** **

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

** **

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

| **(Mark  One)**                                                                              |
|----------------------------------------------------------------------------------------------|
| **ý**                                                                                   | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13  OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                         |   |   |
| **For the quarterly period ended September 30,  2005**                                  |
| ** **                                                                                   |
| **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 its charter)

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

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days.  Yes    ý  No   o

 

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

 

Indicate by check mark whetherthe registrant is a shell company (as defined in Rule 12b-2 of the ExchangeAct). Yes o  No ý

 

As of November 4, 2005there were 120,812,969 shares of the registrant’s common stock outstanding, parvalue $0.00125.

 

 

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**TABLE OF CONTENTS**

 
| PART I—FINANCIAL INFORMATION | 3                                                                                                        |
|----------------------------------------|----------------------------------------------------------------------------------------------------------|
|                                   |                                                                                                     |   |
|                                   | ITEM 1—CONDENSED  CONSOLIDATED FINANCIAL STATEMENTS                                                 | 3 |
|                                   |                                                                                                     |   |
|                                   | ITEM  2—MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF  OPERATIONS | 30 |
|                                   |                                                                                                     |   |
|                                   | ITEM  3—QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS                                 | 65 |
|                                   |                                                                                                     |   |
|                                   | ITEM 4—CONTROLS  AND PROCEDURES                                                                     | 67 |
|                                   |                                                                                                     |   |
| PART II—OTHER  INFORMATION   | 75                                                                                                       |
|                                   |                                                                                                     |   |
|                                   | ITEM 1—LEGAL  PROCEEDINGS                                                                           | 75 |
|                                   |                                                                                                     |   |
|                                   | ITEM  2—UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS                                 | 77 |
|                                   |                                                                                                     |   |
|                                   | ITEM  3—DEFAULTS UPON SENIOR SECURITIES                                                             | 77 |
|                                   |                                                                                                     |   |
|                                   | ITEM  4—SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                         | 77 |
|                                   |                                                                                                     |   |
|                                   | ITEM 5—OTHER  INFORMATION                                                                           | 77 |
|                                   |                                                                                                     |   |
|                                   | ITEM 6—EXHIBITS                                                                                     | 77 |
|                                   |                                                                                                     |   |
|                                   | Signatures                                                                                               | 78 |
|                                   |                                                                                                     |   |
|                                   | Exhibit Index                                                                                       |   |

 

2

----

 

**PART I—FINANCIAL INFORMATION**

 

**ITEM 1—CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**UTSTARCOM, INC.**

 

**CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)**

 

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

 

 
| ** **                                                                                                                                                                                   | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                   | ** ** | **2005**               | ** ** | **2004**              | ** ** |
| **ASSETS**                                                                                                                                                                                   |       |                   |       |                  |       |
| Current assets:                                                                                                                                                                              |       |                   |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                    |       | $                      | 496,126    |                  | $          | 562,532 |   |
| Short-term investments                                                                                                                                                                       |       | 15,091                 |       | 136,283               |       |
| Accounts receivable, net of allowances for  doubtful accounts of $83,585 and $49,438 at September 30, 2005 and  December 31, 2004, respectively                                    |       | 552,535                |       | 719,625               |       |
| Accounts receivable, related parties, net  of allowances for doubtful accounts of $8 and $1,769 at September 30,  2005 and December 31, 2004, respectively                         |       | 26,920                 |       | 86,988                |       |
| Notes receivable                                                                                                                                                                             |       | 22,934                 |       | 26,982                |       |
| Inventories                                                                                                                                                                                  |       | 474,485                |       | 590,832               |       |
| Deferred costs/Inventories at customer  sites under contracts                                                                                                                                |       | 201,241                |       | 198,155               |       |
| Prepaids                                                                                                                                                                                     |       | 54,107                 |       | 112,525               |       |
| Restricted cash and short-term investments                                                                                                                                                   |       | 36,922                 |       | 33,347                |       |
| Current deferred taxes                                                                                                                                                                       |       | —                 |       | 143,123               |       |
| Other current assets                                                                                                                                                                         |       | 29,040                 |       | 42,058                |       |
| Total current assets                                                                                                                                                                         |       | 1,909,401              |       | 2,652,450             |       |
| Property, plant and equipment, net                                                                                                                                                           |       | 251,009                |       | 268,759               |       |
| Long-term investments                                                                                                                                                                        |       | 37,427                 |       | 35,590                |       |
| Goodwill                                                                                                                                                                                     |       | 3,063                  |       | 180,627               |       |
| Intangible assets, net                                                                                                                                                                       |       | 80,775                 |       | 98,211                |       |
| Other long-term assets                                                                                                                                                                       |       | 31,932                 |       | 80,368                |       |
| Total assets                                                                                                                                                                                 |       | $                      | 2,313,607  |                  | $          | 3,316,005 |   |
|                                                                                                                                                                                         |       |                   |       |                  |       |
| **LIABILITIES,  MINORITY INTEREST AND STOCKHOLDERS’ EQUITY**                                                                                                                            |       |                   |       |                  |       |
| Current liabilities:                                                                                                                                                                         |       |                   |       |                  |       |
| Accounts payable                                                                                                                                                                             |       | $                      | 291,466    |                  | $          | 407,536 |   |
| Short-term debt                                                                                                                                                                              |       | 226,400                |       | 351,183               |       |
| Income taxes payable                                                                                                                                                                         |       | 25,244                 |       | 143,778               |       |
| Customer advances                                                                                                                                                                            |       | 159,123                |       | 323,938               |       |
| Deferred revenue                                                                                                                                                                             |       | 98,719                 |       | 66,941                |       |
| Other current liabilities                                                                                                                                                                    |       | 250,260                |       | 241,577               |       |
| Total current liabilities                                                                                                                                                                    |       | 1,051,212              |       | 1,534,953             |       |
|                                                                                                                                                                                         |       |                   |       |                  |       |
| Long-term debt                                                                                                                                                                               |       | 274,900                |       | 410,655               |       |
| Total liabilities                                                                                                                                                                            |       | 1,326,112              |       | 1,945,608             |       |
|                                                                                                                                                                                         |       |                   |       |                  |       |
| Commitments and contingencies (Note 15)                                                                                                                                                      |       |                   |       |                  |       |
| Minority interest in consolidated  subsidiaries                                                                                                                                              |       | 5,287                  |       | 5,025                 |       |
| Stockholders’ equity:                                                                                                                                                                   |       |                   |       |                  |       |
| Common stock: $0.00125 par value;  authorized: 750,000,000 shares; issued and outstanding: 120,013,339 and  114,486,632 at September 30, 2005 and December 31, 2004,  respectively |       | 151                    |       | 144                   |       |
| Additional paid-in capital                                                                                                                                                                   |       | 1,165,227              |       | 1,123,065             |       |
| Deferred stock compensation                                                                                                                                                                  |       | (4,052                 | )          | (6,102                | )          |
| Retained earnings (accumulated deficit)                                                                                                                                                      |       | (195,915               | )          | 243,452               |       |
| Accumulated other comprehensive income                                                                                                                                                       |       | 16,797                 |       | 4,813                 |       |
| Total stockholders’ equity                                                                                                                                                              |       | 982,208                |       | 1,365,372             |       |
| Total liabilities, minority interest and  stockholders’ equity                                                                                                                          |       | $                      | 2,313,607  |                  | $          | 3,316,005 |   |

 

See accompanying notes to the condensed consolidated financialstatements

 

3

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**UTSTARCOM, INC.**

 

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(UNAUDITED)**

 

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

 
| ** **                                                                                       | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                       | ** ** | **2005**                                  | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                             |       |                                      |       |                                     |       |   |   |   |   |
| Net sales                                                                                        |       |                                      |       |                                     |       |   |   |   |   |
| Unrelated party                                                                                  |       | $                                         | 629,004    |                                     | $          | 613,016 |   | $ | 1,927,479 |   | $ | 1,892,298 |   |
| Related party                                                                                    |       | 6,303                                     |       | 32,000                                   |       | 332,584 |   | 64,637 |   |
|                                                                                             |       | 635,307                                   |       | 645,016                                  |       | 2,260,063 |   | 1,956,935 |   |
| Cost of net sales                                                                                |       |                                      |       |                                     |       |   |   |   |   |
| Unrelated party                                                                                  |       | 578,017                                   |       | 488,363                                  |       | 1,712,440 |   | 1,435,135 |   |
| Related party                                                                                    |       | 3,344                                     |       | 19,519                                   |       | 146,041 |   | 32,361 |   |
| Gross profit                                                                                     |       | 53,946                                    |       | 137,134                                  |       | 401,582 |   | 489,439 |   |
| Operating expenses:                                                                              |       |                                      |       |                                     |       |   |   |   |   |
| Selling, general and administrative                                                              |       | 88,708                                    |       | 74,916                                   |       | 299,728 |   | 209,689 |   |
| Research and development                                                                         |       | 60,797                                    |       | 56,026                                   |       | 193,078 |   | 154,276 |   |
| In-process research and development                                                              |       | —                                    |       | —                                   |       | 660 |   | 1,400 |   |
| Amortization of intangible assets                                                                |       | 6,643                                     |       | 3,639                                    |       | 20,391 |   | 9,946 |   |
| Restructuring                                                                                    |       | 3,378                                     |       | —                                   |       | 18,505 |   | — |   |
| Impairment on long-lived assets                                                                  |       | 218,094                                   |       | —                                   |       | 218,094 |   | — |   |
| Total operating expenses                                                                         |       | 377,620                                   |       | 134,581                                  |       | 750,456 |   | 375,311 |   |
|                                                                                             |       |                                      |       |                                     |       |   |   |   |   |
| Operating income (loss)                                                                          |       | (323,674                                  | )          | 2,553                                    |       | (348,874 | ) | 114,128 |   |
|                                                                                             |       |                                      |       |                                     |       |   |   |   |   |
| Interest income                                                                                  |       | 1,673                                     |       | 1,339                                    |       | 4,474 |   | 4,530 |   |
| Interest expense                                                                                 |       | (3,876                                    | )          | (1,206                                   | )          | (12,864 | ) | (3,428 | ) |
| Gain on extinguishment of subordinated  notes                                                    |       | 20,297                                    |       | —                                   |       | 31,392 |   | — |   |
| Other income (expense), net                                                                      |       | 7,352                                     |       | 1,162                                    |       | (1,723 | ) | 14,211 |   |
| Income (loss) before income taxes, minority  interest and equity in loss of affiliated companies |       | (298,228                                  | )          | 3,848                                    |       | (327,595 | ) | 129,441 |   |
| Income tax expense (benefit)                                                                     |       | 103,650                                   |       | (1,906                                   | )          | 110,048 |   | 22,773 |   |
| Minority interest in (earnings) losses of  consolidated subsidiaries                             |       | 3                                         |       | (40                                      | )          | 94 |   | (127 | ) |
| Equity in loss of affiliated companies                                                           |       | (786                                      | )          | (727                                     | )          | (1,818 | ) | (2,925 | ) |
| Net income (loss)                                                                                |       | $                                         | (402,661   | )                                        | $          | 4,987 |   | $ | (439,367 | ) | $ | 103,616 |   |
|                                                                                             |       |                                      |       |                                     |       |   |   |   |   |
| Earnings (Loss) per share - Basic                                                                |       | $                                         | (3.40      | )                                        | $          | 0.04 |   | $ | (3.79 | ) | $ | 0.91 |   |
| Earnings (Loss) per share - Diluted                                                              |       | $                                         | (3.40      | )                                        | $          | 0.04 |   | $ | (3.79 | ) | $ | 0.78 |   |
|                                                                                             |       |                                      |       |                                     |       |   |   |   |   |
| Weighted average shares used in per-share  calculation:                                          |       |                                      |       |                                     |       |   |   |   |   |
| - Basic                                                                                          |       | 118,262                                   |       | 113,945                                  |       | 115,902 |   | 114,110 |   |
| - Diluted                                                                                        |       | 118,262                                   |       | 133,226                                  |       | 115,902 |   | 136,214 |   |

 

See accompanying notes to the condensed consolidated financialstatements.

 

4

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**UTSTARCOM, INC.**

 

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(UNAUDITED)**

** **

**(In thousands)**

 
| ** **                                                                            | ** ** | **Nine months ended September 30,** | ** ** |
|---------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                            | ** ** | **2005**                                 | ** ** | **2004** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                 |       |                                     |       |   |   |
| Net income (loss)                                                                     |       | $                                        | (439,367   | ) | $ | 103,616 |   |
| Adjustments to reconcile net income (loss)  to net cash used in operating activities: |       |                                     |       |   |   |
| Depreciation and amortization                                                         |       | 78,489                                   |       | 52,563 |   |
| Non-qualified stock option exercise tax  benefits                                     |       | (832                                     | )          | 3,612 |   |
| Net loss on sale of assets                                                            |       | 3,870                                    |       | 7 |   |
| Amortization of debt issuance costs                                                   |       | 1,612                                    |       | 1,749 |   |
| Warrants adjustment to fair value                                                     |       | —                                   |       | (46 | ) |
| Gain on sale of investment                                                            |       | —                                   |       | (2,116 | ) |
| Long-lived assets impairment                                                          |       | 218,094                                  |       | — |   |
| Non-cash restructuring charges                                                        |       | 12,389                                   |       | — |   |
| In-process research and development                                                   |       | 660                                      |       | 1,400 |   |
| Net loss on long-term investments                                                     |       | —                                   |       | 1,608 |   |
| Stock compensation expense                                                            |       | 1,712                                    |       | 327 |   |
| Provision for doubtful accounts                                                       |       | 38,115                                   |       | 17,552 |   |
| Inventory provision                                                                   |       | 42,060                                   |       | 21,190 |   |
| Equity in loss of affiliated companies                                                |       | 1,818                                    |       | 2,925 |   |
| Deferred income taxes                                                                 |       | 173,730                                  |       | (6,865 | ) |
| Minority interest in earnings (losses) of  consolidated subsidiary                    |       | (94                                      | )          | 127 |   |
| Gain on extinguishment of debt                                                        |       | (31,392                                  | )          | — |   |
| Changes in operating assets and  liabilities, net of effects of acquisitions:         |       |                                     |       |   |   |
| Accounts receivable                                                                   |       | 197,884                                  |       | (385,010 | ) |
| Inventories                                                                           |       | 88,532                                   |       | (202,171 | ) |
| Deferred costs/Inventories at customer  sites under contracts                         |       | (14,240                                  | )          | 390,074 |   |
| Other current and non-current assets                                                  |       | 79,616                                   |       | 54,729 |   |
| Accounts payable                                                                      |       | (120,472                                 | )          | 82,639 |   |
| Income taxes payable                                                                  |       | (118,615                                 | )          | 15 |   |
| Customer advances                                                                     |       | (167,666                                 | )          | (183,054 | ) |
| Deferred revenue                                                                      |       | 30,928                                   |       | 12,862 |   |
| Other current liabilities                                                             |       | 6,795                                    |       | 12,663 |   |
| Net cash provided by (used in) operating  activities                                  |       | 83,626                                   |       | (19,604 | ) |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                 |       |                                     |       |   |   |
| Additions to property, plant and equipment                                            |       | (60,904                                  | )          | (105,209 | ) |
| Investment in affiliates, net of cash  acquired                                       |       | (3,550                                   | )          | (6,000 | ) |
| Purchase of business                                                                  |       | (24,326                                  | )          | (43,980 | ) |
| Proceeds from disposal of property                                                    |       | 695                                      |       | — |   |
| Purchase of technology licenses                                                       |       | (750                                     | )          | (3,775 | ) |
| Change in restricted cash                                                             |       | 176                                      |       | (7,512 | ) |
| Purchase of short-term investments                                                    |       | (149,469                                 | )          | (170,704 | ) |
| Proceeds from sale of short-term  investments                                         |       | 270,672                                  |       | 170,280 |   |
| Net cash provided by (used in) investing  activities                                  |       | 32,544                                   |       | (166,900 | ) |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                 |       |                                     |       |   |   |
| Issuance of stock, net of expenses                                                    |       | 4,327                                    |       | 18,402 |   |
| Net proceeds from borrowings                                                          |       | 346,284                                  |       | 215,000 |   |
| Repayments of borrowings                                                              |       | (478,081                                 | )          | (40,000 | ) |
| Repurchase of stock                                                                   |       | —                                   |       | (107,567 | ) |
| Cash paid to extinguish debt                                                          |       | (57,136                                  | )          | — |   |
| Proceeds from settlement of bond hedge and  call option                               |       | 1,445                                    |       | — |   |
| Capital contributions from minority  interests                                        |       | 356                                      |       | — |   |
| Proceeds from equity offering                                                         |       | —                                   |       | 474,554 |   |
| Net cash provided by (used in) financing  activities                                  |       | (182,805                                 | )          | 560,389 |   |
| Effect of exchange rate changes on cash                                               |       | 229                                      |       | 3,461 |   |
| Net increase (decrease) in cash and cash  equivalents                                 |       | (66,406                                  | )          | 377,346 |   |
| CASH AND CASH EQUIVALENTS AT BEGINNING OF  PERIOD                                     |       | 562,532                                  |       | 377,747 |   |
| CASH AND CASH EQUIVALENTS AT END OF PERIOD                                            |       | $                                        | 496,126    |   | $ | 755,093 |   |
|                                                                                  |       |                                     |       |   |   |
| Supplemental disclosure of cash flow  information:                                    |       |                                     |       |   |   |
| Cash paid:                                                                            |       |                                     |       |   |   |
| Interest                                                                              |       | $                                        | 11,294     |   | $ | 3,860 |   |
| Income taxes                                                                          |       | 10,872                                   |       | 9,137 |   |
| Non-cash operating activity                                                           |       |                                     |       |   |   |
| Accounts receivable transferred to notes  receivable                                  |       | 40,210                                   |       | 64,003 |   |

 

See accompanying notes to the condensed consolidated financialstatements.

