements extending thestatute of limitations for the FCPA issues under investigation by the SEC andthe DOJ and the immigration issues under investigation by the DOJ.  At this time, we cannot predict when anyinquiry will be completed or what the outcome of any inquiry will be.  These inquiries could harm relationships withexisting customers and our ability to obtain new customers and partners.  If the SEC or the DOJ makes a determinationthat we have violated federal laws, we may face sanctions including, but notlimited to, fines, disgorgement and an injunction.  Additionally, such a determination by the SECor the DOJ could adversely affect our business, results of operations, financialposition and cash flow, and ultimately our stock price.

 

We have also been in communication with the SEC regardingour voluntary review of our historical option grant awards grant practices andour review of certain historical sales contracts in China.  Although we have now completed both of thosevoluntary reviews, it is possible that the SEC may question the findings of ourreviews or initiate its own review into related matters.

 

It is possible that the findings and outcome of any ofthese inquiries may affect other lawsuits that are pending.  These inquiries could divert managementattention and resources, which could harm our business.

 

*Failure to achieve and maintaineffective internal controls in accordance with Section 404 of the Sarbanes-OxleyAct of 2002 could have a material adverse effect on our business and stockprice.*

 

Section 404 of the Sarbanes-Oxley Act of 2002(“Sarbanes-Oxley Act”) requires that we establish and maintain anadequate internal control structure and procedures for financial reporting andinclude a report of management on our internal control over financialreporting.  Our annual report onForm 10-K must contain an assessment by management of the effectiveness ofour internal control over financial reporting and must include disclosure ofany material weaknesses in internal control over financial reporting that wehave identified.  In addition, ourindependent registered public accounting firm must attest to and report onmanagement’s assessment of the effectiveness of our internal control overfinancial reporting.

 

                Wehave identified material weaknesses in our internal control over financialreporting.  See “Part I Item 4 — Controlsand Procedures—Management’s Report on Internal Control Over FinancialReporting.”  As of the date of thisquarterly report on Form 10-Q, we are still in the process of implementingremedial measures related to the material weaknesses identified in 2004 through2006.  If our efforts to remediate theweaknesses we identified are not successful, our business and operating resultscould be harmed and the reliability of our financial statements could beimpaired, which could adversely affect our stock price.  The requirements of Section 404 of theSarbanes-Oxley Act are ongoing and also apply to future years.  We expect that our internal control overfinancial reporting will continue to evolve as we continue in our efforts totransform our business.  Although we arecommitted to continue to improve our internal control processes and we willcontinue to diligently and vigorously review our internal control overfinancial reporting in order to ensure compliance with the Section 404requirements, any control system, regardless of how well designed, operated andevaluated, can provide only reasonable, not absolute, assurance that itsobjectives will be met.  In addition,successful remediation of the noted control deficiencies is dependent on theCompany’s ability to hire and retain qualified personnel.  Therefore, we cannot be certain that in thefuture additional material weaknesses or significant deficiencies will notexist or otherwise be discovered.

 

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**RISKS RELATED TO CONDUCTING BUSINESS INCHINA**

 

*China’s governmental and regulatoryreforms may impact our ability to do business in China.*

 

Since 1978, the Chinese government has been in a state ofevolution and reform.  The reforms haveresulted in and are expected to continue to result in significant economic andsocial development in China.  Many of thereforms are unprecedented or experimental and may be subject to change orreadjustment due to a variety of political, economic and social factors.  Multiple government bodies are involved inregulating and administering affairs in the telecommunications and informationtechnology industries, among which the Ministry of Information Industry (“MII”),the National Development and Reform Commission (“NDRC”), the State-ownedAssets Supervision and Administration Commission (“SASAC”) and the StateAdministration of Radio, Film and Television (“SARFT”) play the leadingroles.  These government agencies havebroad discretion and authority over all aspects of the telecommunications andinformation technology industry in China, including but not limited to, settingthe telecommunications tariff structure, granting carrier licenses andfrequencies, approving equipment and products, granting product licenses,approving of the form and content of transmitted data, specifying technologicalstandards as well as appointing carrier executives, all of which may impact ourability to do business in China.