 

5

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**UTSTARCOM, INC.**

 

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

 

**1.****                                                                                     ****BASIS OF PRESENTATION:**

 

The accompanying unauditedcondensed consolidated financial statements include the accounts of UTStarcom, Inc.(the “Company”) and its wholly and majority owned subsidiaries. All significantintercompany accounts and transactions have been eliminated in the preparationof the condensed consolidated financial statements. The minority interests inconsolidated subsidiaries and equity in affiliated companies are shownseparately in the condensed consolidated financial statements.  The Company also consolidates variableinterest entities (“VIE”) as defined by Financial Accounting Standards BoardInterpretation No. 46 (“FIN 46”) “Consolidation of Variable InterestEntities” where the Company is the primary beneficiary.  Investments in affiliated companies areaccounted for using the cost or equity method, as applicable.

 

The accompanying financialstatements as of September 30, 2005 and for the three and nine monthsended September 30, 2005 and 2004 have been prepared by the Companypursuant to the rules and regulations of the Securities and ExchangeCommission (the “SEC”). Certain information and footnote disclosures normallyincluded in financial statements prepared in accordance with generally acceptedaccounting principles have been condensed or omitted pursuant to such rules andregulations. The December 31, 2004 balance sheet was derived from auditedfinancial statements, but does not include all disclosures required bygenerally accepted accounting principles. These condensed consolidatedfinancial statements should be read in conjunction with the Company’s audited December 31,2004 financial statements, including the notes thereto, and the otherinformation set forth in the Company’s Annual Report on Form 10-K for theyear ended December 31, 2004.

 

In the opinion ofmanagement, the accompanying unaudited condensed consolidated financialstatements reflect all adjustments (consisting of only normal recurringadjustments) 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 months and ninemonths ended September 30, 2005 are not necessarily indicative of theoperating results for the full year.

 

**2.****                                                                                      REVENUERECOGNITION:**

 

Revenuesfrom sales of telecommunications equipment and handsets are recognized whenpersuasive evidence of an arrangement exists, delivery of the product hasoccurred, customer acceptance has been obtained, the fee is fixed ordeterminable and collectability is reasonably assured. If the payment due fromthe customer is not fixed or determinable under certain circumstances, due toextended payment terms, revenue is recognized as payments become due from thecustomer, assuming all other criteria for revenue recognition are met. Anypayments received prior to revenue recognition are recorded as customeradvances. Normal payment terms differ for various reasons amongst differentcustomer regions, depending upon common business practices for customers withina region. Shipping and handling costs are recorded as revenues and costs ofrevenues. Any expected losses on contracts are recognized when identified.

 

Salesmay be generated from complex contractual arrangements that require significantrevenue recognition judgments, particularly in the areas of multiple elementarrangements. Where multiple elements exist in an arrangement, the arrangementfee is allocated to the different elements based upon verifiable objectiveevidence of the fair value of the elements, as governed under Emerging IssuesTask Force Issue (“EITF”) No. 00-21, and SEC Staff Accounting Bulletin No. 104(“SAB 104”). Multiple element arrangements primarily involve the sale ofPersonal Access Systems (“PAS”), a family of wireless access handsets, wirelessconsumer products and core infrastructure equipment or Internet Protocol-basedPAS, (“iPAS”), wireless access systems that employ micro cell radio technologyand specialized handsets, allowing service providers to offer subscribers bothmobile and fixed access to telephone services. These multiple elementarrangements include the sale of PAS or iPAS equipment with handsets,installation and training and the provision of such equipment to differentlocations for the same customer. Revenue is recognized as each element isearned, namely upon installation and acceptance of equipment or delivery ofhandsets, provided that the fair value of the undelivered element(s) hasbeen determined, the delivered element(s) has stand-alone value, there isno right of return on delivered element(s), and the Company is in control ofthe undelivered element(s). For arrangements that include service elements,including promotional support and installation, for which verifiable objectiveevidence of fair value does not exist, revenue is deferred until such servicesare deemed complete.

 

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 will not recognize revenue before final acceptance isgranted by the customer if acceptance is considered substantive to thetransaction. Additionally, the Company does not recognize revenue when cashpayments are received from customers for transactions that do not have thecustomer’s final acceptance. The Company records these cash receipts ascustomer advances, and defers revenue recognition until final acceptance isreceived.

 

 

6

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Wheremultiple elements exist in an arrangement that includes software, and thesoftware is considered more than incidental

tothe equipment or services in the arrangement, software and software relatedelements are recognized under the provisions of Statement of Position 97-2, asamended, and EITF No. 03-05. The Company allocates revenues to eachelement of software arrangements based on vendor specific objective evidence (“VSOE”).VSOE of each element is based on the price charged when the same element issold separately. The Company uses the residual method to recognize revenue whenan arrangement includes one or more elements to be delivered at a future dateand VSOE of the fair value of all the undelivered elements exists. Under theresidual method, the fair value of the undelivered elements is deferred and theremaining portion of the arrangement fee is recognized as revenue. If evidenceof fair value of one or more undelivered elements does not exist, revenue isdeferred and recognized when delivery of those elements occurs or when fairvalue can be established.

 

TheCompany recognizes revenue for system integration, installation and trainingupon completion of performance and if all other revenue recognition criteriaare met. Other service revenue, such as that related to maintenance and supportcontracts, is recognized ratably over the contract term. Revenues from serviceswere less than 10% of revenues for all periods.

 

TheCompany also sells products through resellers. Revenue is generally recognizedwhen the standard price protection period, which ranges from 30 to 90 days, haslapsed. If collectability cannot be reasonably assured in a resellerarrangement, revenue is recognized upon sell-through to the end customer andreceipt of cash. There may be additional obligations in reseller arrangementssuch as inventory rotation, or stock exchange rights on the product. As such,revenue is recognized in accordance with Statement of Financial AccountingStandards No. 48, “Revenue Recognition When Right of Return Exists,” (“SFAS48”). The Company has developed reasonable estimates for stock exchanges.Estimates are derived based on historical experience with similar types ofsales 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 the Company records its estimate of the rebate amountat the time of the sale. The Company also enters into sales incentive programs,such as co-marketing arrangements, with certain wireless and handset customers.The Company records the incurred incentive as a reduction of revenue when thesales revenue is recognized.

 

Theassessment of collectability is also a factor in determining whether revenueshould be recognized. The Company assesses collectability 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 often requires letters of credit from its customers that canbe drawn on demand if the customer defaults on its payment. If the Companydetermines that collection of a payment is not reasonably assured, the Companyrecognizes revenue at the time collection becomes reasonably assured, which isgenerally upon receipt of cash. Occasionally, the Company enters into revenuesharing arrangements. Under these arrangements, the Company collects revenuesonly after its customer, the telecommunications service provider, collectsservice revenues. When the Company enters a revenue sharing arrangement, theCompany does not recognize revenue until collection is reasonably 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 booked until the Company recognizes the related customerrevenue. Advances from customers are recognized when the Company has collectedcash from the customer, prior to recognizing revenue. Deferred revenue isrecorded if there are undelivered elements after final acceptance has beenobtained.

 

**3.****                                                                                     ****EARNINGS PER SHARE:**

 

Basic earnings per share iscomputed by dividing net income or loss available to holders of common stock bythe weighted average number of shares of the Company’s common stock outstandingduring the period. Diluted earnings per share is determined by adjusting netincome or loss as reported by the effect of dilutive securities and increasingthe number of shares by potentially dilutive shares of common stock outstandingduring the period. Potentially dilutive shares of common stock consist ofemployee stock options, a written call option, warrants, convertiblesubordinated notes and unvested acquisition-related stock options. Potentiallydilutive shares are excluded from the computation of diluted net loss per sharein which their effect would be anti-dilutive.

 

7

----

 

The following is a summaryof the calculation of basic and diluted earnings per share:

 
| ** **                                                         | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|--------------------------------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| **(in thousands except per share data)**                           | ** ** | **2005**                                  | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                               |       |                                      |       |                                     |       |   |   |   |   |
| Numerator:                                                         |       |                                      |       |                                     |       |   |   |   |   |
|                                                               |       |                                      |       |                                     |       |   |   |   |   |
| Net income (loss) for basic EPS computation                        |       | $                                         | (402,661   | )                                        | $          | 4,987 |   | $ | (439,367 | ) | $ | 103,616 |   |
|                                                               |       |                                      |       |                                     |       |   |   |   |   |
| Effect of dilutive securities-7/8%  convertible subordinated notes |       | —                                    |       | 816                                      |       | — |   | 2,663 |   |
| Net income (loss) adjusted for dilutive  securities                |       | $                                         | (402,661   | )                                        | $          | 5,803 |   | $ | (439,367 | ) | $ | 106,279 |   |
|                                                               |       |                                      |       |                                     |       |   |   |   |   |
| Denominator:                                                       |       |                                      |       |                                     |       |   |   |   |   |
|                                                               |       |                                      |       |                                     |       |   |   |   |   |
| Shares used to compute basic EPS                                   |       | 118,262                                   |       | 113,945                                  |       | 115,902 |   | 114,110 |   |
| Dilutive common stock equivalent shares:                           |       |                                      |       |                                     |       |   |   |   |   |
| Stock options                                                      |       | —                                    |       | 1,994                                    |       | — |   | 4,442 |   |
| Written call option                                                |       | —                                    |       | —                                   |       | — |   | 349 |   |
| Conversion of convertible subordinated  notes                      |       | —                                    |       | 16,919                                   |       | — |   | 16,919 |   |
| Warrants                                                           |       | —                                    |       | —                                   |       | — |   | 12 |   |
| Unvested acquisition-related stock                                 |       | —                                    |       | 368                                      |       | — |   | 382 |   |
| Shares used to compute diluted EPS                                 |       | 118,262                                   |       | 133,226                                  |       | 115,902 |   | 136,214 |   |
|                                                               |       |                                      |       |                                     |       |   |   |   |   |
| Earnings per share - basic                                         |       | $                                         | (3.40      | )                                        | $          | 0.04 |   | $ | (3.79 | ) | $ | 0.91 |   |
| Earnings per share - diluted                                       |       | $                                         | (3.40      | )                                        | $          | 0.04 |   | $ | (3.79 | ) | $ | 0.78 |   |

 

Certain potential sharesrelated to employee stock options outstanding during the three and nine monthsended September 30, 2005 and 2004 were excluded in the diluted per sharecomputations, since their exercise prices were greater than the average marketprice of the Company’s common stock during the periods and, accordingly, theireffect is anti-dilutive under the treasury stock method.  For the three and nine months ended September 30,2005, these shares totaled 18.2 million with a weighted average exerciseprice of $20.90 per share and 17.3 million shares with a weighted averageexercise price of $21.51 per share, respectively.  For the three and nine months ended September 30,2004, these shares totaled 12.5 million with a weighted average exerciseprice of $25.87 per share and 3.5 million shares with a weighted averageexercise price of $33.07 per share, respectively.  

 

The Company has 7/8%convertible subordinated notes (“Notes”) outstanding which are eligible forconversion into shares of common stock. For each $1,000 of aggregate principalamount of notes converted, the Company will deliver approximately 42.0345shares of common stock, if the Company’s closing stock price exceeds aspecified threshold as of the last trading day of the immediately precedingfiscal quarter. In September 2004, the EITF reached a consensus related toEITF No. 04-8 “The Effect of Contingently Convertible Debt on DilutedEarnings per Share” which requires contingently convertible debt instruments tobe treated as “if converted” for the purpose of computing the earnings pershare.  The conversion is assumed in thisdiluted EPS computation for the three and nine months ended September 30,2004.

 

The net income for thediluted EPS computation reflects the reduction in interest expense of $0.8million and $2.6 million, net of tax, for the three and nine months ended September 30,2004, respectively, that would result from an assumed conversion of the 7/8%convertible subordinated notes.

 

In connection with theissuance of the Notes in March 2003, the Company entered into convertiblebond hedge and call option transactions to reduce the potential dilution fromconversion of the notes. Both the bond hedge and call option transactions maybe settled at the Company’s option either in cash or net shares and expire on March 1,2008.

 

During the three monthsended September 30, 2004, the average price of the Company’s stock wasbelow the specified strike prices of both the convertible bond hedge and calloption transactions that the Company entered into to reduce the potentialdilution from conversion of the notes.

 

For the nine months ended September 30,2004, the dilutive and anti-dilutive effects of the call option and the bondhedge were derived by taking the weighted average of the first, second, andthird quarters, in accordance with SFAS 128. For the nine months ended September 30,2004, this would have the effect of decreasing the denominator for dilutedearnings per share by 2.7 million shares for the bond hedge transaction, andincreasing the denominator for diluted earnings per share by 0.3 million sharesfor the call option transaction. However, only the dilutive effect of the 0.3million shares for the nine months ended September 30, 2004, with respectto the call option transaction were included in the Company’s diluted earningsper share calculation above. The convertible bond hedge, under SFAS 128, isalways anti-dilutive.

 

8

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**4.****                                                                                     ****STOCK-BASED COMPENSATION:**

 

The Company accounts foremployee stock option grants in accordance with Accounting Principles BoardOpinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) andhas adopted the disclosure-only alternative of SFAS No. 123, as amended bySFAS No. 148, “Accounting for Stock-Based Compensation” (“SFAS 123”).Under APB 25, compensation expense is based on the difference, if any, on thedate of grant between the fair value of the common stock and the exercise priceof the option.

 

The fair value of warrants,options or stock exchanged for services from non-employees is expensed over theperiod benefited. The warrants and options are valued using the Black-Scholesoption pricing model.

 

The following tableillustrates the effect on net income or loss and earnings or loss per share ifthe Company had applied the fair value recognition provisions of SFAS 123 tostock-based employee compensation:

 
| ** **                                                                                                               | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| **(in thousands, except per share data)**                                                                                | ** ** | **2005**                                  | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                                                     |       |                                      |       |                                     |       |   |   |   |   |
| Basic                                                                                                                    |       |                                      |       |                                     |       |   |   |   |   |
|                                                                                                                     |       |                                      |       |                                     |       |   |   |   |   |
| Net income (loss):                                                                                                       |       |                                      |       |                                     |       |   |   |   |   |
| As reported                                                                                                              |       | $                                         | (402,661   | )                                        | $          | 4,987 |   | $ | (439,367 | ) | $ | 103,616 |   |
| Add: Stock-based employee compensation  expense included in reported net income (loss), net of related tax effects       |       | 372                                       |       | 59                                       |       | 1,194 |   | 257 |   |
| Deduct: Total compensation expense  determined under fair value based method for all awards, net of related tax  effects |       | (5,235                                    | )          | (8,817                                   | )          | (17,253 | ) | (25,471 | ) |
| Pro forma net income (loss)                                                                                              |       | $                                         | (407,524   | )                                        | $          | (3,771 | ) | $ | (455,426 | ) | $ | 78,402 |   |
|                                                                                                                     |       |                                      |       |                                     |       |   |   |   |   |
| Basic income (loss) per share:                                                                                           |       |                                      |       |                                     |       |   |   |   |   |
| As reported                                                                                                              |       | $                                         | (3.40      | )                                        | $          | 0.04 |   | $ | (3.79 | ) | $ | 0.91 |   |
| Pro forma                                                                                                                |       | $                                         | (3.45      | )                                        | $          | (0.03 | ) | $ | (3.93 | ) | $ | 0.69 |   |
|                                                                                                                     |       |                                      |       |                                     |       |   |   |   |   |
| Diluted                                                                                                                  |       |                                      |       |                                     |       |   |   |   |   |
|                                                                                                                     |       |                                      |       |                                     |       |   |   |   |   |
| Net income (loss):                                                                                                       |       |                                      |       |                                     |       |   |   |   |   |
| As reported                                                                                                              |       | $                                         | (402,661   | )                                        | $          | 4,987 |   | $ | (439,367 | ) | $ | 103,616 |   |
| Effect of dilutive securities-7/8%  Convertible subordinated notes                                                       |       | —                                    |       | —                                   |       | — |   | 2,663 |   |
| Add: Stock-based employee compensation  expense included in reported net income (loss), net of related tax effects       |       | 372                                       |       | 59                                       |       | 1,194 |   | 257 |   |
| Deduct: Total compensation expense  determined under fair value method for all awards, net of related tax effects        |       | (5,235                                    | )          | (8,817                                   | )          | (17,253 | ) | (25,471 | ) |
| Pro forma net income (loss)                                                                                              |       | $                                         | (407,524   | )                                        | $          | (3,771 | ) | $ | (455,426 | ) | $ | 81,065 |   |
|                                                                                                                     |       |                                      |       |                                     |       |   |   |   |   |
| Diluted income (loss) per share:                                                                                         |       |                                      |       |                                     |       |   |   |   |   |
| As reported                                                                                                              |       | $                                         | (3.40      | )                                        | $          | 0.04 |   | $ | (3.79 | ) | $ | 0.78 |   |
| Pro forma                                                                                                                |       | $                                         | (3.45      | )                                        | $          | (0.03 | ) | $ | (3.93 | ) | $ | 0.61 |   |

 

Thefollowing assumptions were used to calculate the fair values:

 
| ** **                                | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|-------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                                | ** ** | **2005**                                  | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                | ** ** | ** **                                | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| Stock  Options:                           |       |                                      |       |                                     |       |   |   |   |   |
|                                      |       |                                      |       |                                     |       |   |   |   |   |
| Expected  remaining term in years         |       | 4.00                                      |       | 3.00                                     |       | 3.18 |   | 3.00 |   |
| Weighted  average risk-free interest rate |       | 3.96                                      | %          | 2.35                                     | %          | 3.78 | % | 2.76 | % |
| Expected dividend  rate                   |       | 0.00                                      | %          | 0.00                                     | %          | 0.00 | % | 0.00 | % |
| Volatility                                |       | 71.00                                     | %          | 56.50                                    | %          | 65.67 | % | 59.00 | % |

 

9

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**5.****                                                                                     ****COMPREHENSIVE INCOME:**

 

The reconciliation of netincome to comprehensive income for the three and nine months ended September 30,2005 and 2004 is as follows:

 
| ** **                             | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|----------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| **(in thousands)**                     | ** ** | **2005**                                  | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                   |       |                                      |       |                                     |       |   |   |   |   |
| Net income  (loss)                     |       | $                                         | (402,661   | )                                        | $          | 4,987 |   | $ | (439,367 | ) | $ | 103,616 |   |
| Unrealized  gain (loss) on investments |       | (22                                       | )          | (1,829                                   | )          | (30 | ) | (1,350 | ) |
| Foreign  currency translation          |       | 12,570                                    |       | (550                                     | )          | 12,014 |   | (48 | ) |
| Total  comprehensive income            |       | $                                         | (390,113   | )                                        | $          | 2,608 |   | $ | (427,383 | ) | $ | 102,218 |   |

 

**6.****                                                                                     ****CASH, CASH EQUIVALENTS ANDSHORT-TERM********INVESTMENTS:**

 

Cash and cash equivalentsconsist of instruments with maturities of three months or less at the date ofpurchase. There were no available-for-sale securities included in cash and cashequivalents at September 30, 2005 or December 31, 2004. Short-terminvestments, consisting entirely of available-for-sale securities, were$15.1 million and $136.3 million at September 30, 2005 and December 31,2004, respectively. These available-for-sale securities consist ofgovernment-backed notes, commercial paper, floating rate corporate bonds andfixed income corporate bonds. These investments are recorded at fair value. Anyunrealized holding gains or losses are reported as a component of comprehensiveincome. Realized gains and losses are reported in earnings.

 

The Company accepts banknotes receivable with maturity dates of between three and six months from itscustomers in China in the normal course of business.  Such bank notes are negotiable instrumentsand classified as short-term investments. The Company may discount these notes with banking institutions inChina.  A sale of these notes isreflected as a reduction of short-term investments and the proceeds of thesettlement of these notes are included in cash flows from investing activitiesin the consolidated statement of cash flows. Bank notes totaling $73.1 millionwere sold during the nine months ended September 30, 2005.  None were sold during the three months ended September 30,2005 nor for the three and nine months ended September 30, 2004. Anynotes that have been sold are not included in the Company’s consolidatedbalance sheets as the criteria for sale treatment established by Statement ofFinancial Accounting Standards No. 140, “Accounting for Transfers andServicing of Financial Assets and Extinguishment of Liabilities” (“SFAS 140”),have been met. Under SFAS 140, upon a transfer, the transferor or entitymust derecognize 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.  Thecost of settling these notes receivable was $0.6 million for the nine monthsended September 30, 2005.

 

**7.****                                                                                     ****SHORT-TERM********RESTRICTED CASH ANDINVESTMENTS:**

 

At September 30, 2005,the Company had short-term restricted cash and investments of $36.9 millioncomprised of restricted cash held for standby letters of credit.  At December 31,2004, the Company had restricted cash and short-term investments of $33.3million primarily comprised of $24.3 million of restricted cash and $8.6million of restricted short-term investments for standby letters of credit.

 

The Company issues standbyletters of credit primarily to support international sales activities outsideof China. When the Company submits a bid for a sale, often the potentialcustomer will require that the Company issue a bid bond or a standby letter ofcredit to demonstrate its commitment through the bid process.  Inaddition, the Company may be required to issue standby letters of credit asguarantees for advance customer payments upon contract signing or performanceguarantees. The standby letters of credit usually expire six to nine monthsfrom date of issuance without being drawn by the beneficiary thereof. Finally,the Company may issue commercial letters of credit in support of purchasecommitments.

 

**8**.                                                                                      **ACCOUNTS AND NOTES RECEIVABLE****:**

 

TheCompany accepts commercial notes receivable with maturity dates of betweenthree and six months from its customers in China in the normal course ofbusiness. Notes receivable available for sale was $22.9 million and $27.0million at September 30, 2005 and December 31, 2004, respectively.The Company may discount these notes with banking institutions in China. A saleof these notes is reflected as a reduction of notes receivable and the proceedsof the settlement of these notes are included in cash flows from operatingactivities in the consolidated statement of cash flows.  Any notes that have been sold are notincluded in the Company’s consolidated balance sheets as the criteria for saletreatment established by SFAS 140, has been met. There were no notes receivablesold during the three and nine months ended September 30, 2005 and 2004.

 

10

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On August 1, 2005, theCompany entered into a Committed Receivables Purchase Agreement (“Agreement”)with a commercial bank, whereby the Company may sell up to $100.0 million ofits eligible accounts receivable, as defined in the Agreement.  The Agreement contains provisions customaryin transactions of this nature including certain commitment fees.  As of September 30, 2005, no receivableshad been sold and pursuant to provisions of the Agreement, the Company recordedcommitment fees amounting to $0.1 million.

 

**9**.                                                                                      **INVENTORIES:**

 

As of September 30,2005 and December 31, 2004, total inventories consisted of the following:

 
| ** **                                       | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| **(in thousands)**                               | ** ** | **2005**               | ** ** | **2004**              | ** ** |
| ** **                                       | ** ** | ** **             | ** ** | ** **            | ** ** |
| Inventories:                                     |       |                   |       |                  |       |
|                                             |       |                   |       |                  |       |
| Raw  materials                                   |       | $                      | 86,568     |                  | $          | 154,977 |   |
| Work-in-process                                  |       | 36,792                 |       | 65,551                |       |
| Finished  goods                                  |       | 280,691                |       | 271,357               |       |
| Inventories  at customer sites without contracts |       | 70,434                 |       | 98,947                |       |
| Total  Inventories                               |       | $                      | 474,485    |                  | $          | 590,832 |   |

 

**10.****                                                                              ****ACQUISITIONS:**

 

*Pedestal*

 

OnMay 13, 2005, the Company completed its acquisition of substantially allof the assets and certain liabilities of Pedestal Networks, Inc. (“Pedestal”).  Pedestal develops and designs UniversalBroadband Server (“UBS”), an environmentally hardened, line-powered remoteIP-based Digital Subscriber Line Access Multiplexer (“IP DSLAM”).  The acquisition was intended to assist in theCompany’s expansion into digital subscriber line (“DSL”) and IP-basedtelevision (“IPTV”) by providing the Company with a strong remote broadbandsolution that is fully US-certified and complements other existing DSL, IPTVand optical product families.  The totalconsideration for this transaction was $3.0 million.  Approximately $2.6 million in cash was paidat the closing date and an additional $0.4 million in cash is payable one yearfrom the closing date in the absence of a material breach of the originalcontractual terms. The acquisition was accounted for under the purchase methodof accounting.

 

Theexisting technology acquired included the entire Pedestal family of IP DSLAMand UBS.  The Company intends tointegrate the Pedestal product line with the Company’s Triple-Play products andIPTV solutions.  In addition to developedproduct technology, the Company acquired fixed assets, in-process research anddevelopment (“IPR&D”) and customer relationships.

 

Atthe acquisition, Pedestal had one project under development related to thegigabit ethernet product that qualified for IPR&D.  The gigabit ethernet project is focused onsupporting a majority of Pedestal’s products and is considered 80% complete asof September 30, 2005.  In assessingPedestal’s IPR&D project, the Company considered key product characteristicsincluding the product’s development stage at the acquisition date, the product’slife cycle and the product’s future prospects. The Company also considered the rate at which technology changes in thebroadband equipment industry, the industry’s competitive environment and theeconomic outlook for both local and global markets.  The amount of the purchase price allocated toIPR&D of $0.7 million was charged to the Company’s results of operations.

 

Theresults of operations of Pedestal have been integrated with the “Broadband”segment and included in the Company’s Consolidated Statements of Operationsbeginning on the acquisition date of May 13, 2005.  The pro forma effects of this acquisition onthe Company’s financial statements are not significant.

 

Subsequentto the May 13, 2005 acquisition of Pedestal, the Company completed theallocation of the purchase price based in part upon an independentvaluation.  The estimated useful lives ofthe customer relationships and developed technology intangible assets are twoyears and five years, respectively.

 

11

----

 

Thefollowing table summarizes the final allocation of the purchase price forPedestal based, in part, upon the final independent valuation:

 
| **(in thousands)**                           | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|
| ** **                                   | ** ** | ** ** | ** ** |
| Fair value  of tangible assets               |       | $          | 1,177      |   |
| Fair value  of liabilities assumed           |       | (297       | )          |
| Fair value  of identified intangible assets: |       |       |       |
| Developed technology                         |       | 1,319      |       |
| IPR&D                                    |       | 660        |       |
| Customer relationships                       |       | 141        |       |
| Total  purchase price                        |       | $          | 3,000      |   |

 

*Giga*

 

OnOctober 29, 2004, the Company entered into an asset purchase agreementwith Giga Telecom, Inc. (“Giga”), a Korean corporation that develops anddesigns wireless handsets. The acquisition is intended to facilitate theCompany’s expansion into the CDMA handset market. The Company completed theacquisition on January 4, 2005. At the closing, $13.0 million in cash waspaid, and an additional $2.0 million was paid into an escrow account for sixmonths which was released in July, 2005. The total consideration for the acquisition, funded from cash on hand,was approximately $18.9 million, including $2.0 million in acquisition-relatedtransaction costs, a $1.5 million payment made previously to be applied againstthe purchase price and an earn-out of $0.5 million paid subsequently uponcompletion of certain product design milestones. 

 

Thefollowing table summarizes the allocation of the purchase price for Giga based,in part, upon an independent valuation:

 
| **(in thousands)**                                                                              | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|------------|------------|
|                                                                                            |       |       |       |
| Fair value  of tangible net assets                                                              |       | $          | 458        |   |
| Fair value  of identified intangible assets:                                                    |       |       |       |
| Existing technology                                                                             |       | 1,200      |       |
| Pre-existing royalty agreement                                                                  |       | 1,920      |       |
| Excess of costs of acquiring Giga over fair  value of identified net assets acquired (goodwill) |       | 15,371     |       |
|                                                                                            |       |       |       |
| Total  purchase price                                                                           |       | $          | 18,949     |   |

 

Theexcess of the purchase price over the fair value of the identified net assetsof approximately $15.4 million was allocated to goodwill and assigned to theHandsets segment.  The goodwill createdin this acquisition results from the decreased time to market and designrelated synergies.  This goodwill waswritten off in September 2005 as a result of the intangible and otherlong-lived asset impairment.  Foradditional information regarding the intangible and other long-lived assetsimpairment, refer to Note 11, Goodwill and Intangible Assets.

 

Inaccordance with EITF No. 04-1, “Accounting for Preexisting Relationshipsbetween the Parties to a Business Combination,” a settlement gain of $0.4million relating to the pre-existing royalty agreement was recognized andrecorded under Research and Development expense in the Consolidated Statementsof Operations. The purchased existing technology and pre-existing royaltyagreement are to be amortized within a year.

 

Theresults of operations of Giga have been integrated with the “Handsets” segmentand included in the Company’s Consolidated Statement of Operations subsequentto the acquisition.  The pro formaeffects of this acquisition on the Company’s financial statements are not significant.

 

**11****.                          GOODWILL ANDINTANGIBLE ASSETS:**

 

Intangible assets classified asgoodwill and those with indefinite lives are not amortized.  Intangible assets with determinable lives areamortized over their estimated useful lives. The Company performs an annual impairment test of its goodwill as ofNovember 1st of each year. The Company also tests for impairment between annual tests if a“triggering” event occurs that may have the effect of reducing the fair valueof a reporting unit below their respective carrying values.  When conducting its goodwill impairmentanalysis, the Company calculates its impairment charges based on the two-steptest prescribed in SFAS 142, “Goodwill and Other Intangible Assets” (“SFAS142”) and using the estimated fair value of the respective reportingunits.  The Company uses the presentvalue of future cash flows from the respective reporting units to determine theestimated fair value of the reporting unit and the implied fair value ofgoodwill. The Company also tests its long-lived assets in the Company’s assetsgroups for potential impairment in accordance with SFAS 144, “Accounting forthe Impairment or Disposal of Long-lived Assets.” (“SFAS 144”)  The Company’s long-lived assets are testedfor recoverability based on undiscounted cash flows, and if impaired, writtendown to fair value based on either discounted cash flows or appraised values.

 

12

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The Company held a series ofplanning meetings in September 2005 to assess the current business forecastsfor all of its reporting units.  Thisassessment analyzed various factors including a reduction in the rate of growthof PAS subscribers in the third quarter, a delay of the expected granting of 3Glicenses in China and Japan, challenges with product quality primarily in theCompany’s Broadband reporting unit, a narrowing of the Company’s strategicfocus related to the Company’s product offerings and greater than expectedrevenue and margin decline due to continued pricing pressures for several ofthe Company’s key markets. The Company concluded these factors combined representeda triggering event.

 

The Company determined that thesignificant adverse changes in the business outlook could indicate the carryingvalue of certain of its long-lived assets groups may not be recoverable andcould indicate the fair value of the Company’s reporting units may be belowtheir fair value.  As a result, theCompany performed interim impairment tests on goodwill and certain other long-livedtangible and intangible assets.

 

*Goodwill:*

 

The Company performed animpairment analysis pursuant to SFAS 142 as of September 30, 2005 for all ofits reporting units.  The Companycompared the fair value of the reporting units to their carrying value.  The Company determined the fair value of eachreporting unit using both present value and comparable company techniquesbased, in part, upon an independent valuation. The fair values of the reporting units were reconciled to the Company’soverall market capitalization at September 30, 2005.

 

As of September 30, 2005, theCompany has not completed the second step of the goodwill impairment test forits Wireless and PCD units. However, the Company has used its best estimate toassess the goodwill impairment for these two units. The Company expects tocomplete the second step test of the goodwill impairment analysis for itsWireless and PCD units in the fourth quarter of 2005 and any adjustment basedon the completion of the measurement of the impairment analysis will berecognized in the fourth quarter of 2005.

 

Based on the impairmentassessment noted above, a goodwill impairment charge of $192.9 million has beenestimated and was recorded during the three months ended September 30, 2005 towrite off the full value of goodwill for the Wireless, Broadband, Handsets andPCD business units.

 

The beginning of year goodwillreallocation and changes to the carrying value of the Company’s goodwill fromJanuary 1, 2005 through September 30, 2005 are reflected below:

 
| **(in thousands)**                | ** ** | **Goodwill** | ** ** |
|-----------------------------------|------------|--------------|------------|
| ** **                        | ** ** | ** **   | ** ** |
| December 31,  2004:          | ** ** | ** **   | ** ** |
| ** **                        | ** ** | ** **   | ** ** |
| China                             |       | $            | 118,787    |   |
| International                     |       | 37,132       |       |
| Personal  Communications Division |       | 24,708       |       |
| Total                             |       | $            | 180,627    |   |

 
| ** **         | ** ** | **January 1,** | ** ** | ** **    | ** ** | **Exchange**     | ** ** | ** **     | ** ** | **September 30,** | ** ** |
|--------------------|------------|---------------------|------------|---------------|------------|------------------|------------|----------------|------------|------------------------|------------|
| **(in thousands)** | ** ** | **2005**            | ** ** | **Additions** | ** ** | **rate changes** | ** ** | **Impairment** | ** ** | **2005**               | ** ** |
| ** **         | ** ** | ** **          | ** ** | ** **    | ** ** | ** **       | ** ** | ** **     | ** ** | ** **             | ** ** |
| Handsets           |       | $                   | 74,003     |          | $          | 15,371           |       | $              | (37        | )                      | $          | (89,337 | ) | $ | — |   |
| Wireless           |       | 55,641              |       | —        |       | 29               |       | (55,670        | )          | —                 |       |
| PCD                |       | 24,710              |       | —        |       | 2                |       | (24,712        | )          | —                 |       |
| Broadband          |       | 23,210              |       | —        |       | —           |       | (23,210        | )          | —                 |       |
| Service            |       | 3,063               |       | —        |       | —           |       | —         |       | 3,063                  |       |
| Total              |       | $                   | 180,627    |          | $          | 15,371           |       | $              | (6         | )                      | $          | (192,929 | ) | $ | 3,063 |   |

 

 

13

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* *

*Long-livedAssets:*

 

The Company also tested itslong-lived assets in all of the Company’s assets groups for potentialimpairment during the current quarter in accordance with SFAS 144.  Based on this analysis, the Companydetermined that the undiscounted expected future cash flows for the Broadbandand Handset asset groups were less than the carrying value of their net assets.

 

The Company determinedthe relative estimated fair value of tangible assets through a comparison ofsimilar assets, and wherever practical, based on quoted market prices takinginto consideration the asset type, age, condition, and physical location of theasset. As a result of this analysis, the Company recorded an impairment chargeof $14.1 million for long-lived tangible assets related to the Broadband assetgroup and $9.4 million for long-lived tangible assets related to the Handsetasset group.

 

In addition, the Companydetermined that the fair value of technology intangible assets within theBroadband and Handset asset groups as calculated using the discounted futurecash flows was less than the carrying value of the net assets and as such, theCompany recorded a net asset write-off of $1.7 million.