 

                Anyof the following changes in China’s political and economic conditions andgovernmental policies could have a substantial impact on our business:

 

•             the promulgation of new laws and regulations and the interpretation ofthose laws and regulations;

 

•             inconsistent enforcement and application of the telecommunicationsindustry’s rules and regulations by the Chinese government between foreign anddomestic companies;

 

•             the restructuring of telecommunications carriers in China, includingpolicy making governing 3G network infrastructure and licensing;

 

•             restrictions on IPTV license grants, which could limit the potentialmarket for our products;

 

•             the introduction of measures to control inflation or stimulate growth;

 

•             the introduction of new guidelines for tariffs and service rates, whichaffect our ability to competitively price our products and services;

 

•             changes in the rate or method of taxation;

 

•             the imposition of laws, rules or regulations affecting the direct orindirect nationalization of assets controlled by non-governmental persons orentities;

 

•             the imposition of additional restrictions on currency conversion andremittances abroad; or

 

•             any actions that limit our ability to develop, manufacture, import orsell our products in China, or to finance and operate our business in China.

 

                Inaddition to modifying the existing telecommunications regulatory framework, theChinese government is currently preparing a draft of a standard, nationaltelecommunications law (“Telecommunications Law”) to provide a uniformregulatory framework for the telecommunications industry.  Currently a draft of the law has beenfinished and delivered to the National People’s Congress for discussion.  We do not yet know the final nature or scopeof the regulations that would be created if the Telecommunications Law ispassed.  Accordingly, we cannot predict whetherit will have a positive or negative effect on us or on some or all aspects ofour business.

 

                UnderChina’s current regulatory structure, the communications products that we offerin China must meet government and industry standards.  In addition, a network access license for theequipment must be obtained.  Without alicense, telecommunications equipment is not allowed to be connected to publictelecommunications networks or sold in China. Moreover, we must ensure that the quality of the telecommunicationsequipment for which we have obtained a network access license is stable andreliable, and will not negatively affect the quality or performance of otherinstalled licensed products.

 

*China’s changing economic environmentmay impact our ability to do business in China.*

 

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Since 1978, the Chinese government has been reforming theeconomic system in China to increase the emphasis placed on decentralizationand the utilization of market forces in the development of China’seconomy.  These reforms have resulted insignificant economic growth.  However,any economic reform policies or measures in China may from time to time bemodified or revised by the Chinese government. While we may be able to benefit from the effects of some of thesepolicies, these policies and other measures taken by the Chinese government toregulate the economy could also have a significant negative impact on economicconditions in China, which would result in a negative impact on our business.

 

*China’s entry into the World TradeOrganization and relaxation of trade restrictions have led to increased foreigninvestment in China’s telecommunications industry and may lead to increasedcompetition in our markets which may have an adverse impact on our business.*

 

China’s economic environment has been changing as aresult of China’s entry, in December of 2001, into the World Trade Organization(“WTO”).  Foreign investment in thetelecommunications sector is regulated by the “Provisions on Administration ofForeign Invested Telecommunications Enterprises” promulgated by the StateCouncil in December 2001 and effective as of January 1, 2002.  The provisions brought foreign equity limitsinto conformity with China’s WTO commitments, allowing foreign investors to ownequity generally up to 49% for basic telecom services enterprises and up to 50%for value-added telecom services enterprises. Furthermore, China is gradually introducing a market oriented pricingmechanism for telecommunication services. On July 13, 2005, China’s Ministry of Information Industry (“MII”)and National Development and Reform Commission (“NDRC”) approved the launch ofplan-based pricing for fixed-line telephone service by China’s two fixed-lineoperators, China Telecom and China Netcom. In August 2005, MII and NDRC endorsed a “Circular on the Changes inAdministration of Telecom Service Pricing,” which became effective onOctober 1, 2005 and further relaxed the pricing administration on certaintelecom services.   As China graduallyrelaxes such legal provisions, international telecommunication service vendorsmay seize this opportunity to adjust their China strategy, increasing theirinvestment in China and converting some of their joint-ventures intofully-owned enterprises.

 

                Asthe existing international vendors increase their investment in China, and morevendors enter the China market, the competition in the telecommunicationequipment market may increase, and as a result, our business may suffer. IfChina’s entry into the WTO results in increased competition or has a negativeimpact on China’s economy, our business could suffer. In addition, althoughChina is increasingly according foreign companies and foreign investmententerprises established in China the same rights and privileges as Chinesedomestic companies as a result of its admission into the WTO, special laws,administrative rules and regulations governing foreign companies and foreigninvestment enterprises in China may still place foreign companies at adisadvantage in relation to Chinese domestic companies and may adversely affectour competitive position.