 

As of September 30, 2005 andDecember 31, 2004, intangible assets consisted of the following:

 
| ** **                      | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------|------------|------------------------|------------|-----------------------|------------|
| **(in thousands)**              | ** ** | **2005**               | ** ** | **2004**              | ** ** |
| Intangible  assets:             |       |                   |       |                  |       |
|                            |       |                   |       |                  |       |
| Existing  technology            |       | $                      | 39,530     |                  | $          | 39,530 |   |
| Less  accumulated amortization  |       | (20,042                | )          | (14,933               | )          |
|                            |       | $                      | 19,488     |                  | $          | 24,597 |   |
|                            |       |                   |       |                  |       |
| Customer  relationships         |       | $                      | 57,220     |                  | $          | 57,220 |   |
| Less  accumulated amortization  |       | (10,391                | )          | (5,455                | )          |
|                            |       | $                      | 46,829     |                  | $          | 51,765 |   |
|                            |       |                   |       |                  |       |
| Supplier  relationships         |       | $                      | 5,300      |                  | $          | 5,300 |   |
| Less  accumulated amortization  |       | (2,429                 | )          | (442                  | )          |
|                            |       | $                      | 2,871      |                  | $          | 4,858 |   |
|                            |       |                   |       |                  |       |
| Trade names                     |       | $                      | 4,940      |                  | $          | 4,940 |   |
| Less  accumulated amortization  |       | (2,162                 | )          | (966                  | )          |
|                            |       | $                      | 2,778      |                  | $          | 3,974 |   |
|                            |       |                   |       |                  |       |
| Backlog                         |       | $                      | 5,150      |                  | $          | 5,150 |   |
| Less accumulated  amortization  |       | (4,884                 | )          | (2,483                | )          |
|                            |       | $                      | 266        |                  | $          | 2,667 |   |
|                            |       |                   |       |                  |       |
| Non-compete  agreement          |       | $                      | 10,800     |                  | $          | 10,800 |   |
| Less  accumulated amortization  |       | (2,475                 | )          | $                     | (450       | ) |
|                            |       | $                      | 8,325      |                  | $          | 10,350 |   |
|                            |       |                   |       |                  |       |
| Pre-existing  royalty agreement |       | $                      | 218        |                  | $          | — |   |
| Less  accumulated amortization  |       | —                 |       | —                |       |
|                            |       | $                      | 218        |                  | $          | — |   |
|                            |       |                   |       |                  |       |
| Total  intangible assets        |       | $                      | 80,775     |                  | $          | 98,211 |   |

 

 

Amortization expense was$6.6 million and $3.6 million for the three months ended September 30,2005 and 2004, respectively, and was $20.4 million and $9.9 million forthe nine months ended September 30, 2005 and 2004, respectively.  The estimated aggregate amortization expensefor intangibles for each of the five years from the year endedDecember 31, 2006 through the year ended December 31, 2010 is$18.9 million, $16.0 million, $12.7 million, $6.9 millionand $5.1 million, and is $15.7 million in the aggregate thereafter.

 

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The weighted averageamortization period for each class of unamortized identifiable intangibleassets include the following:

 
| **(in years)**                  | ** ** | **Weighted Average Life** | ** ** |
|---------------------------------|------------|---------------------------|------------|
| ** **                      | ** ** | ** **                | ** ** |
| Technology                      |       | 2.9                       |       |
| Customer  relationships         |       | 7.1                       |       |
| Supplier  relationships         |       | 1.1                       |       |
| Trade names                     |       | 2.1                       |       |
| Backlog                         |       | 0.1                       |       |
| Non-compete                     |       | 3.1                       |       |
| Pre-existing  royalty agreement |       | 0.3                       |       |
| Total                           |       | 3.4                       |       |

 

**12.****                                                                              ****LONG-TERM INVESTMENTS:**

 

The Company’s investmentsare as follows:

 
| ** **                     | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------|------------|------------------------|------------|-----------------------|------------|
| **(in thousands)**             | ** ** | **2005**               | ** ** | **2004**              | ** ** |
| ** **                     | ** ** | ** **             | ** ** | ** **            | ** ** |
| Softbank  China                |       | $                      | 5,294      |                  | $          | 5,294 |   |
| Cellon  International          |       | 8,000                  |       | 8,000                 |       |
| Restructuring  Fund No. 1 |       | 2,508                  |       | 1,836                 |       |
| Global Asia  Partners L.P.     |       | 1,701                  |       | 1,150                 |       |
| Fiberxon  Inc.                 |       | 3,000                  |       | 3,000                 |       |
| Immenstar                      |       | 2,000                  |       | 2,000                 |       |
| Matsushita  Joint Venture      |       | 5,604                  |       | 7,959                 |       |
| GCT  SemiConductor             |       | 3,000                  |       | 3,000                 |       |
| Xalted  Networks               |       | 3,000                  |       | —                |       |
| Infinera                       |       | 1,902                  |       | 1,902                 |       |
| Others                         |       | 1,418                  |       | 1,449                 |       |
|                           |       |                   |       |                  |       |
| Total                          |       | $                      | 37,427     |                  | $          | 35,590 |   |

 

 

15

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*SoftbankChina*

 

The Company has a$5.3 million investment in Softbank China, an investment fund establishedby SOFTBANK CORP. focused on investments in Internet companies in China. Thisinvestment is intended to enable the Company to participate in the anticipatedgrowth of Internet-related businesses in China. SOFTBANK CORP. and its relatedcompanies are significant stockholders of the Company. The Company’s investmentconstitutes 10% of the funding for Softbank China, with SOFTBANK CORP.contributing the remaining 90%. The fund has a separate management team, andnone of the Company’s employees are employed by the fund. Many of the fund’sinvestments are and will be in privately held companies, many of which arestill in the start-up or development stages. These investments are inherentlyrisky as the markets for the technologies or products the companies have underdevelopment are typically in the early stages and may never materialize. TheCompany accounts for this investment under the cost method. For additionalinformation regarding transactions with SOFTBANK CORP., refer to Note 18,Related Party Transactions.

 

*CellonInternational*

 

In September 2001, theCompany invested $2.0 million in Cellon International Holdings Corporation (“Cellon”). Cellon designs wireless terminals and related technology for handsetmanufacturers and private distributors. The Company invested an additional $3.0million in each of April and December 2002. As of September 30,2005, the Company had a 9% ownership interest in Cellon. This investment isaccounted for under the cost method, and its carrying value is evaluated forpossible impairment based on the achievement of business objectives andmilestones, the financial condition and prospects of the company and otherrelevant factors. As of September 30, 2005, the Company has not recordedany impairment of this investment. The Company has outstanding purchasecommitments with Cellon.  For additionalinformation regarding transactions with Cellon, refer to Note 18, Related PartyTransactions.  

 

*RestructuringFund No. 1*

 

During fiscal 2002, theCompany invested $2.0 million in Restructuring Fund No. 1, a venturecapital investment limited partnership established by SOFTBANK INVESTMENTCORP., an affiliate of SOFTBANK CORP. SOFTBANK America Inc., an entityaffiliated with SOFTBANK CORP., is a significant stockholder of the Company.The fund focuses on leveraged buyout investments in companies in Asiaundergoing restructuring or bankruptcy procedures. The total fund offering isexpected to be between approximately $150.0 million and$226.0 million, with each investor contributing a minimum of $0.8 million.The fund has a separate management team, and none of the Company’s employeesare employed by the fund. The Company accounts for this investment under theequity method of accounting.  The Companyhad insignificant gain and loss for the three months ended September 30,2005 and recorded $0.7million of equity gain for the nine months ended September 30, 2005.  No significant gains or losses were recordedduring the three and nine months ended September 30, 2004.

 

*GlobalAsia Partners, L.P.*

 

The Company invested $1.0 millionin Global Asia Partners L.P. in June 2002, $1.0 million in June 2003and an additional $0.5 million in the second quarter of 2005, and has acommitment to invest up to a maximum of $5.0 million. The remaining amountis due at such times and in such amounts as shall be specified in one or morefuture capital calls to be issued by the general partner. The fund size isanticipated to be $10.1 million and the fund was formed to make privateequity investments in private or pre-IPO technology and telecommunicationscompanies. The fund’s geographic focus is on technology investments in Asia, inparticular in India and China. The Company accounts for this investment underthe equity method of accounting.   Therewere no gains or losses for the three and nine months ended September 30,2005.  There were no losses and $0.5million of losses recorded during the three and nine months ended September 30,2004 respectively.

 

*FiberxonInc.*

 

In September 2002, theCompany invested $2.0 million in Fiberxon, Inc. (“Fiberxon”), a companythat develops and sells optical modules and related systems. In March 2004,the Company invested an additional $1.0 million in Fiberxon. This investment isaccounted for under the cost method, and its carrying value is evaluated forpossible impairment based on the achievement of business objectives andmilestones, the financial condition and prospects of the company and otherrelevant factors. As of September 30, 2005, the Company had not recordedany impairment in respect of this investment. For additional informationregarding transactions with Fiberxon, refer to Note 18, Related PartyTransactions.

 

*MatsushitaJoint Venture*

 

In July 2002, theCompany entered into a joint venture agreement with Matsushita CommunicationIndustrial Co., Ltd., a stockholder of the Company, to jointly design anddevelop, manufacture and sell telecommunication products. The Company has a 49%ownership interest in the joint venture company, which has a registered sharecapital of $10.0 million. The cash

 

16

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consideration of$4.9 million payable by the Company was paid in October 2002. As theCompany does not have voting control over significant matters of the jointventure company, the investment in and results of operations of the jointventure company are accounted for using the equity method of accounting.  During the fourth quarter of 2004, theCompany contributed an additional $9.3 million (its 49% of the $19 millioncapital call) to the joint venture.  TheCompany recorded equity losses of $0.9 million and $2.5 million for the threeand nine months ended September 30, 2005, respectively and $0.7 millionand $2.9 million for the three and nine months ended September 30, 2004,respectively.  

 

*XaltedNetworks*

 

In May 2005, theCompany invested $2.0 million in Xalted Networks (“Xalted”) and in August 2005the Company invested an additional $1.0 million.  Xalted is a development stage companyproviding telecommunication operator customers with a comprehensive set ofnetwork systems, software solutions and service offerings.  The Company has less than a 10% ownershipinterest in Xalted and accounts for the investment under the cost method.

 

**13.****                                                                              ****DEBT:**

 

The following represents theoutstanding borrowings at September 30, 2005 and December 31, 2004:

 
| ** **                      | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------|------------|------------------------|------------|-----------------------|------------|
| **(in thousands)**              | ** ** | **2005**               | ** ** | **2004**              | ** ** |
| ** **                      | ** ** | ** **             | ** ** | ** **            | ** ** |
| Notes  payable                  |       | $                      | 93         |                  | $          | 1,183 |   |
| Bank loans                      |       | 226,607                |       | 358,155               |       |
| Convertible  subordinated notes |       | 274,600                |       | 402,500               |       |
|                            |       |                   |       |                  |       |
| Total debt                      |       | $                      | 501,300    |                  | $          | 761,838 |   |
| Long-term  debt                 |       | 274,900                |       | 410,655               |       |
| Short-term  debt                |       | $                      | 226,400    |                  | $          | 351,183 |   |

 

At September 30, 2005,the Company had loans with various banks totaling $218.0 million with interestrates ranging from 3.58% to 5.02% per annum. These bank loans mature within twelve months and are included inshort-term debt.

 

The Company has a bank loanin connection with an equipment purchase resulting from the consolidation ofMDC Holding Limited and its affiliated entities (“MDC”).  On January 10, 2003, a third partyestablished a bank loan with Shanghai Pudong Development Bank for the purchaseof the equipment.  The obligations of thebank loan and related equipment were assumed by the Company on January 23,2003, and subsequently transferred to MDC on December 31, 2003.  The bank loan of $8.3 million bears interestat a rate of 4.94% per annum, and expires on January 10, 2006.  The Company does not serve as legal obligorfor the loan.

 

The Company has a bank loanin connection with a joint venture which the Company consolidated.  As of September 30, 2005, the bank loanamounts to $0.3 million, at an interest rate of 9.00% per annum, and expires inJune 2008.  The Company does notserve as legal obligor for the loan.

 

The Company had availableborrowing facilities of $589.6 million for future borrowings as of September 30,2005. $283.5 million of these facilities expire in 2005 and $306.1 millionof these facilities expire in 2006 with interest rates ranging from 3.58% to5.02%. The Company has not guaranteed any debt not included in the consolidatedbalance sheet.

 

On March 12, 2003, theCompany completed an offering of $402.5 million of convertiblesubordinated notes (the “Notes”) due March 1, 2008 to qualified buyerspursuant to Rule 144A under the Securities Act of 1933, as amended. TheNotes bear interest at a rate of 7/8% per annum and are convertible into theCompany’s common stock at a conversion price of $23.79 per share and aresubordinated to all present and future senior debt of the Company. Holders ofthe notes may convert their notes only if: (i) the price of the Company’scommon stock issuable upon conversion of a note reaches a specified threshold, (ii) specifiedcorporate transactions occur, or (iii) the trading price for the notesfalls below certain thresholds. At the initial conversion price, each $1,000principal amount of notes will be convertible into 42.0345 shares of commonstock. Expenses associated with the convertible subordinated notes issuancewere $11.1 million and have been recorded in other long-term assets and arebeing amortized over the life of the notes.

 

Inthe second quarter of 2005, the Company entered into an agreement to exchange1,482,000 shares of Company’s common stock with a fair value of approximately$10.6 million and approximately $15.8 million in cash for $38.0 millionaggregate principal amount of its outstanding Notes with one of its noteholders.  In the third quarter of 2005,the Company completed

 

17

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fouradditional exchanges wherein the Company exchanged a total of 3,506,100 sharesof the Company’s common stock with a fair value of approximately $27.0 millionand approximately $41.4 million in cash for $89.9 million aggregate principalamounts of its notes.  These exchangesare considered an early extinguishment of debt in which the aggregate fairvalue of the common stock and cash is less than the carrying value of theNotes.  Accordingly, the Company recordeda gain, net of write-off of unamortized issuance expenses, of $20.3 million and$31.4 million for the three and nine months ended September 30, 2005,respectively, on such extinguishment in accordance with the provisions of APB26, “Early Extinguishment of Debt”, and SFAS 145, “Rescission of FASB StatementsNo. 4, 44, and 64, Amendment of FASB Statement No. 13, and TechnicalCorrections.”

 

Concurrent with the issuanceof the Notes in March 2003, the Company entered into a convertible bondhedge and call option transaction at a cost of $43.8 million. The convertiblebond hedge allowed the company to purchase 16.9 million shares of its commonstock at $23.79 per share from the other party to the agreement. The writtencall option allowed the holder to purchase 16.9 million shares of the Company’scommon stock from the Company at $32.025 per share. Both the bond hedge andcall option transactions may be settled at the Company’s option either in cashor net shares and expire on March 1, 2008.

 

Theconvertible bond hedge and call option were amended as a result of theaforementioned early extinguishment of the Notes.  As part of the amendment, the Companyreceived proceeds of $0.5 million and $1.4 million during the three and ninemonths ended September 30, 2005, respectively, which were recorded againstadditional paid-in capital. Theamended 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 purchase 11.5 millionshares of the Company’s common stock from the Company at $32.025 per share.

 

The Company recorded theseinstruments at cost. The convertible bond hedge and call option transactionsare expected to reduce the potential dilution from conversion of the notes. Theoptions have been included in stockholders’ equity in accordance with theguidance in Emerging Issues Task Force Issue No. 00-19, “Accounting forDerivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock.”

 

**14.****                                                                              ****WARRANTY OBLIGATIONS ANDOTHER GUARANTEES:**

 

Warranty obligations are asfollows:

 
| ** **                                        | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|---------------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| **(in thousands)**                                | ** ** | **2005**                                  | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                              |       |                                      |       |                                     |       |   |   |   |   |
| Beginning of  period                              |       | $                                         | 58,586     |                                     | $          | 34,236 |   | $ | 46,596 |   | $ | 26,267 |   |
| Accruals for  warranties issued during the period |       | 15,260                                    |       | 12,949                                   |       | 47,828 |   | 38,049 |   |
| Settlements  made during the period               |       | (18,196                                   | )          | (11,425                                  | )          | (38,774 | ) | (28,556 | ) |
| Balance at  end of period                         |       | $                                         | 55,650     |                                     | $          | 35,760 |   | $ | 55,650 |   | $ | 35,760 |   |

 

*Warranty obligations:*

 

During thethird quarter 2005, the Company has continued to experience product repairissues.  As such the Company has recordedadditional warranty charges of approximately $9.0 million primarily related toNetRing and iAN8000 equipment sold to Japan Telecom, an affiliate of SOFTBANKCORP and SOFTBANK America Inc. During the first quarter 2005, the Company incurreda special warranty charge for certain asynchronous digital subscriber line(“ADSL”) equipment sold to SBBC, an affiliate of SOFTBANK CORP and SOFTBANKAmerica Inc., during 2003 and 2004. Since the agreement to repair these partsexceed the Company’s normal warranty terms, the Company recorded an additional specialwarranty coverage in the first quarter of $9.5 million. 

 

*Other:*

 

Certain of the Company’ssales contracts include provisions under which customers would be indemnifiedby the Company in the event of, among other things, a third-party claim againstthe customer for intellectual property rights infringement related to the Company’sproducts. There are no limitations on the maximum potential future paymentsunder these guarantees. The Company has not accrued any amount in relation tothese provisions as no such claims have been made and the Company believes ithas valid, enforceable rights to the intellectual property embedded in itsproducts.

 

18

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**15.****                                                                              ****COMMITMENTS ANDCONTINGENCIES:**

 

*Leases:*

 

The Company leases certainfacilities under non-cancelable operating leases that expire at various datesthrough 2010.  The minimum future leasepayments under the leases at September 30, 2005 were as follows:

 
| **(in thousands)**            | ** ** | **September 30, 2005** | ** ** |
|-------------------------------|------------|-----------------------------|------------|
| ** **                    | ** ** | ** **                  | ** ** |
| 1 year                        |       | $                           | 22,630     |   |
| 2 year                        |       | 11,468                      |       |
| 3 year                        |       | 7,146                       |       |
| 4 year                        |       | 4,797                       |       |
| 5 year and  after             |       | 2,634                       |       |
|                          |       |                        |       |
| Total  minimum lease payments |       | $                           | 48,675     |   |

 

Rent expense for the threeand nine months ended September 30, 2005 were $5.2 million and $16.2million, respectively.

 

Other contractualobligations and commitments were as follows:

 
| ** **                              | ** ** | **September 30, 2005** | ** ** |
|-----------------------------------------|------------|-----------------------------|------------|
| ** **                              | ** ** | **Payments Due by Period**  | ** ** |
| ** **                              | ** ** | ** **                  | ** ** | **Less than** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **(in thousands)**                      | ** ** | **Total**                   | ** ** | **1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** |
|                                    |       |                        |       |   |   |   |   |   |   |
| Notes  payable                          |       | $                           | 93         |   | $ | 93 |   | $ | — |   | $ | — |   |
| Bank loans                              |       | $                           | 226,607    |   | $ | 226,307 |   | $ | 300 |   | $ | — |   |
| Convertible  subordinated notes         |       | $                           | 274,600    |   | $ | — |   | $ | 274,600 |   | $ | — |   |
| Interest  payable on subordinated notes |       | $                           | 6,007      |   | $ | 2,403 |   | $ | 3,604 |   | $ | — |   |
| Standby  letters of credit              |       | $                           | 50,657     |   | $ | 50,168 |   | $ | 489 |   | $ | — |   |

 

*Notes payable*

 

Occasionally, the Companyissues short-term notes payable to certain vendors in lieu of trade accountspayable.  The payment terms are normally three to nine months and aretypically non-interest bearing.

 

*Bank loans*

 

At September 30, 2005,the Company had loans with various banks totaling $218.0 million with interestrates ranging from 3.58% to 5.02% per annum. These bank loans mature within twelve months and are included inshort-term debt.

 

The Company has a bank loanin connection with an equipment purchase resulting from the consolidation ofMDC.  On January 10, 2003, a thirdparty established a bank loan with Shanghai Pudong Development Bank for thepurchase of the equipment.  Theobligations of the bank loan and related equipment were assumed by the Companyon January 23, 2003, and subsequently transferred to MDC on December 31,2003.  The bank loan of $8.3 millionbears interest at 4.94% per annum, and expires on January 10, 2006.  The Company does not serve as legal obligorfor the loan.

 

The Company has a bank loanin connection with one of the Company’s consolidated joint ventures.  As of September 30, 2005, the bank loanamounts to $0.3 million, bears interest at a rate of 9.00% per annum, andexpires on June 15, 2008.  TheCompany does not serve as legal obligor for the loan.

 

*Convertible subordinated notes*

 

As of September 30,2005, the Company had outstanding $274.6 million of convertiblesubordinated notes, due March 1, 2008, that bear interest at a rate of7/8% per annum, payable semiannually on May 1 and September 1, areconvertible into the Company’s common stock at a conversion price of $23.79 pershare and are subordinated to all present and future senior debt of theCompany. The principal is due only at maturity of the notes.  For additional information regarding these notesrefer to Note 13, Debt.

 

*Standby letters of credit*

 

The Company issues standbyletters of credit primarily to support international sales activities outsideof China. When the Company submits a bid for a sale, often the potentialcustomer will require that the Company issue a bid bond or a standby letter ofcredit to demonstrate its commitment through the bid process. In addition, theCompany may be required to issue standby letters of credit as guarantees foradvance customer payments upon contract signing or performance guarantees. Thestandby letters of credit usually expire six to twelve months from the date ofissuance without being drawn by the beneficiary thereof. The Company may issuecommercial letters of credit in support of purchase commitments.

 

19

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*Purchasecommitments*

 

The Company is obligated topurchase raw materials and work-in-process inventory under various orders fromvarious suppliers, all of which should be fulfilled without adverseconsequences material to the operations or financial condition of the Company.As of September 30, 2005, total open commitments under these purchaseorders were approximately $654.1 million which are primarily related topurchase commitments of the PCD business unit.

 

*Investmentcommitments*

 

As of September 30,2005, the Company had invested a total of $2.5 million in Global AsiaPartners L.P. The fund size is anticipated to be $10.1 million and thefund was formed to make private equity investments in private or pre-IPOtechnology and telecommunications companies in Asia. The Company has acommitment to invest up to a maximum of $5.0 million. The remaining amountis due at such times and in such amounts as shall be specified in one or morefuture capital calls to be issued by the general partner.

 

*Intellectual property*

 

Certain sales contractsinclude provisions under which customers would be indemnified by the Company inthe event of, among other things, a third-party claim against the customer forintellectual property rights infringement related to the Company’s products.There are no limitations on the maximum potential future payments under theseguarantees. The Company has not accrued any amounts in relation to theseprovisions as no such claims have been made and the Company believes it has validenforceable rights to the intellectual property embedded in its products.

 

*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.  The actions have been consolidated in UnitedStates District Court for the Northern District of California.  The lead plaintiffs in the case filed a FirstAmended Consolidated Complaint on July 26, 2005.  The First Amended Complaint allegedviolations of the Securities Exchange Act of 1934, and was brought on behalf ofa putative class of shareholders who purchased the Company’s stock after April 16, 2003and before September 20, 2004. In addition to the Company defendants, the plaintiffs also sued Banc ofAmerica Securities LLC and Softbank. The Complaint seeks recovery of damages inan unspecified amount.

 

The plaintiffshave indicated that they will file a motion to amend their complaint.  If the motion to amend is granted, plaintiffsmay file an amended complaint that broadens their claims and the putative classperiod.  The plaintiffs’ motion to amendtheir complaint is due on November 28, 2005.  

 

Thislitigation is in its preliminary stages, and the Company cannot predict itsoutcome.  Management of the Companybelieves that the claims are not meritorious. Nevertheless, an adverse outcome in the litigation, if it occurred,could have a material adverse effect of the Company’s results of operations,financial position or cash flows.  As of September 30,2005, no loss amount has been accrued because a loss is not considered probableor estimable.

 

*Shareholder Derivative Litigation*

 

Beginning in August 2004,several shareholder derivative actions were filed in the Superior Court ofCalifornia for Alameda County.  Theactions alleged claims for breach of fiduciary duty against certain of ourcurrent and former directors and officers and name the Company as a nominaldefendant. The parties have entered into a settlement agreement.  On October 28, 2005, the Court approvedthe parties’ settlement of all claims. The settlement did not have a significant financial impact on operations.

 

*SEC Investigation*

* *

The Companyhas received notice of a formal inquiry by the staff of the Securities &Exchange Commission into certain aspects of the Company’s financialdisclosures. The Company’s Audit Committee, Board of Directors, and managementare fully cooperating in the inquiry.

 

20

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*IPOAllocation*

* *

On October 31,2001, a complaint was filed in United States District Court for the SouthernDistrict of New York against the Company, some of the Company’s directors andofficers and various underwriters for the Company’s initial public offering.  Substantially similar actions were filedconcerning the initial public offerings for more than 300 different issuers,and the cases were coordinated as *In reInitial Public Offering Securities Litigation*, 21 MC 92 for pretrialpurposes.  In April 2002, aconsolidated amended complaint was filed in the matter against the Company,captioned *In re UTStarcom, Initial PublicOffering Securities Litigation*, Civil Action No. 01-CV-9604.  Plaintiffs allege violations of theSecurities Act of 1933 and the Securities Exchange Act of 1934 throughundisclosed improper underwriting practices concerning the allocation of IPOshares in exchange for excessive brokerage commissions, agreements to purchaseshares at higher prices in the aftermarket and misleading analyst reports.  Plaintiffs seek unspecified damages on behalfof a purported class of purchasers of the Company’s common stock between March 2,2000 and December 6, 2000.  TheCompany’s directors and officers have been dismissed without prejudice pursuantto a stipulation.  On February 19,2003, the Court granted in part and denied in part a motion to dismissbrought by defendants including the Company. The order dismisses all claims against the Company except for a claimbrought under Section 11 of the Securities Act of 1933, which alleges thatthe registration statement filed in accordance with the IPO wasmisleading.  In June 2004, astipulation of settlement and release of claims against the issuer defendants,including the Company, was submitted to the court for approval.  The terms of the settlement, if approved,would dismiss and release all claims against the participating defendants(including the Company).  In exchange forthis dismissal, D&O insurance carriers would agree to guarantee a recoveryby the plaintiffs from the underwriter defendants of at least $1 billion, andthe issuer defendants would agree to an assignment or surrender to theplaintiffs of certain claims the issuer defendants may have against theunderwriters.  On February 15, 2005,the Court issued an order granting conditional preliminary approval of thesettlement.  On August 31, 2005, theCourt entered an order confirming its preliminary approval of thesettlement.  The settlement remainssubject to a number of conditions, including final court approval.  The total amount of the loss associated withthe above litigation is not determinable at this time.  Therefore, the Company is unable to currentlyestimate the loss, if any, associated with the litigation.

 

*StarentPatent Infringement Litigations*

 

The Companyhas sued Starent Networks Corporation (“Starent”) for patent infringement inthe U.S. District Court for the Northern District of California.  On March 22, 2004, the Companyfiled its Complaint.  On June 3, 2004,the Company served its Complaint on Starent. On July 30, 2004, Starent filed and served its answer andcounterclaims.  On August 30, 2004,the Company served and filed its Amended Complaint.  In the Company’s Amended Complaint, theCompany asserts that Starent infringes a UTStarcom patent through themanufacture, use, offer for sale, and sale of Starent’s ST-16 IntelligentMobile Gateway.  The Company seeks, interalia, compensatory damages and injunctive relief.  Starent filed its answer to the AmendedComplaint and counterclaims on September 17, 2004.  In its answer and counterclaims, Starentdenies the Company’s allegations and seeks a declaration that thepatent-in-suit is not infringed, is invalid, and is unenforceable.  The Court held an initial case management conferenceon November 2, 2004.  On February 17, 2005,the Company filed a motion for a preliminary injunction against Starent’s use,sale, and offer for sale of products having the infringing feature.  The Court held a hearing on the Company’smotion on May 11, 2005 and denied the Company’s motion on June 17,2005.  On June 30, 2005, the Courtheld a hearing on the proper meaning or construction of the claims of thepatent-in-suit  and entered an orderconstruing these claims on August 11, 2005.  On September 20, 2005, Starent filed amotion for summary judgment of non-infringement and UTStarcom filed a motionfor summary judgment that Starent is estopped from asserting invalidity andunenforceability.  On October 4,2005, Starent filed a motion to strike UTStarcom’s final infringementcontentions.  All three motions arescheduled for oral argument on November 8, 2005.

 

On February 16,2005, the Company filed a second suit against Starent for patent infringementin the U.S. District Court for the Northern District of California.  On May 6, 2005, the Company served theComplaint on Starent.  In the Complaint,the Company asserts that Starent infringes a UTStarcom patent through Starent’sdevelopment and testing of a software upgrade for its customer’s installed ST-16Intelligent Mobile Gateways.  The Companyseeks, inter alia, declaratory and injunctive relief.  Starent filed its answer and counterclaims onMay 31, 2005, denying the Company’s allegations and seeking a declarationthat the patent-in-suit is not infringed, is invalid, and isunenforceable.  On June 16, 2005,the Company filed a motion to strike Starent’s affirmative defense and dismissStarent’s counterclaim alleging inequitable conduct.  On July 19, 2005, the parties stipulatedthat Starent would file an amended answer and counterclaim by July 27,2005 and that the Company would withdraw its motion to strike.

 

*FennerInvestments Patent Infringement Litigation*

 

On January 6, 2005,Fenner Investments, Ltd. (“Fenner”) filed suit against the Company and co-defendantsJuniper Networks, Inc., Nokia, Inc., Nortel Networks Corp., LucentTechnologies, Inc., and Cisco Systems, Inc. in the U.S. DistrictCourt for the Eastern District of Texas. On May 17, 2005, Fenner amendedits complaint to add as defendants Ericsson Inc., Ericsson AB,Telefonaktiebolaget LM Ericsson, and Alcatel USA Inc.  The suit alleges that unspecified productsand services infringe two Fenner patents and seeks compensatory and injunctiverelief.  The Court has scheduled ahearing to construe the claims of the patents-in-suit for February 28,2006.  The Court has also scheduled trialfor October 10, 2006.  This lawsuitis in its initial stage and it is not possible to reliably predict the outcomeor any relief that could be awarded, as the litigation process is inherentlyuncertain.

 

21

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TheCompany is a party to other litigation matters and claims that are normal inthe course of operations, and while the results of such litigation matters and claimscannot be predicted with certainty, the Company believes that the final outcomeof such matters will not have a material adverse impact on its financialposition or results of operations.

 

**16.****                                                                              ****STOCKHOLDERS’ EQUITY:**

 

For the three and ninemonths ended September 30, 2005, net proceeds from the exercise of stockoptions were $0.1 million and $0.8 million, respectively.  For the threeand nine months ended September 30, 2004, the Company had $0.7 million and$14.7 million, respectively, of net proceeds from the exercise of stockoptions.  Total shares purchased through the Company’s Employee StockPurchase Plan were 439,000 and 211,750 for net proceeds of $3.6 million and$3.7 million for the three and nine months ended September 30, 2005 and2004, respectively.

 

The Company issued 3,506,100 and 4,988,100 shares of common stock inconjunction with the debt extinguishment agreement entered into during thethree months and nine months ended September 30, 2005, respectively.  Foradditional information regarding the debt extinguishment refer to Note 13,Debt.  Additional paid-in capitalwas increased by $27.0 million and $37.5 million in connection with the shareissuance and by $0.5 million and $1.4 million related to proceeds received inconnection with the amendment of the convertible bond hedge and call optionduring the three and nine months ended September 30, 2005, respectively.

 

On March 12, 2004, theCompany’s Board of Directors approved a stock repurchase program, authorizingthe Company’s repurchase of up to 5,000,000 shares of its outstanding commonstock over a period of 6 months. The Board approved an additional repurchase of1,623,000 shares in a privately negotiated transaction with an institution,which was completed in March 2004.  There were no shares repurchasedin the three and nine months ended September 30, 2005.

 

**17.****                                                                              ****SEGMENT REPORTING:**

 

TheCompany historically managed its business as a single reportable segment.During 2004, the Company continued to expand its focus on markets and operationsoutside of China. Effective with the fourth quarter of 2004, it was determinedthat the Company’s chief operating decision makers, in accordance with SFAS No. 131,“Disclosures about Segments of an Enterprise and Related Information,” wereevaluating performance, making operating decisions and allocating resourcesbased on two operating segments, (i) China and (ii) all other regionsreferred to as International (“International”).

 

OnNovember 1, 2004, the Company acquired selected assets of the wirelesshandset division of Audiovox Corporation. The acquired business has beenintegrated into the Company as a separate and distinct operating divisionreferred to as the Personal Communications Division (“PCD”). As the Companydetermined to evaluate performance and allocate resources to this division, itwas considered a third operating segment.

 

Asa result, as of December 31, 2004, the Company was organized, principallybased on geographical market locations, in three operating segments, China,International and PCD, and each segment consisted of one reporting unit.

 

Effective in the first quarter of 2005, the Company elected toreorganize its business based principally upon product family and realigned itsbusiness into five operating units, (i) Broadband Infrastructure, (ii) WirelessInfrastructure, (iii) Handsets, (iv) PCD, and (v) Service.  Each operating unit represents its ownreporting segment and each operating unit is responsible for its own worldwideproduction and sales management.

 

TheCompany currently evaluates operating performance of and allocates resources tothe reporting segments based on segment gross profit.  Cost of sales and direct expenses in relationto production are assigned to the reporting segments.  Corporate headquarters expenses andnon-operating items are not allocated to the segments.  The accounting policies used in measuringsegment assets and operating performance are the same as those used bycorporate and are consistently applied across all segments.