 

*Uncertainties with respect to theChinese legal system may adversely affect us.*

 

                Weconduct our business in China primarily through our wholly owned subsidiariesincorporated in China. Our subsidiaries are generally subject to laws andregulations applicable to foreign investment in China. Accordingly, ourbusiness might be affected by China’s developing legal system. Since 1978, manynew laws and regulations covering general economic matters have beenpromulgated in China, and government policies and internal rules promulgated bygovernmental agencies may not be published in time, or at all. As a result, wemay operate our business in violation of new rules and policies without havingany knowledge of their existence. In addition, there are uncertaintiesregarding the interpretation and enforcement of laws, rules and policies inChina. Governmental authorities have broad discretion in the interpretation andenforcement of the laws, regulations and rules. The Chinese legal system isbased on written statutes, and prior court decisions have limited precedentialvalue. Because many laws and regulations are relatively new and the Chineselegal system is still evolving, the interpretations of many laws, regulationsand rules are not always uniform. Moreover, the relative inexperience of China’sjudiciary in many cases creates additional uncertainty as to the outcome of anylitigation, and the interpretation of statutes and regulations may be subjectto government policies reflecting domestic political changes. Finally,enforcement of existing laws or contracts based on existing law may beuncertain and sporadic, and it may be difficult to obtain swift and equitableenforcement, or to obtain enforcement of a judgment by a court of anotherjurisdiction. Any litigation in China may be protracted and result insubstantial costs and diversion of resources and management’s attention.

 

*If tax benefits available to oursubsidiaries located in China are reduced or repealed, our business could suffer.*

 

On March 16, 2007, China’stop legislature, the National People’s Congress, passed the China CorporateIncome Tax Law (“CIT Law”).  CIT Law willbe effective on January 1, 2008.  Underthe CIT Law, China’s dual tax system for domestic enterprises and foreigninvestment enterprises (“FIEs”) would be effectively replaced by a unifiedsystem.  The new law establishes a taxrate of 25% for most enterprises and a reduced tax rate of 15% for certainqualified high technology enterprises.

 

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Prior to this change in tax law, certain subsidiariesand joint ventures located in China enjoyed tax benefits in China which aregenerally available to FIEs.   The taxholidays/incentives for FIEs were applicable or potentially applicable toUTStarcom ChongQing Telecom Co. Ltd. (“CUTS”), UTStarcom Telecom Co., Ltd. (“HUTS”),Hangzhou UTStarcom Telecom Co., Ltd. (“HSTC”) and UTStarcom China Co., Ltd. (“UTSC”),our active subsidiaries in China, because these entities may qualify asaccredited technologically advanced enterprises.

CIT Law targets certain industries for the reduced 15%tax rate for certain qualified high technology enterprises. For FIEsestablished before the promulgation of the new law who currently enjoy lowertax rates, any increase in their tax rates would be gradually phased in overfive years.  Significant regulationsregarding the interpretation and implementation of the new tax law are stillpending.  There is potential risk thatour subsidiaries may not qualify for the reduced 15% tax rate.  Therefore, the new law may have an adverseimpact on our future tax expense in China.

 

Moreover, the Chinese central government may review andaudit tax benefits granted by local or provincial authorities and could determineto disallow such benefits. Certain of our subsidiaries and joint ventureslocated in China enjoy tax benefits in China that are generally available toforeign investment enterprises. If these tax benefits are reduced, disallowedor repealed due to changes in tax laws or determination by the Chinesegovernment, our business could suffer.

 

*Our ability to continue successfuldeployment of PAS system and sales of PAS handsets are limited by certainfactors, including the following:*

 

*Maturing PAS market and increasedcompetition in handsets and tariffs.*

 

                Themarket for PAS exceeded 96 million users as of the end of fiscal year 2006and is available in most of the provinces throughout China. We believe the PASmarket has matured. For example, during fiscal year 2005, net sales of thePAS/iPAS system and the wireless infrastructure market declined significantlyas compared to fiscal year 2004.  Thisdecline continued through fiscal year 2006, and the first quarter of 2007. Ifadditional handset competitors enter the market, or if competitors decide tofurther reduce pricing, our sales of PAS handsets may be adversely impacted.

 

                Furthermore,competition from mobile operators, such as China Mobile and China Unicom, hasincreased in cities where PAS is deployed. Mobile operators offering specialpromotional pricing or incentives to customers, such as free incoming calls orfree mobile-to-mobile calls, have harmed the ability of our customers, ChinaTelecom and China Netcom, to compete effectively. The continued use of suchincentive programs by mobile operators may adversely impact China Telecom andChina Netcom’s ability to increase PAS subscriptions. Due to our relationshipswith China Telecom and China Netcom, reduced subscription growth at thesecarriers may have a material adverse effect on our pricing and harm ourbusiness or results of operations.

 

*Our PAS system and handsets sales mayexperience a sharp decline if China Telecom or China Netcom obtain licensesallowing them to deliver mobile services.*

 

China’s media sources have widely reported that the MIImay grant 3G mobile licenses to China Telecom or China Netcom, or to both in2007. If China Telecom or China Netcom obtains 3G mobile licenses, they mayre-allocate capital expenditures to construct 3G networks, and as aconsequence, may significantly reduce capital expenditures relating to PASnetworks that utilize our existing products. In addition, it is possible thatcurrent PAS frequency bands utilized by PAS networks may be reallocated for useby 3G networks, resulting in the restriction of or shutting down of PASnetworks. If this were to occur, we could lose current and potential futurecustomers of our products, and our financial condition and results ofoperations could be significantly harmed.

 

*We only have trial licenses for the PASsystem and handsets in China.*

 

                Weonly have trial licenses for our PAS systems and handsets. We have applied for,but have not yet received, a final official network access license for our PASsystems and handsets. Based upon communication with the MII, we understand thatour PAS systems and handsets are considered to still be in the trial period andsales of our PAS systems and handsets may continue to be made by us during thistrial period, but that licenses will ultimately be required. If we fail toobtain the required 

 

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licenses, we could be prohibited from making furthersales of the unlicensed products, including our PAS systems and handsets, inChina, which would substantially harm our business, financial condition andresults of operations. The regulations implementing these requirements are notvery detailed, have not been applied by a court and may be interpreted andenforced by regulatory authorities in a number of different ways. Our externallegal counsel in China has advised us that China’s governmental authorities mayinterpret or apply the regulations with respect to which licenses are requiredand the ability to sell a product while a product is in the trial period in amanner that is inconsistent with the information received by our legal counselin China, and either of these conditions could have a material adverse effecton our business, financial condition and results of operations.

 

*Increasing centralization of purchasingdecision-making by carriers may lead to customer concentration and affectthe results of our business.*

 

Most Chinese carriers have three levels of operations:the central headquarters level, the provincial level and the local city/countylevel. Both central and provincial levels are independent legal persons andhave their own corporate mandate. The purchasing decision-making processmay take various forms for different projects and may also differ significantlyfrom carrier to carrier. In the case of PAS systems, we negotiate and enterinto all China Netcom contracts with the provincial operators. However, thecentral headquarters of China Telecom has chosen to exert its influence in thepurchasing decision-making process by negotiating contractual terms, suchas purchase price, payment terms, and acceptance clauses at the central level.The provincial operator then further negotiates the contract based on theguidelines provided by the headquarters. We enter into final contracts with theprovincial operator. However, if this trend of centralized decision-makingexpands to unified purchasing, resulting in the negotiation and execution ofcontracts at the central headquarter level, there may be a concentration ofcustomers which could have a significant impact on our business. If ChinaNetcom follows China Telecom and exerts the headquarters’ influence in pricenegotiation, it may give downward pressure to the margin of our PAS systemproducts to China Netcom.

 

*Television over the internet is a newbusiness in China and laws regulating the business have not been fullydeveloped and may be unpredictable. Unfavorable regulation of the industry mayadversely affect our IPTV operations in China and negatively impact ourbusiness.*

 

Broadcasting television over the internet has onlyrecently begun in China. The State Administration of Radio, Film and Television(SARFT), the central government’s regulatory body, issued a measure inJuly 2004 to regulate the broadcasting of audio-visual programsthrough the information network, which includes our Internet Protocoltelevision (IPTV) business. SARFT categorized the information network into themobile telecommunication network, fixed communications network, microwavecommunication network, cable television network, satellite or othermetropolitan area network, wide area network, local area network and otherinformation networks categories. The receiving terminal equipment includescomputers, television sets, mobile phones and other electronic products. Whileregulating the IPTV business, SARFT is encouraging development in China of thedigital television business, a business that may be competitive with IPTV inthe target market. The digital television and IPTV target complementary marketsand it is not clear the extent of support SARFT will provide for IPTV insetting regulations. For example, the Guangzhou Administration of Radio, Film,and Television, the municipal regulatory body in the city of Guangzhou, issueda notice to stop all IPTV business in Guangzhou on December 25, 2005.  The Zhejiang Administration of Radio, Film,and Television, the local regulatory body in the province of Zhejiang, issued asimilar notice on January 10, 2006. In both instances, SARFT had notformally endorsed the launch of commercial IPTV services in those localities.Because the IPTV industry relates to both television and telecom sectors, itmay be subject to regulation by different governmental authorities, includingthe Ministry of Information Industry (MII). At the end of 2005, an official of MII declared that MII and SARFT wouldjointly administer the IPTV industry in the coming years. However, due to alack of uniform regulation on the development of the IPTV industry, we cannotpredict that our IPTV business will operate smoothly in China. Our business maysuffer if the law or policy in China does not encourage the IPTV industry.