 

 

22

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Summarized below are theCompany’s segment sales revenue and gross profit for the three and nine monthsended September 30, 2005 and 2004, respectively, based on the newreporting segment structure.  

 
| ** **                         | ** ** | **Three months ended September 30, 2005** | ** ** | ** **   | ** ** |
|------------------------------------|------------|------------------------------------------------|------------|--------------|------------|
| **(in thousands)**                 | ** ** | **Broadband**                                  | ** ** | **Wireless** | ** ** | **Handsets** | ** ** | **PCD** | ** ** | **Service** | ** ** | **Total** | ** ** |
|                               |       |                                           |       |         |       |   |   |   |   |   |   |   |   |
| Revenue from  external customers   |       | $                                              | 32,934     |         | $          | 113,431 |   | $ | 106,294 |   | $ | 363,637 |   | $ | 19,011 |   | $ | 635,307 |   |
| Gross profit                       |       | (14,086                                        | )          | 32,477       |       | 13,646 |   | 13,199 |   | 8,710 |   | 53,946 |   |
|                               |       |                                           |       |         |       |   |   |   |   |   |   |   |   |
| ** **                         | ** ** | **Three months ended September 30, 2004** | ** ** | ** **   | ** ** |
| ** **                         | ** ** | **Broadband**                                  | ** ** | **Wireless** | ** ** | **Handsets** | ** ** | **PCD** | ** ** | **Service** | ** ** | **Total** | ** ** |
|                               |       |                                           |       |         |       |   |   |   |   |   |   |   |   |
| Revenue from  external customers   |       | $                                              | 51,928     |         | $          | 419,630 |   | $ | 161,028 |   | $ | — |   | $ | 12,430 |   | $ | 645,016 |   |
| Gross profit                       |       | 5,885                                          |       | 104,797      |       | 23,680 |   | — |   | 2,772 |   | 137,134 |   |
|                               |       |                                           |       |         |       |   |   |   |   |   |   |   |   |
|                               |       | **Nine months ended September 30, 2005**  |       |         |       |
| ** **                         | ** ** | **Broadband**                                  | ** ** | **Wireless** | ** ** | **Handsets** | ** ** | **PCD** | ** ** | **Service** | ** ** | **Total** | ** ** |
|                               |       |                                           |       |         |       |   |   |   |   |   |   |   |   |
| Revenue from  external customers   |       | $                                              | 422,588    |         | $          | 371,541 |   | $ | 380,416 |   | $ | 1,021,452 |   | $ | 64,066 |   | $ | 2,260,063 |   |
| Gross profit                       |       | 168,194                                        |       | 104,041      |       | 51,145 |   | 42,881 |   | 35,321 |   | 401,582 |   |
|                               |       |                                           |       |         |       |   |   |   |   |   |   |   |   |
|                               |       | **Nine months ended September 30, 2004**  |       |         |       |
| ** **                         | ** ** | **Broadband**                                  | ** ** | **Wireless** | ** ** | **Handsets** | ** ** | **PCD** | ** ** | **Service** | ** ** | **Total** | ** ** |
|                               |       |                                           |       |         |       |   |   |   |   |   |   |   |   |
| Revenue from  external customers   |       | $                                              | 148,895    |         | $          | 1,176,433 |   | $ | 591,799 |   | $ | — |   | $ | 39,808 |   | $ | 1,956,935 |   |
| Gross profit                       |       | 41,062                                         |       | 322,764      |       | 111,330 |   | — |   | 14,283 |   | 489,439 |   |
|                               |       |                                           |       |         |       |   |   |   |   |   |   |   |   |
| Assets by segment are as  follows: |       |                                           |       |         |       |   |   |   |   |   |   |   |   |
|                               |       |                                           |       |         |       |   |   |   |   |   |   |   |   |
|                               |       | **As of September 30, 2005**              |       |         |       |
| **(in thousands)**                 | ** ** | **Broadband**                                  | ** ** | **Wireless** | ** ** | **Handsets** | ** ** | **PCD** | ** ** | **Service** | ** ** | **Total** | ** ** |
| Total long-lived  assets           |       | $                                              | 51,086     |         | $          | 94,332 |   | $ | 51,606 |   | $ | 1,506 |   | $ | 52,479 |   | $ | 251,009 |   |
| Total assets                       |       | 471,209                                        |       | 848,997      |       | 471,334 |   | 413,698 |   | 108,369 |   | 2,313,607 |   |
|                               |       |                                           |       |         |       |   |   |   |   |   |   |   |   |
|                               |       | **As of December  31, 2004**              |       |         |       |
| ** **                         | ** ** | **Broadband**                                  | ** ** | **Wireless** | ** ** | **Handsets** | ** ** | **PCD** | ** ** | **Service** | ** ** | **Total** | ** ** |
| Total long-lived  assets           |       | $                                              | 50,454     |         | $          | 106,003 |   | $ | 46,325 |   | $ | 1,330 |   | $ | 64,647 |   | $ | 268,759 |   |
| Total assets                       |       | 1,018,608                                      |       | 1,184,649    |       | 676,022 |   | 363,298 |   | 73,428 |   | 3,316,005 |   |

 

Sales data by geographicalareas are as follows:

 
| ** **         | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|--------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **         | ** ** | ** **                           | ** ** | **% of net**                        | ** ** | ** ** | ** ** | **% of net** | ** ** | ** ** | ** ** | **% of net** | ** ** | ** ** | ** ** | **% of net** | ** ** |
| **(in thousands)** | ** ** | **2005**                             | ** ** | **sales**                           | ** ** | **2004** | ** ** | **sales** | ** ** | **2005** | ** ** | **sales** | ** ** | **2004** | ** ** | **sales** | ** ** |
|               |       |                                 |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| United  States     |       | $                                    | 359,131    |                                | 57%        |   | $ | 13,211 |   | 2% |   | $ | 987,524 |   | 44% |   | $ | 44,969 |   | 2% |   |
| China              |       | 210,954                              |       | 33%                                 |       | 589,552 |   | 92% |   | 727,653 |   | 32% |   | 1,778,440 |   | 91% |   |
| Japan              |       | 13,794                               |       | 2%                                  |       | 34,075 |   | 5% |   | 398,853 |   | 18% |   | 75,607 |   | 4% |   |
| Other              |       | 51,428                               |       | 8%                                  |       | 8,178 |   | 1% |   | 146,033 |   | 6% |   | 57,919 |   | 3% |   |
| Total net  sales   |       | $                                    | 635,307    |                                | 100%       |   | $ | 645,016 |   | 100% |   | $ | 2,260,063 |   | 100% |   | $ | 1,956,935 |   | 100% |   |

 

Long-lived assets bygeographical areas are as follows:

 
| ** **               | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|--------------------------|------------|------------------------|------------|-----------------------|------------|
| **(in thousands)**       | ** ** | **2005**               | ** ** | **2004**              | ** ** |
| ** **               | ** ** | ** **             | ** ** | ** **            | ** ** |
| U.S.                     |       | $                      | 17,947     |                  | $          | 24,958 |   |
| China                    |       | 222,292                |       | 229,469               |       |
| Other                    |       | 10,770                 |       | 14,332                |       |
| Total  long-lived assets |       | $                      | 251,009    |                  | $          | 268,759 |   |

 

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**18.****                                                                              ****RELATED PARTY TRANSACTIONS:**

 

*Softbank*

 

The Company recognizedrevenue of $3.4 million and $53.5 million for the three and nine months ended September 30,2005, respectively, and $32.0 million and $64.6 million for the three and ninemonths ended September 30, 2004, respectively, with respect to sales oftelecommunications equipment and services to SBBC, an affiliate of SOFTBANKCORP. and SOFTBANK America Inc., which, as of September 30, 2005,owned 12.2% of the Company’s outstanding stock. SBBC offers asynchronousdigital subscriber line (“ADSL”) coverage throughout Japan, which is marketedunder the name “YAHOO! BB.” In addition, the Company supports SBBC’s newfiber-to-the-home service through sales of its carrier class Gigabit EthernetPassive Optical Network (“GEPON”) product as well as its multi-service opticaltransport product (“NetRingTM”).

 

Included in accountsreceivable at September 30, 2005 and December 31, 2004 were $22.7million and $86.8 million due from SOFTBANK CORP., respectively. Customeradvances were $5.4 million and $5.5 million as of September 30, 2005 and December 31,2004, respectively.  Deferred revenue was$5.6 million and $0.5 million as of September 30, 2005 and December 31,2004, respectively.

 

During August 2004, theCompany entered into several agreements with Japan Telecom Co., Ltd (“JT”), awholly owned subsidiary of SOFTBANK Corp. These agreements relate to the saleof *i*AN-8000 equipment withspecified value and delivery dates, as well as an oral agreement whichsubsequently converted into specific service contracts to manage a salespromotional program for JT. The total gross value of this agreement is $534.1million. The Company has determined that the service activities revenue shouldbe recorded net of expected promotional spending.

 

Because the Company had notprovided these activities in the past and could not estimate the fair value ofthese services, the Company determined under the guidance of SAB 104 that allrevenue related to these agreements should be deferred. The Company haddelivered and received final acceptance for all equipment contemplated underthese agreements in the quarter ended March 31, 2005.  In addition, $217.5 million was included incustomer advance as of December 31, 2004, related to these agreements.

 

The promotional servicesdiscussed above involved contracting with third party promotional vendors, whoin turn, facilitated the marketing and subscriber recruitment for the JTfiber-to-the-home program. During the fourth quarter of 2004, the Companydetermined that it would end its involvement with the JT promotional programafter completion of the contract discussed above. Accordingly, late in thefourth quarter of 2004 and during the first quarter of 2005, the Company eithercancelled or assigned to another party all third party contracts withpromotional vendors related to the JT contract. Such termination or assignmentof all third party promotional agreements, as well as effective satisfaction ofthe Company’s obligations with JT under such agreements, satisfied the revenuerecognition criteria for these agreements and as such, the net value of thepromotional services and the value of equipment delivered, which totaled $204.8million, was reported in the quarter ended March 31, 2005.

 

The Company also enteredinto an agreement with JT during the third quarter of 2004 to supply chassisequipment with an approximate value of $75 million. The equipment shipped underthis agreement is considered linked to the *i*AN-8000sale noted above and as such, was also deferred until the completion of theabove-mentioned promotional activities.  As discussed above, the revenue recognitioncriteria related to the sale of the *i*AN-8000equipment was satisfied in the first quarter of 2005 and as such, the revenuerelated to the chassis sale of $66.5 million was reported in the quarter ended March 31,2005.

 

The Company recognizedrevenue of $2.5 million and $278.6 million for the three and nine months ended September 30,2005, respectively, with respect to sales of telecommunications equipment toJT.  At September 30, 2005, deferredrevenue from JT was $14.5 million and $3.9 million was included in accountsreceivable due from JT.

 

The Company has invested inSoftbank China and Restructuring Fund No. 1, which are investment vehiclesestablished by SOFTBANK CORP. and its affiliates.  See Note 12.

 

On July 17, 2003, theCompany entered into a Mezzanine Loan Agreement with BB Modem Rental PLC (“BBModem”), an affiliate of SOFTBANK CORP. Under the terms of the agreement, theCompany loaned BB Modem $10.1 million at an effective interest rate of 12.01%per annum, for the purpose of investing in a portfolio of ADSL modems andassociated modem rental agreements, from SBBC. SBBC will continue to servicesuch modems and modem rental agreements. The Company’s loan is subordinated tocertain senior lenders of BB Modem, and repayments are payable to the Companyover a 42-month period through January 31, 2007, with a substantialportion of the principal amount of the loan scheduled to be repaid duringthe last 16 months of this period. The Company’s recourse for nonpayment of theloan is limited to the assets of BB Modem, the account into which subscriberpayments are made and its rights under the securitization transaction

 

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documents. The value of BBModem’s modems that serve as collateral for the loan may decrease over time andmay not be sufficient upon sale to pay the outstanding amounts on the loans.The Company assesses the loan for impairment whenever events or changes incircumstances indicate that the carrying amount may not be recoverable. TheCompany periodically reviews the underlying quality of the asset pool securingthe loan to assess whether impairment has incurred and needs to be recorded.During the three and nine months ended September 30, 2005, the Companyrecorded $0.3 million and $1.0 million, respectively, in interest income inrespect to this loan.  During the threeand nine months ended September 30, 2004, the Company recorded $0.3million and $1.0 million, respectively, in interest income in respect to thisloan.  The loan receivable balances at September 30,2005 and December 31, 2004 were approximately $10.7 million and $11.8million, respectively, and were included in other long-term assets.

 

On April 5, 2003, theCompany repurchased 8.0 million shares of common stock beneficially ownedby SOFTBANK America Inc., at a purchase price of $17.385 per share. Thetotal cost of the repurchase was $139.6 million including transactionfees. In connection with this repurchase transaction, SOFTBANK America Inc.entered into an agreement with the Company not to offer, sell or otherwisedispose of the Company’s common stock for a period of one year, subject to anumber of exceptions. As of September 30, 2005, SOFTBANK America Inc.beneficially owned approximately 12.2% of the Company’s outstanding stock.

 

On August 29, 2002, theCompany completed the repurchase of 6.0 million shares of the Company’s commonstock for $72.9 million from SOFTBANK America, Inc.

 

*Cellon*

 

In October 2002, theCompany entered into a license and a royalty agreement with CellonInternational Holding Corporation (“Cellon”), in which the Company has a 9%ownership interest. Per the terms of the royalty agreement, the Company isrequired to pay Cellon $3.00 per unit shipped for a minimum of 0.1 millionunits. This agreement is not material to the overall financial results ofCellon. The Company has evaluated its relationship with Cellon under FIN 46,and determined that consolidation is not necessary.

 

*Fiberxon*

 

The Company has an outstandingpurchase commitment with Fiberxon, in which the Company has an 11% ownershipinterest, to purchase component parts for optical networking products. TheCompany anticipates it will be able to fulfill this commitment without materialadverse consequences to the operations or financial condition of the Company.Purchases from Fiberxon totaled $0.1 million and $6.7 million during the threeand nine months ended September 30, 2005. As of September 30, 2005the Company had $0.5 million in accounts payable and $2.9 million of openpurchase commitments to Fiberxon.

 

*StarcomProducts, Inc.*

 

The Company obtainsengineering consulting and employee placement services from Starcom Products, Inc.(“Starcom”), which is 31% owned by an individual related to a member of theCompany’s Board of Directors. The Company paid $1.1 million to Starcom in2004.   In the three and nine monthsended September 30, 2005, the Company obtained services from this entityin the amount of $0.1 million and $0.6 million, respectively.

 

*XaltedNetworks*

 

In May and August 2005, theCompany invested $2.0 million and $1.0 million, respectively, in Xalted, adevelopment stage company in the telecommunication industry. The Company has less than a 10% ownership interest in Xalted and the investmentis accounted for under the cost method.  The Company made a purchaseof $0.5 million for license rights and services from SysTeam, anaffiliated company to Xalted, in the quarter ended September 30,2005.

 

*MatsushitaJoint Venture*

 

In July 2002, the Companyentered into a joint venture agreement with Matsushita Communication IndustrialCo., Ltd., a stockholder of the Company, to jointly design and develop,manufacture and sell telecommunication products. The Company paid $14.2 millionin cash and holds a 49% ownership interest in the joint venture company. TheCompany does not have voting control over significant matters of the jointventure company; the investment in and results of operations of the jointventure company are accounted for using the equity method of accounting.  At September 30, 2005, the Company had $3.1million in customer advance received from the joint venture for a researchproject which the Company expects to complete in the fourth quarter of 2005.  For the nine months ended September 30, 2005,there was no sales revenue recorded by the Company and purchases from the jointventure were immaterial.

 

**19.****                                                                              ****RESTRUCTURING COSTS****:**

 

In the second quarter offiscal 2005, the Company announced and initiated a restructuring plan.

 

During the three and ninemonths ended September 30, 2005, the Company incurred approximately $3.4million and $24.0 million, respectively, in expenses in relation to therestructuring plan actions.  The threemonth expense consists primarily of $2.1 million related to severance paymentsand $1.2 million in asset impairments primarily related to the write-off ofequipment and licenses associated with discontinued products and which areincluded in operating expenses.

 

During the nine months endedSeptember 30, 2005, the Company incurred approximately $24.0 million inexpenses in relation to the restructuring plan actions, primarily consisting of(i) $9.8 million related to severance payments (ii) $8.7

 

25

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million in asset impairmentsprimarily related to the write-off of equipment and licenses associated withdiscontinued products, which are included in operating expenses and (iii) $5.5million in inventory write-off associated with discontinued products.  Included in the severance payments is a $0.7million non-cash settlement for the reversal of housing allowance accrual inChina.  Restructuring expense related tothe inventory write-off is included in cost of sales in the Statements of Operations.  As of September 30, 2005, approximately965 employees had been terminated or placed in the workforce reductionprograms.

 

The following table displaysa rollforward of the restructuring plan associated costs for the three and ninemonths ended September 30, 2005:

 
| ** **           | ** ** | **Charges**                 | ** ** | **Charges**                 | ** ** | ** **  | ** ** | ** **     | ** ** | ** **                  | ** ** |
|----------------------|------------|-----------------------------|------------|-----------------------------|------------|-------------|------------|----------------|------------|-----------------------------|------------|
| ** **           | ** ** | **Three months ended**      | ** ** | **Nine months ended**       | ** ** | **Cash**    | ** ** | **Non-cash**   | ** ** | **Balance**                 | ** ** |
| **(in thousands)**   | ** ** | **September 30, 2005** | ** ** | **September 30, 2005** | ** ** | **payment** | ** ** | **settlement** | ** ** | **September 30, 2005** | ** ** |
| ** **           | ** ** | ** **                  | ** ** | ** **                  | ** ** | ** **  | ** ** | ** **     | ** ** | ** **                  | ** ** |
| **Wireless**         |       |                        |       |                        |       |        |       |           |       |                        |       |
| Severance  payments  |       | $                           | 1,014      |                        | $          | 1,908       |       | $              | (2,010     | )                           | $          | 102 |   | $ | — |   |
| Asset  impairment    |       | 437                         |       | 6,461                       |       | $           | —     |           | (6,461     | )                           | —     |   |
| Inventory  write-off |       |                        |       | 5,543                       |       | $           | —     |           | (5,543     | )                           | —     |   |
|                 |       |                        |       |                        |       |        |       |           |       |                        |       |
| **Broadband**        |       |                        |       |                        |       |        |       |           |       |                        |       |
| Severance  payments  |       | 216                         |       | 1,577                       |       | $           | (1,599     | )              | 22         |                        | —     |   |
| Asset  impairment    |       | —                      |       | 1,079                       |       | $           | (110       | )              | (969       | )                           | —     |   |
| Inventory  write-off |       | —                      |       |                        |       |        |       |           |       | —                      |       |
|                 |       |                        |       |                        |       |        |       |           |       |                        |       |
| **Handsets**         |       |                        |       |                        |       |        |       |           |       |                        |       |
| Severance  payments  |       | 2                           |       | 965                         |       | $           | (1,062     | )              | 97         |                        | —     |   |
| Asset  impairment    |       | —                      |       | 350                         |       | $           | —     |           | —     |                        | 350        |   |
| Inventory  write-off |       | —                      |       | —                      |       | $           | —     |           | —     |                        | —     |   |
|                 |       |                        |       |                        |       |        |       |           |       |                        |       |
| **PCD**              |       |                        |       |                        |       |        |       |           |       |                        |       |
| Severance  payments  |       | —                      |       | —                      |       | $           | —     |           | —     |                        | —     |   |
| Asset  impairment    |       | —                      |       | —                      |       | $           | —     |           | —     |                        | —     |   |
| Inventory  write-off |       | —                      |       | —                      |       | $           | —     |           | —     |                        | —     |   |
|                 |       |                        |       |                        |       |        |       |           |       |                        |       |
| **Service**          |       |                        |       |                        |       |        |       |           |       |                        |       |
| Severance  payments  |       | 9                           |       | 1,166                       |       | $           | (1,218     | )              | 52         |                        | —     |   |
| Asset  impairment    |       | —                      |       | —                      |       | $           | —     |           | —     |                        | —     |   |
| Inventory  write-off |       | —                      |       | —                      |       | $           | —     |           | —     |                        | —     |   |
|                 |       |                        |       |                        |       |        |       |           |       |                        |       |
| **Corporate**        |       |                        |       |                        |       |        |       |           |       |                        |       |
| Severance  payments  |       | 897                         |       | 4,164                       |       | $           | (4,571     | )              | 476        |                        | 69         |   |
| Asset  impairment    |       | 803                         |       | 835                         |       | $           | —     |           | (165       | )                           | 670        |   |
| Inventory  write-off |       |                        |       |                        |       |        |       |           |       | —                      |       |
|                 |       |                        |       |                        |       |        |       |           |       |                        |       |
| **Summary  Totals**  |       |                        |       |                        |       |        |       |           |       |                        |       |
| Severance  payments  |       | $                           | 2,138      |                        | $          | 9,780       |       | $              | (10,460    | )                           | $          | 749 |   | $ | 69 |   |
| Asset  impairment    |       | 1,240                       |       | 8,725                       |       | (110        | )          | (7,595         | )          | 1,020                       |       |
| Inventory  write-off |       | —                      |       | 5,543                       |       | —      |       | (5,543         | )          | —                      |       |
|                 |       |                        |       |                        |       |        |       |           |       |                        |       |
| Total                |       | $                           | 3,378      |                        | $          | 24,048      |       | $              | (10,570    | )                           | $          | (12,389 | ) | $ | 1,089 |   |

 

Included inthe $24.0 million restructuring charge for the nine months endedSeptember 30, 2005 was $5.5 million recorded with cost of net salesand $18.5 million recorded as an operating expense.

 

**20.****                                                                              ****OTHER INCOME AND EXPENSES:**

 

The other income (expense)balances in the three and nine months ended September 30, 2005 and 2004were comprised of the following items:

 
| ** **                            | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|---------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| **(in millions)**                     | ** ** | **2005**                                  | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                            | ** ** | ** **                                | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| Foreign  exchange gains (losses)      |       | $                                         | 7.3        |                                     | $          | (0.5 | ) | $ | (7.3 | ) | $ | — |   |
| Japan  consumption tax refund         |       | —                                    |       | 0.7                                      |       | 6.0 |   | 2.1 |   |
| Chinese  government financial subsidy |       | —                                    |       | —                                   |       | 0.5 |   | 10.2 |   |
| Net  investment gains and dividends   |       | —                                    |       | 1.1                                      |       | — |   | 1.1 |   |
| Other                                 |       | 0.1                                       |       | (0.1                                     | )          | (0.9 | ) | 0.8 |   |
| Total                                 |       | $                                         | 7.4        |                                     | $          | 1.2 |   | $ | (1.7 | ) | $ | 14.2 |   |

 

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**21.****                                                                              ****CREDIT RISK AND CONCENTRATION:**

 

For the three and ninemonths ended September 30, 2005, approximately 33% and 32% of the Company’ssales, respectively, were derived from China. For both three and nine months ended September 30, 2004,approximately 92% and 91% of the Company’s sales, respectively, were derivedfrom China.

 

For the three and ninemonths ended September 30, 2005, sales recorded in Japan accounted forapproximately 2% and 18% of total sales, respectively, mainly resulting fromthe first quarter recognition of deferred revenue recorded in prior year.  Refer to Note 18, Related Party Transactions,for additional information.  For thethree and nine months ended September 30, 2004, sales recorded in Japanaccounted for approximately 5% and 4% of total sales, respectively.

 

One customer accounted forapproximately 18% of net sales for the three months ended September 30,2005 and two customers accounted for approximately 12% and 11% of net sales forthe nine months ended September 30, 2005.  Two customers accounted for approximately 13% and 12% of net sales forthe three months September 30, 2004 and two customers accounted forapproximately 14% and 12% of net sales for the nine months ended September 30,2004.  Additionally, at September 30,2005, no customer accounted  for  more than 10% of  the accounts  receivable balance;  at December 31, 2004, one customer  accounted for approximately 15%  of  theaccounts  receivable balance.

 

**22.****                                                                              ****INCOME TAXES:**

** **

In establishing its deferredincome tax assets and liabilities, the Company makes judgments andinterpretations based on the enacted tax laws and published tax guidanceapplicable to its operations as well as the amount and jurisdiction of futuretaxable income.  The Company recordsdeferred tax assets and liabilities and evaluates the need for valuationallowances to reduce the deferred tax assets to realizable amounts.  SFAS 109, “Accounting for Income Taxes” (“SFAS109”) requires that a valuation allowance be established when it is more likelythan not that all or a portion of a deferred tax asset will not berealized.  A review of all availablepositive and negative evidence needs to be considered, including a company’scurrent and past performance, the market environment in which the companyoperates, the utilization of past credits, length of carryback and carryforwardperiods and existing contracts or sales backlog that will result in futureprofits.

 

As of September 30,2005, the Company did not believe it was more likely than not that it wouldgenerate a sufficient level and proper mix of taxable income within theappropriate period to utilize all the deferred tax assets. As a result of thereview undertaken at September 30, 2005, the Company has concluded that itwas appropriate to establish a full valuation allowance on its net deferred taxassets in the United States and China.  Accordingly,the Company recorded $93.1 million non-cash charge at September 30,2005.

 

Income tax expense was$103.6 million and a benefit of $1.9 million for the three months ended September 30,2005 and 2004, respectively.  Income taxexpense was $110.0 million and $22.8 million for the nine months ended September 30,2005 and 2004, respectively.

 

During thethree months ended September 30, 2005, the Company recorded a $93.1million non-cash charge to provide a full valuation allowance on its remainingnet deferred tax assets at September 30, 2005 in the United States andChina.  The Company expects to continueto maintain a full valuation allowance on its deferred tax assets in the UnitedStates and China until an appropriate level of profitability is reached or weare able to develop tax strategies which would enable us to conclude that it ismore likely than not that a portion of our deferred tax assets would berealizable.

 

**23.****                                                                              ****ACCOUNTING FOR DERIVATIVEINSTRUMENTS AND HEDGING ACTIVITIES:**

** **

The Company uses derivativefinancial instruments to manage its exposures to foreign currency exchange ratechanges. The derivative instruments are accounted for pursuant to SFAS No. 133,“Accounting for Derivative Instruments and Hedging Activities,” as amended bySFAS No. 138, “Accounting for Certain Derivative Instruments and CertainHedging Activities” (“SFAS 133”). As amended, SFAS 133 requires that an entityrecognize all derivatives as either assets or liabilities on the balance sheet,measure those instruments at fair value and recognize changes in the fair valueof derivatives in earnings in the period of change unless the derivativequalifies as an effective hedge that offsets certain exposures. Such contractsare designated at inception to the related foreign currency exposures beinghedged. Pursuant to its foreign currency exchange hedging policy, the Companymay hedge the related receivable and payables denominated in foreign currenciesusing forward foreign currency exchange rate contracts. Beginning in the firstquarter of 2004, the Company hedged certain of its Japanese Yen-denominatedbalance sheet exposures against future movements in foreign currency exchangerates by using foreign currency forward contracts. Hedged transactions aredenominated in U.S. dollars on behalf of these transactions denominated inJapanese Yen.  Gains and losses on these fair value hedges are intended tooffset gains and losses from the revaluation of Japanese Yen-denominatedrecognized assets and liabilities. There were no hedging activities in thethree and nine months ended September 30, 2005. The net result of thesegains and losses on contracts and revaluation included in interest and otherincome (expense) was insignificant for the three and nine months ended September 30,2004. The Company’s foreign currency forward contracts generally mature withinthree months. These derivative financial instruments are not held forspeculative trading purposes. There were no foreign currency forward contractsopen at September 30, 2005.

 

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**24.****                                                                              ****RECENT ACCOUNTINGPRONOUNCEMENTS:**

** **

InDecember 2004, the Financial Accounting Standards Board, “FASB” issuedSFAS No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123(R)”).  SFAS 123(R) will require the Company tomeasure all employee stock-based compensation awards using a fair value methodand record such expense in its consolidated financial statements.  In addition, the adoption of SFAS 123(R) willrequire additional accounting related to the income tax effects and additionaldisclosure regarding the cash flow effects resulting from share-based paymentarrangements.

 

InMarch 2005, the Securities and Exchange Commission (the “SEC”) issuedStaff Accounting Bulletin no. 107 (“SAB 107”) which provides guidance regardingthe application of SFAS 123(R). SAB 107 expresses views of the staff regardingthe interaction between SFAS No. 123(R), Share-Based Payment, and certainSEC rules and regulations and provides the staff’s views regarding thevaluation of share-based payment arrangements for public companies. Inparticular, SAB 107 provides guidance related to share-based paymenttransactions with non-employees, the transition from nonpublic to public entitystatus, valuation methods (including assumptions such as expected volatilityand expected term), the accounting for certain redeemable financial instrumentsissued under share-based payment arrangements, the classification ofcompensation expense, non-GAAP financial measures, first-time adoption of SFAS123(R) in an interim period, capitalization of compensation cost related toshare-based payment arrangements, the accounting for income tax effects ofshare-based payment arrangements upon adoption of SFAS 123(R), the modificationof employee share options prior to adoption of SFAS 123(R) and disclosures inManagement’s Discussion and Analysis (“MD&A”) subsequent to adoption ofSFAS 123(R).

 

On April 14, 2005, theSEC approved a new rule that delays the effective date for SFAS 123(R) toannual periods beginning after June 15, 2005.  The adoption of SFAS 123(R) on January 1,2006 is expected to have a material impact on the Company’s consolidatedresults of operations, financial position and statement of cash flows.  The Company is evaluating the transitionmethod and pricing model alternatives upon adoption.

 

InDecember 2004, the FASB issued FSP No. FAS 109-2, “Accounting andDisclosure Guidance for the Foreign Earnings Repatriation Provision within theAmerican Jobs Creation Act of 2004.”  TheAmerican Jobs Creation Act of 2004 provides a one-time 85% dividends receiveddeduction for certain foreign earnings that are repatriated under a plan forreinvestment in the United States, provided certain criteria are met.  FSP No. FAS 109-2 is effective immediatelyand provides accounting and disclosure guidance for the repatriationprovision.  FSP No. FAS 109-2 allowscompanies additional time to evaluate the effects of the law on its unremittedearnings for the purpose of applying the “indefinite reversal criteria” underAPB Opinion No. 23, “Accounting for Income Taxes—Special Areas,” andrequires explanatory disclosures from companies that have not yet completed theevaluation.  The Company is currentlyevaluating the effects of the repatriation provision and their impact on itsconsolidated financial statements.  TheCompany does not expect to complete this evaluation before the end of2006.  The range of possible amounts ofunremitted earnings that is being considered for repatriation under thisprovision is between zero and $540 million and the related potential range ofincome tax is between zero and $28 million.

 

InNovember 2004, the FASB issued SFAS No. 151, “Inventory Costs, anamendment of ARB No. 43, Chapter 4,” (“SFAS 151”). SFAS 151 clarifies thatabnormal inventory costs such as costs of idle facilities, excess freight andhandling costs, and wasted materials (spoilage) are required to be recognizedas current period charges. The provisions of SFAS 151 are effective for thefiscal year beginning after June 15, 2005. The adoption of SFAS 151 is notexpected to have a material impact on the Company’s consolidated financialposition, results of operations and cash flows.

 

InJune 2005, the FASB’s Emerging Issues Task Force (“EITF”) issued EITFIssue No. 05-02 “The Meaning of ‘Conventional Convertible Debt Instrument’in EITF Issue 00-19 ‘Accounting for Derivative Financial Instruments Indexedto, and Potentially Settled in, a Company’s Own Stock,’” which retains theexception in paragraph 4 of EITF Issue No. 00-19 for conventionalconvertible debt instruments. Those instruments in which the holder has anoption to convert the instrument into a fixed number of shares (or acorresponding amount of cash at the issuer’s discretion) and its ability toexercise the option is based on either (a) the passage of time or (b) acontingent event, should be considered “conventional” for purposes of applyingthat exception. The consensus should be applied on a prospective basis for newor modified instruments starting from the third quarter of 2005. The adoptionof EITF No. 05-02 is not expected to have a material effect onthe Company’s consolidated financial statements or results of operations.

 

OnJune 1, 2005, the FASB issued FASB Statement No. 154, AccountingChanges and Error Corrections (“SFAS 154”), which will require entities thatmake a voluntary change in accounting principle to apply that changeretrospectively to prior periods’ financial statements, unless this would beimpracticable. SFAS 154 supersedes Accounting Principles Board Opinion No. 20,Accounting Changes (“APB 20”), which previously required that most voluntarychanges in accounting principle be recognized by including in the currentperiod’s net income the cumulative effect of changing to the new accountingprinciple.  SFAS 154 also makes adistinction between “retrospective application” of an accounting principle andthe “restatement” of financial statements to reflect the correction of anerror.

 

Under SFAS 154, if an entitychanges its method of depreciation, amortization, or depletion for long-lived,non-financial assets, the change must be accounted for as a change inaccounting estimate. Under APB 20, such a change would have been reported as achange in accounting principle. SFAS 154 applies to accounting changes anderror corrections that are made in fiscal years beginning after December 15,2005. The adoption of SFAS 154 is not expected to have a material effect on theCompany’s consolidated financial statements or results of operations.

 

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**25.****                                                                              ****SUBSEQUENT EVENT:**

 

On October 11,2005, the Company provided an interest free, $12.4 million loan to a party inChina as seed capital for a venture organized to participate in the emergingIPTV market. The loan is partially secured, is payable in 10 years and may becalled early without penalty. In addition, the Company expects to make anincremental $12.8 million equity investment related to this venture in thefourth quarter of 2005 or the first quarter of 2006.  A portion of the $12.8 million equityinvestment will be used to extinguish the $12.4 million loan noted above. 

 

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**ITEM 2—MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS**

 

**FORWARD-LOOKING STATEMENTS**

 

This Report on Form 10-Qcontains forward-looking statements within the meaning of the federalsecurities laws. These statements are based on information that is currentlyavailable to management. We intend such forward-looking statements to becovered by the safe harbor provisions of the Private Securities LitigationReform Act of 1995, and we are including this statement for purposes ofcomplying with those provisions. The forward-looking statements include,without limitation, those concerning the following: our expectations as to thenature of possible trends, including our expectations about continuing growthin the number of subscribers for telecommunications products in the countriesin which we do business; our expectations regarding competition in the marketsin which we compete; our expectation that there will be fluctuations in ouroverall gross profit, gross profit as a percentage of sales, net sales(including sales to specific customers), gross margin, product mix, quarter toquarter results, customer base, selling prices, our ability to reduce cost ofsales and accounts receivable; our expectations concerning days sales outstanding;our expectations regarding the evolution of our internal controls overfinancial reporting and the existence or discovery of future additionalmaterial weaknesses or significant deficiencies; our expectations regarding theexpenditure of significant resources to comply with Section 404 of theSarbanes-Oxley Act and other related rules; our expectations regarding ourannual effective tax rate and our activities to manage our tax structure on aworldwide basis; ; our expectations regarding trends in customer acceptance ofour products; our expectations regarding trends in our industry; ourexpectations regarding future growth of our business and operations; ourexpectations regarding the importance of continued investment in research anddevelopment for our long-term success; our expectations regarding the status ofproducts under development; our expectations regarding our future levels ofcash and cash equivalents, as well as our expectation that existing creditfacilities, short-term investments, cash and cash equivalents will besufficient to finance our operations for the foreseeable future; ourexpectations regarding our ability to proceed with the extension or renewal ofexisting credit facilities and the uncertainty of such renewal; our expectationsregarding the possible need for additional financing and the uncertaintyconcerning the availability of such financing on commercially reasonable terms,or at all; our expectations regarding our currency risk management activities;our expectations regarding the potential impact on our results of operations,financial position and statement of cash flows from changes in legal andaccounting regulations; our expectations regarding the possibility of hedgingcertain Japanese Yen-denominated balance sheet exposures against futuremovements in foreign currency exchange rates by using foreign currency forwardcontracts; our expectations regarding licensing requirements and our ability toreceive licenses in China for our PAS system and other products; our expectationsregarding the development of 3G networks in China; our expectations regardingour ability to grow our Wireless segment with products supporting the emerging3G market in China; our expectations regarding the development of a market forIPTV products and our ability to compete in such market; our expectationsregarding our ability to successfully introduce new and innovative Broadbandproducts in the countries in which we do business and to generally expand ourBroadband Infrastructure and handset product base; our expectation that ourBroadband Infrastructure and Wireless Infrastructure sales may stabilize in thenear term; our expectation that gross profit from external customers for ourPCD segment may remain stable for the remainder of 2005; our expectationsregarding our ability to maintain our Wireless Infrastructure market positionand support the growth of our Handset segment sales by introducing newproducts; our expectations regarding the impact of a reorganization oftelecommunications companies in China; our expectation that our business willcontinue to be significantly influenced by the political, economic and legalenvironment in China, as well as expectations about the nature of political,economic and legal reform in China; our expectations regarding the importanceof sales in China to our operating results; our expectations regarding theimportance of the China market for our technologies and development; ourexpectations regarding the anticipated decrease in the percentage of total salesgenerated from China as we continue to grow internationally; our expectationsregarding efficiencies we hope to achieve in supply chain management andinventory purchasing, as well as trends in inventory growth; our expectationsregarding our restructuring effort to reduce costs; our expectations regardingour ability to implement and enhance our administrative infrastructure; ourexpectations regarding our ability to expand into new markets around the worldand address potential market opportunities; our expectations regarding theanticipated growth of Internet-related businesses in China; our expectationsregarding the long-term demand for our PAS/iPAS products and the continuedimportance of the PAS technology and market in the future; our expectationsregarding our ability to support our customers in China as they managesubscriber demand for their PAS networks over the next several years; ourexpectations regarding our ability to fulfill outstanding purchase commitments;our expectations regarding the eventual decrease in the pace of our sales to acertain customer; our expectations regarding our ability to offer more advancedproducts at higher average selling prices; our expectations regarding ourability to repair certain units under special warranty coverage in a timelymanner; and our expectations regarding our costs associated with our globaltransformation. Additional forward-looking statements may be identified by thewords “anticipate,” “expect,” “believe,” “intend,” “will,” and similar expressions,as they relate to us or our management. Investors are cautioned that theseforward-looking statements are inherently uncertain. These statements aresubject to risks and uncertainties that may cause actual results and events todiffer materially. For a detailed discussion of these risks and uncertainties,see the “Factors Affecting Future Operating Results” section of thisForm 10-Q. We do not guarantee future results and undertake no obligationto update the forward-looking statements to reflect events or circumstancesoccurring after the date of this Form 10-Q.