 

*We currently do not have a license toengage in the IPTV operator service business in China and development of ourIPTV business depends upon the cooperation of IPTV license holder(s) andnetwork operators. If we are unable to work cooperatively with licenseholder(s) and network operators, our business may suffer.*

 

                Underthe measures issued by SARFT in July 2004, entities intending to engage inthe IPTV operator service business should obtain a license from SARFT andforeign investment enterprises are prohibited from engaging in the IPTVoperator service business. In practice, SARFT only grants such licenses tostate-owned companies. Since we are the technical service and equipmentprovider in this field, our business development will depend on the cooperationof license holders and network operators. Our business may suffer if we fail tocooperate with license holders or network operators, or if the licenseholder(s) we’re cooperating with lose their licenses.

 

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**RISKS RELATED TO OUR STOCK PERFORMANCEAND CONVERTIBLE DEBT SECURITIES**

 

*Our stock price is highly volatile.*

 

                Thetrading price of our common stock has fluctuated significantly since ourinitial public offering in March of 2000. Our stock price could be subject towide fluctuations in the future in response to many events or factors,including those discussed in the preceding risk factors relating to ouroperations, as well as:

 

•             actual or anticipated fluctuations in operating results, actual oranticipated gross profit as a percentage of net sales, levels of inventory, ouractual or anticipated rate of growth and our actual or anticipated earnings pershare;

 

•             changes in expectations as to future financial performance or changes infinancial estimates or buy/sell recommendations of securities analysts;

 

•             changes in governmental regulations or policies in China;

 

•             our, or a competitor’s, announcement of new products, services ortechnological innovations;

 

•             the operating and stock price performance of other comparable companies;and

 

•             news and commentary emanating from the media, securities analysts orgovernment bodies in China relating to us and to the industry in general.

 

                Generalmarket conditions and domestic or international macroeconomic factors unrelatedto our performance may also affect our stock price. For these reasons,investors should not rely on recent trends to predict future stock prices orfinancial results. In addition, following periods of volatility in a company’ssecurities, securities class action litigation against a company is sometimesinstituted. We have experienced substantial costs and the diversion ofmanagement’s time and resources on this type of litigation and may do so in thefuture.

 

                Inaddition, public announcements by China Telecom, China Netcom, China Mobile,and China Unicom each of which exert significant influence over many of ourmajor customers in China, may contribute to volatility in the price of ourstock. The price of our stock may react to such announcements.

 

*SOFTBANK CORP. with its relatedentities, including SOFTBANK America Inc., has significant influence overour management and affairs, which it could exercise against the best interestsof our stockholders.*

 

                SOFTBANKCORP. and its related entities, including SOFTBANK America Inc.(collectively, “SOFTBANK”), beneficially owned approximately 12% of ouroutstanding stock as of June 30, 2007. As a result, SOFTBANK has the ability to influence all matters submittedto our stockholders for approval, as well as our management and affairs.Matters that could require stockholder approval include:

 

•             election and removal of directors;

 

•             our merger or consolidation with or into another entity; and

 

•             sale of all or substantially all of our assets.

 

                Thisconcentration of ownership may delay or prevent a change of control ordiscourage a potential acquirer from making a tender offer or otherwiseattempting to obtain control of us, which could decrease the market price ofour common stock.

 

*Delaware law and our charter documentscontain provisions that could discourage or prevent a potential takeover, evenif the transaction would benefit our stockholders.*

 

                Othercompanies may seek to acquire or merge with us. Our acquisition or merger couldresult in benefits to our stockholders, including an increase in the value ofour common stock. Some provisions of our Certificate of Incorporation andBylaws, as well as provisions of Delaware law, may discourage, delay or preventa merger or acquisition that a stockholder may consider favorable. Theseprovisions include:

 

•             authorizing the board of directors to issue additional preferred stock;

 

•             prohibiting cumulative voting in the election of directors;

 

•             limiting the persons who may call special meetings of stockholders;

 

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•             prohibiting stockholder action by written consent;

 

•             creating a classified board of directors pursuant to which our directorsare elected for staggered three year terms; and

 

•             establishing advance notice requirements for nominations for election tothe board of directors and for proposing matters that can be acted on by stockholdersat stockholder meetings.

 

W*e**face a variety of risks related to our convertible subordinated notes.*

 

                Weface a variety of risks with respect to our convertible subordinated notes duein 2008 (“Notes”), including the following:

 

•                                          we have significantly increased our leverage as a result of the sale ofthe Notes which could have an adverse impact on our ability to obtainadditional financing for working capital;

 

•                                          we may be limited in our ability to purchase the Notes in the event of achange in control, either for cash or stock, which could result in ourdefaulting on the Notes at the time of the change in control, and purchases forstock would be subject to market risk; and

 

•                                          hedging transactions related to the Notes and our common stock and othertransactions, as well as changes in interest rates and our creditworthiness,may affect the value of our common stock.

 

Inaddition, we are subject to various covenants pursuant to the terms of theindenture governing the Notes (the “Indenture”). Should we fail to comply withcertain covenants in the Indenture, including covenants requiring us to filecertain reports required to be filed pursuant to the Exchange Act (the “SECReports”) with the Securities and Exchange Commission (the “SEC”) and toprovide the Trustee for the notes (the “Trustee”) with copies of such reportsand certain certificates regarding our compliance with our obligations underthe Indenture, the Trustee or the holders of 25% of the aggregate principalamount of the Notes outstanding (the “25% Holders”) could accelerate thematurity of the Notes and the Notes could become immediately due andpayable.  In the past, there have beendelays in filing such reports: For example, as of November 9, 2006 andcontinuing through the date hereof there has been a delay in the filing of ourQuarterly Report on Form 10-Q for the quarter ended September 30, 2006 (the “2006Q3 Form 10-Q”), our Annual Report on Form 10-K for the fiscal year endedDecember 31, 2006 (the “2006 Form 10-K”), our Quarterly Report on Form 10-Q forthe quarter ended March 31, 2007 (the “2007 Q1 Form 10-Q”), and our QuarterlyReport on Form 10-Q for the quarter ended June 30, 2007 (the “2007 Q2 Form10-Q,” and together with the 2006 Q3 Form 10-Q, the 2006 Form 10-K, and the2007 Q1 Form 10-Q, the “Delayed Reports”). We received a notice from theTrustee on May 31, 2007, asserting that our failure to file the 2006 Q3 Form10-Q, the 2006 Form 10-K and the 2007 Q-1 Form 10-Q had resulted in a defaultunder the Indenture, and that if we failed to file such reports within 60 days,an event of default would arise under the Indenture.

 

In July2007, we sought and obtained the requisite consents from holders of the Notesto certain amendments to the Indenture, which provide that (i) any failure byus to file SEC Reports with the SEC and provide copies of such reports andcertain certificates to the Trustee prior to 5:30 p.m. New York City time onOctober 15, 2007 (the “Expiration Date”) will not cause a default under theIndenture, (ii) any such failure continuing after the Expiration Date wouldcause a default under the Indenture, which would be deemed to have occurred asof the Expiration Date, and (iii) we will pay additional interest on the Notesof (a) 6.75% annually from January 9, 2007 to and including July 25, 2007, and(b) 10.0% annually from and including July 26, 2007 to the date the Notes arepaid, prepaid, converted, redeemed or otherwise cease to be outstanding (ineach case, in addition to interest of 7/8% annually, as provided by theIndenture, without regard to any amendments). Although we filed our Q3 2006Form 10Q and our 2006 Form 10K prior to October 15, 2007, we did not file ourQ1 2007 Form 10Q and our Q2 2007 Form 10Q and deliver copies of such report andcertain certificates to the Trustee on or prior to October 15, 2007.  As a result, on October 15,2007, we received a notice from the Trustee asserting that our failure to fileour Q1 2007 Form 10-Q and our Q2 2007 Form 10-Q had resulted in a default underthe Indenture, as amended by the First and Second Supplemental 

 

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Indentures, and that if we failed to filesuch reports within 60 days of October 15, 2007, an event of default wouldarise under the Indenture.  As of the date of the filing of this Form10-Q for the quarter ended June 30, 2007, we have filed all required reportswith the SEC prior to the Demand Date set forth in the October 15thnotice of default, and, as a result, we believe that no Event of Default underthe Indenture occurred.

 

If anevent of default under the Indenture were to occur, and the maturity of theNotes were accelerated, and all unpaid principal and accrued interest isdeclared immediately due and payable, our business would be seriously harmed.  Inaddition, if we are able to raise capital to refinance indebtedness under theNotes by issuing new convertible notes, the terms of such notes may besignificantly less favorable than the terms of the Notes, and may cause greaterdilution to holders of our common stock.

 

*Our failure to timely file periodic reports with theSecurities and Exchange Commission could result in the delisting of our commonstock from the NASDAQ Stock Market.*

As a result of our failure to timely file ourQuarterly Report on Form 10-Q for the period ended September 30, 2006 (“Q3 2006Form 10-Q”), our Annual Report on Form 10-K for the year ended December 31,2006, our Quarterly Report on Form 10-Q for the period ended March 31, 2007 (“Q12007 Form 10-Q”) and our Quarterly Report on Form 10-Q for the period endedJune 30, 2007 (“Q2 2007 Form 10-Q”), we have not been in full compliance withNASDAQ Marketplace Rule 4310(c)(14), which requires us to make, on a timelybasis, all filings with the Securities and Exchange Commission required by theSecurities Exchange Act of 1934.

In connection with our failure to timely file ourperiodic reports, we received four NASDAQ Staff Determination letters, datedNovember 15, 2006, March 7, 2007, May 16, 2007 and August 13, 2007, respectively,stating that, as a result of each of these non-timely filings, we were not incompliance with the requirements of Marketplace Rule 4310(c)(14) and,therefore, that our stock was subject to delisting from the NASDAQ StockMarket. We appealed the November 15, 2006 determination to the NASDAQ ListingQualifications Panels (the “Panel”) and were granted a conditional extension toour request for continued listing until April 16, 2007. On April 17, 2007 thePanel extended the deadline for filing our Q3 2006 Form 10-Q  to May 14, 2007.  The Panel alsoextended the deadline for filing our 2006 Form 10-K until July 16, 2007. On May 2, 2007, we asked the NASDAQ Listing and Hearing Review Council (“ListingCouncil”) to review the April 17, 2007 decision of the Panel.  On May 14,2007, the Listing Council called the Panel’s decision for review and stayed thePanel’s decision that required us to file our Q3 2006 Form 10-Q by May 14,2007, and to file our 2006 Form 10-K by July 16, 2007.  On August 23,2007, the Listing Council granted the Company an extension until October 22,2007 to file our delinquent periodic reports and restatements.   On October 9, 2007, we asked the NASDAQBoard of Directors (“NASDAQ Board”) to review the August 23, 2007 decision ofthe Listing Council.  On October 17,2007, the NASDAQ Board called the Listing Council’s decision for review andstayed the Listing Council’s decision, which required us to file our delinquentperiodic reports and restatements by October 22, 2007, pending further reviewby the NASDAQ Board.

On October 10, 2007, we filed our Q3 2006 10-Q and our2006 Form 10-K, and on October 17, 2007 we filed our Q1 2007 Form10-Q.   As of the date of the filingof this Form 10-Q for the quarter ended June 30, 2007, we believe we are incompliance with Marketplace Rule 4310(c)(14).

If we are unable to maintain compliance with theconditions for continued listing required by NASDAQ, then our shares of commonstock may be subject to delisting from the NASDAQ Stock Market. If our shares ofcommon stock are delisted from the NASDAQ Stock Market, they may not beeligible to trade on any national securities exchange or the over-the countermarket. If our common stock is no longer traded through a market system, theliquidity of our common stock may be greatly reduced, which could negativelyaffect its price. In addition, we may be unable to obtain future equityfinancing, or use our common stock as consideration for mergers or otherbusiness combinations. A delisting from the NASDAQ Stock Market may also haveother negative implications, including the potential loss of confidence bysuppliers, customers and employees, the loss of institutional investorinterest, and fewer business development opportunities.

**ITEM 2—UNREGISTERED SALES OFEQUITY SECURITIES AND USE OF PROCEEDS**

 

                None

 

 

**ITEM 3—DEFAULTS UPON SENIORSECURITIES**

 

                None

 

**ITEM 4—SUBMISSION OF MATTERSTO A VOTE OF SECURITY HOLDERS**

 

                None

 

**ITEM 5—OTHER INFORMATION**

 

                None

 

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**ITEM 6—EXHIBITS**

 
| **Exhibit********Number** | ** ** | **EXHIBIT DESCRIPTION**                                                                                                                                                                                                                                                                                                                    |
|---------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **                | ** ** |                                                                                                                                                                                                                                                                                                                                       |
| 3.1                       |       | Thirteenth  Amended and Restated Certificate of Incorporation of UTStarcom, Inc., as  amended. (incorporated by reference to Exhibit 3.1 of Current Report on Form  8-K filed with the SEC on December 12, 2003)                                                                                                                      |
| 3.2                       |       | First  Amended and Restated Bylaws of UTStarcom, Inc., as amended on July 13,  2007 (incorporated by reference to Exhibit 3.2 of the Annual Report on Form  10-K filed with the SEC on October 10, 2007)                                                                                                                              |
| 4.1                       |       | See  exhibits 3.1 and 3.2 for provisions of the Certificate of  Incorporation and Bylaws defining the rights of holders of Common Stock.                                                                                                                                                                                         |
| 4.2                       |       | Specimen  Common Stock Certificate. (incorporated by reference to Exhibit 4.1 of Form  S-1/A filed with the SEC on February 7, 2000)                                                                                                                                                                                                       |
| 4.3                       |       | Third  Amended and Restated Registration Rights Agreement dated  December 14, 1999. (incorporated by reference to Exhibit 4.2 of  Form S-1 filed with the SEC on December 20, 1999)                                                                                                                                              |
| 4.4                       |       | Convertible  Subordinated Notes Indenture dated as of March 12, 2003 between  UTStarcom, Inc. and U.S. Bank National Association, including the  form of the 7/8% Convertible Subordinated Notes due 2008. (incorporated by  reference to Exhibit 4.4 of Quarterly Report on Form 10-Q filed with the SEC  on May 12, 2003) |
| 4.5                       |       | First  Supplemental Indenture, dated January 9, 2007, by and between the Company and  U.S. Bank National Association. (incorporated  by reference to Exhibit 99.2 of Current Report on Form 8-K filed with the SEC  on January 10, 2007)                                                                                                   |
| 4.6                       |       | Underwriting  Agreement, dated January 8, 2004 between the Company and Bank of America  Securities LLC, as amended on January 14, 2004. (incorporated by  reference to Exhibit 4.7 of Form 10-K filed with the SEC on April 15, 2005)                                                                                       |
| 4.7                       |       | Consent  Solicitation Statement dated December 22, 2006 related to the Company’s 7/8%  Convertible Subordinated Notes due 2008 (incorporated by reference to Exhibit  99.2 of Current Report on Form 8-K filed with the SEC on December 22, 2006)                                                                                     |
| 4.8                       |       | Amended  Letter of Consent related to the Company’s 7/8% Convertible Subordinated  Notes due 2008 (incorporated by reference to Exhibit 99.3 of Current Report  on Form 8-K filed with the SEC on January 8, 2007)                                                                                                                    |
| 4.9                       |       | Supplemental  Consent Solicitation Statement dated January 8, 2007 related to the Company’s  7/8% Convertible Subordinated Notes due 2008 (incorporated by reference to  Exhibit 99.2 of Current Report on Form 8-K filed with the SEC on January 8,  2007)                                                                           |
| 4.10                      |       | Second  Consent Solicitation Statement dated July 19, 2007 relating to the Company’s  Convertible Subordinated Notes due 2008 (incorporated by reference to Exhibit  99.2 to the Form 8-K filed with the SEC on July 19, 2007)                                                                                                        |
| 4.11                      |       | Letter  of Consent relating to the Company’s Convertible Subordinated Notes due 2008  (incorporated by reference to Exhibit 99.3 to the Form 8-K filed with the SEC  on July 19, 2007)                                                                                                                                                |
| 4.12                      |       | Second  Supplemental Indenture, dated July 26, 2007, by and between the Company and  U.S. Bank National Association (incorporated by reference to Exhibit 99.1 to  the Form 8-K filed with the SEC on July 30, 2007)                                                                                                                       |
| 10.1*                     |       | Change of Control and Involuntary Termination Severance  Agreement between UTStarcom, Inc. and Peter Blackmore, effective July 2, 2007                                                                                                                                                                                                     |
| 10.2*                     |       | Offer Letter for Peter Blackmore, dated May 27, 2007                                                                                                                                                                                                                                                                                       |
| 23.1                      |       | Consent of Independent Registered Public Accounting  Firm                                                                                                                                                                                                                                                                                  |
| 31.1                      |       | Certification of the Chief Executive Officer pursuant  to Rule 13a-14(a) or Rule 15d-14(a) promulgated under the  Securities Exchange Act of 1934, as amended.                                                                                                                                                                   |
| 31.2                      |       | Certification of the Chief Financial Officer pursuant  to Rule 13a-14(a) or Rule 15d-14(a) promulgated under the  Securities Exchange Act of 1934, as amended.                                                                                                                                                                   |
| 32.1                      |       | Certifications of the Chief Executive Officer and Chief  Financial Officer pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002.                                                                                                                                                                                                |

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*                 Managementcontract, plan or arrangement

 

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**SIGNATURES**

 

                Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|   | UTSTARCOM, INC. |   |
|--------|----------------------|--------|

 
| Date: October 19, 2007 | By:    | /s/ FRANCIS P. BARTON                                                                                       |
|-----------------------------|--------|-------------------------------------------------------------------------------------------------------------|
|                        |   | Francis P. Barton

*Executive Vice President and Chief  Financial Officer*

*(Principal Financial Officer)* |

 

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