 

 

**EXECUTIVE SUMMARY**

 

Wedesign, manufacture and sell telecommunications equipment and handset productsand provide services associated with their operation. Our telecommunicationequipment products are deployed and installed globally primarily by wirelessand wireline telecommunications service providers. We provide an extensiverange of products for transportation of voice, data and video traffic for theseservice providers. We are currently operating in China, Japan, India, theCentral and Latin American region, North America, the European, Middle Easternand African region and southeastern and northern Asia.

 

Wedifferentiate ourselves with products designed to reduce network complexity, integratehigh performance capabilities and allow a simple transition to next generationnetworks. We design our products to facilitate cost-effective and efficientdeployment, maintenance and upgrades.

 

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Ourkey product families fall into three major categories:

 

•                  WirelessInfrastructure:   technologies and products that enable end users, orsubscribers, to send and receive voice and data communication in either a fixedor mobile environment by using wireless devices;

 

•                  BroadbandInfrastructure:   technologies and products that enable service providersto supply high-speed connections, cost effective fixed data and voice and mediacommunication; and

 

•                  Handsets andCustomer Premise Equipment (“CPE”):   consumer devices that allow customersto access wireless and broadband services.

 

Weoperate our business in five segments (i) Broadband Infrastructure,(ii) Wireless Infrastructure, (iii) Handsets, (iv) PersonalCommunications Division (“PCD”), and (v) Services. For the three and ninemonths ended September 30, 2005, we recorded $635.3 million and $2,260.1million of revenue, respectively, a 2% decrease and 15% increase over thecorresponding periods in 2004. Historically, a substantial majority of our sales have been totelecommunication service providers in China.  In fiscal 2004, wecontinued to focus on the diversification of our global customer base andmarket penetration internationally through internal growth as well asacquisitions, and as a result, our sales derived from outside of China as apercentage of total sales have increased. For the three and nine months ended September 30, 2005, 33% and 32% ofour sales were derived from China as compared to 92% and 91% for the comparableperiods last year.  The maturation of ourPAS market together with customer delays in capital spending in anticipation ofnext generation technology equipment have caused lower demand for our productsin China.

 

China has been our largestmarket and we believe that it will continue to be an important market for ourcurrent and future technologies and our development for the foreseeablefuture.  However, we also experienced amaturation of our PAS market in China resulting in our need to have a morediversified product and customer base. We also believe sales generated from China, as a percentage of totalsales, may decline as we continue to grow internationally.

 

We use subscriber growthstatistics to gauge future inventory purchasing requirements as well as toforecast our anticipated revenue growth. We expect the subscriber growth tocontinue, albeit at a slower rate, because China’s teledensity rates, or thenumber of telephones per person in a region, remain relatively low incomparison to that of developed countries.

 

*The number of competitors for communications access andswitching systems and handsets in China has grown in line with China’stelecommunications market expansion. This growth has led to competitive pricingpressure in recent past quarters.*

* *

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

 

Over the past few years, wehave undertaken a significant globalization program and we intend to continueto build our global sales outside of China in the current year.  We intend to continue to improve our internalsupply chain and inventory management processes to ensure timely deliveries. Wealso intend to continue to implement and enhance our administrativeinfrastructure to assist our globalization transformation.

 

As part of thetransformation process, we reviewed our corporate wide operations with the aimof narrowing the strategic focus of our diversification efforts with regard toour market concentration, product portfolio selection, and resourcesallocation. In the second quarter of 2005, we announced and initiated arestructuring plan to rationalize our cost structure in response to the declinein demand for certain of our products and realign investments with key growthopportunities.  During the currentquarter, we determined that certain circumstances have changed sufficiently toindicate that the fair value of certain of our reporting units may be belowtheir book values.  As a result, weconducted an evaluation of our long-lived assets including goodwill, intangibleassets, and certain property plant and equipment for impairment and recordedimpairment charges.

 

We enteredinto agreements to early extinguish a portion of our outstanding 7/8%Convertible Subordinated Notes which we began in the second quarter 2005 andcontinued through the third quarter. These exchanges are considered earlyextinguishments of debt in which the aggregate fair value of the common stockand cash is less than the carrying value of the Notes.  Accordingly, we recorded gains on theexchanges.  As of September 30, 2005, we hadreduced by one third long term debt obligations as compared to the amount ofsuch obligations at December 31, 2004.

 

**KEY TRANSACTIONS**

 

*Debtextinguishment*

 

InJune 2005 we entered into an agreement to exchange 1,482,000 shares of ourcommon stock with a fair value of approximately $10.6 million and approximately$15.8 million in cash for $38.0 million aggregate principal amount of our

 

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outstanding7/8% Convertible Subordinated Notes due 2008 (the “Notes”) as proposed to us byone of our Note holders.  In the thirdquarter of 2005, we completed four additional exchanges for a total of 3,506,100shares of our common stock with a fair value of approximately $27.0 million andapproximately $41.4 million in cash for $89.9 million aggregate principalamount of our Notes.  These exchanges are consideredearly extinguishments of debt in which the aggregate fair value of the commonstock and cash is less than the carrying value of the Notes.  Accordingly, we recorded a gain, net ofwrite-off of unamortized issuance expenses of $20.3 million and $31.4 millionfor the three and nine months ended September 30, 2005, respectively, on theextinguishment.

 

*Acquisitions*

 

Pedestal

 

OnMay 13, 2005, we completed our acquisition of substantially all of theassets and certain liabilities of Pedestal Networks, Inc. (“Pedestal”).  Pedestal develops and designs UniversalBroadband Server (“UBS”); an environmentally hardened, line-powered remoteIP-based Digital Subscriber Line Access Multiplexer (“IP DSLAM”).  The acquisition was intended to assist in ourexpansion into digital subscriber line (“DSL”) and IP-based television (“IPTV”)by providing us with a strong remote broadband solution that is fullyUS-certified and complements other existing DSL, IPTV and optical productfamilies.  The total consideration forthis transaction was $3.0 million. Approximately $2.6 million in cash was paid at the closing date and anadditional $0.4 million in cash is payable one year from the closing date inthe absence of a material breach of the original contractual terms. Theacquisition was accounted for under the purchase method of accounting.

 

Theexisting technology acquired included the entire Pedestal family of IP DSLAMand UBS.  We intend to integrate thePedestal product line with the our Triple-Play products and IPTV solutions.  In addition to developed product technology,we acquired fixed assets, in-process research and development (“IPR&D”) andcustomer relationships.

 

Atthe acquisition, Pedestal had one project under development that qualified forIPR&D.  In assessing Pedestal’sIPR&D project, we considered key product characteristics, including theproduct’s development stage at the acquisition date, the product’s life cycleand the product’s future prospects.  Wealso considered the rate at which technology changes in the broadband equipmentindustry, the industry’s competitive environment and the economic outlook forboth local and global markets.  Theamount of the purchase price allocated to IPR&D of $0.7 million was chargedto our results of operations in the second quarter of 2005.

 

Theresults of operations of Pedestal have been integrated with the “Broadband”segment and included in our Consolidated Statement of Operations beginning onthe acquisition date of May 13, 2005. The pro forma effects of this acquisition on our financial statementsare not significant.

 

Giga

 

On October 29, 2004, weentered into an asset purchase agreement with Giga Telecom, Inc., (“Giga”),a Korean corporation that develops and designs wireless handsets. Theacquisition is intended to facilitate our expansion into the Code DivisionMultiple Access (“CDMA”) handset market. With the acquisition, we gained instant access to an experienced designteam of approximately 100 employees.

 

The acquisition wascompleted on January 4, 2005. At the closing, $13.0 million in cash waspaid, and an additional $2.0 million was paid into an escrow account held by usfor six months which was released in July 2005. The total consideration for the acquisition, funded from cash on hand,was approximately $18.9 million, including $2.0 million acquisition-relatedtransaction costs, a $1.5 million payment made previously to be applied againstthe purchase price and an earn-out of $0.5 million paid subsequently uponcompletion of certain product design milestones.

 

The purchased existingtechnology and pre-existing royalty agreement are to be amortized within ayear.  The results of operation of Gigahave been integrated with the “Handsets” segment subsequent to the acquisition.

 

*AssetImpairment*

 

Intangible assets classified asgoodwill and those with indefinite lives are not amortized.  Intangible assets with determinable lives areamortized over their estimated useful lives. We perform an annual impairment test of our goodwill as of November 1stof each year.  We also test forimpairment between annual tests if a “triggering” event occurs that may havethe effect of reducing the fair value of a reporting unit below theirrespective carrying values.  Whenconducting the goodwill impairment analysis, we calculate impairment chargesbased on the two-step test prescribed in SFAS 142, “Goodwill and OtherIntangible Assets” (“SFAS 142”) and using the estimated fair value of therespective reporting units.  We use thepresent value of future cash flows from the respective reporting units todetermine the estimated fair value of the reporting unit and the implied fairvalue of goodwill. We also test long-lived assets in all of our asset groupsfor potential impairment in accordance with SFAS 144, “Accounting for theImpairment or Disposal of Long-lived Assets.”  Our long-lived assets are tested for recoverability based onundiscounted cash flows, and if impaired, written down to fair value based oneither discounted cash flows or appraised values.

 

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Management held a series ofplanning meetings in September 2005 to assess the current business forecast forall of our reporting units.  Thisassessment analyzed various factors including a reduction in the rate of growthof PAS subscribers in the third quarter, a delay of the expected granting of 3Glicenses in China and Japan, challenges with product quality primarily in ourBroadband reporting unit, a narrowing of our strategic focus related to ourproduct offering and greater than expected revenue and margin decline due tocontinued pricing pressures for several of our key markets.

 

Due to the existence of thetriggering event in September 2005, we determined that there were significantadverse changes in the business outlook which could indicate the carrying valueof certain of its long lived assets groups may not be recoverable and couldindicate the fair value of our reporting units may be below their fairvalue.  As a result, we performed interimimpairment tests on goodwill and certain other long lived tangible and intangibleassets.

 

*Goodwill:*

 

We performed an impairmentanalysis pursuant to SFAS 142 as of September 30, 2005 for all of our reportingunits.  We compared the fair value of thereporting units to their carrying value. We determined the fair value of each reporting unit using both presentvalue and comparable company techniques based, in part, upon an independentvaluation.  The fair values of thereporting units were reconciled to our overall market capitalization atSeptember 30, 2005.

 

As of September 30, 2005, wehave not completed the second step of the goodwill impairment test for ourWireless and PCD units. However, we have used our best estimate to assess thegoodwill impairment for these two units. We expect to complete the second steptest of the goodwill impairment analysis for our Wireless and PCD units in thefourth quarter of 2005 and any adjustment based on the completion of themeasurement of the impairment analysis will be recognized in the fourth quarterof 2005.

 

Based on the impairment assessmentnoted above, a goodwill impairment charge of $192.9 million has been estimatedand was recorded during the three months ended September 30, 2005 to write offthe full value of goodwill for the Wireless, Broadband, Handsets and PCDbusiness units.

 

*Long-livedAssets:*

 

We also tested our long-livedassets  in all of our asset groups forpotential impairment during the current quarter in accordance with SFAS 144,“Accounting for the Impairment or Disposal of Long-lived Assets.”  Based on this analysis, we determined thatthe undiscounted expected future cash flows for the broadband and handset assetgroups were less than the carrying value of the net assets.

 

We determined the relative estimated fair value of tangible assetsthrough a comparison of similar assets, and wherever practical, based on quotedmarket prices taking into consideration the asset type, age, condition, andphysical location of the asset. As a result of this analysis, we recorded animpairment charge of $14.1 million for long-lived tangible assets related tothe Broadband asset group and $9.4 million for long-lived tangible assetsrelated to the Handset asset group.

 

Inaddition, we determined that the fair value of technology intangible assetswithin the Broadband and Handset asset groups as calculated using thediscounted future cash flows was less than the carrying value of the net assetsand as such, we recorded a net asset write-off of $1.7 million.

 
| ** **         | ** ** | **Goodwill**   | ** ** | **Intangible** | ** ** | **PP&E**   | ** ** | ** ** | ** ** |
|--------------------|------------|----------------|------------|----------------|------------|----------------|------------|------------|------------|
| **(in thousands)** | ** ** | **Impairment** | ** ** | **Impairment** | ** ** | **Impairment** | ** ** | **Total**  | ** ** |
|               |       |           |       |           |       |           |       |       |       |
| Handsets           |       | $              | 89,337     |           | $          | 1,678          |       | $          | 9,417      |   | $ | 100,432 |   |
| Wireless           |       | 55,670         |       | —         |       | —         |       | 55,670     |       |
| PCD                |       | 24,712         |       | —         |       | —         |       | 24,712     |       |
| Broadband          |       | 23,210         |       | —         |       | 14,070         |       | 37,280     |       |
| Total              |       | $              | 192,929    |           | $          | 1,678          |       | $          | 23,487     |   | $ | 218,094 |   |
|                    |            |                |            |                |            |                |            |            |            |  |  |  |  |  |

 

* *

*Restructuring costs*

 

In the second quarter offiscal 2005, we announced and initiated a restructuring plan to rationalize ourcost structure in response to the decline in demand for certain of ourproducts.  In addition, the restructuringplan is designed to align investments with key growth opportunities andfacilitate our continuous process of globalization.  The primary goal of these improvements is tooptimize our cost structure and enable us to deliver consistent and sustainableprofitability for our stockholders.

 

During the three monthsended September 30, 2005, we incurred approximately $3.4 million in expenses inrelation to the restructuring plan actions primarily consisting of $2.1 millionin severance payments and $1.2 million in asset impairments primarily relatedto the write-off of equipment and licenses associated with discontinuedproducts.

 

In aggregate, for therestructuring plan we initiated in the second quarter, we incurredapproximately $24.0 million in expenses primarily consisting of $9.8 million inseverance payments, $8.7 million in asset impairments primarily related to thewrite-off of equipment and licenses associated with discontinued products whichare all included in operating expenses and $5.5 million inventory write-offwhich is associated with discontinued products. Restructuring expense related to the inventory write-off is included incost of sales in the Statements of Operations.

 

 

33

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As of September 30, 2005, approximately 965 employees had beenterminated or placed in workforce reduction programs.  We will continue our efforts to evaluatecertain operations and will actively pursue opportunities to divest additionalnon-core assets and may incur additional costs associated with future actionsto further align our business operations.

 

*Subsequentevent*

 

On October 11,2005, the Company provided an interest free, $12.4 million loan to a party inChina as seed capital for a venture organized to participate in the emergingIPTV market. The loan is partially secured and is payable in 10 years and maybe called early without penalty. In addition, the Company expects to make anincremental $12.8 million equity investment related to this venture in thefourth quarter of 2005 or the first quarter of 2006.  A portion of the $12.8 million equityinvestment will be used to extinguish the $12.4 million loan noted above.

 

**RELATEDPARTY TRANSACTIONS:**

 

*Softbank*

 

We recognized revenue of$3.4 million and $53.5 million for the three and nine months ended September30, 2005, respectively, and revenue of $32.0 million and $64.6 million for thethree and nine months ended September 30, 2004, respectively, with respect tosales of telecommunications equipment and services to SBBC, an affiliate ofSOFTBANK CORP. and SOFTBANK America Inc., which is one of our significantstockholders. SBBC offers asynchronous digital subscriber line (“ADSL”)coverage throughout Japan, which is marketed under the name “YAHOO! BB.” Inaddition, we support SBBC’s new fiber-to-the-home service through sales of itscarrier class Gigabit Ethernet Passive Optical Network (“GEPON”) product aswell as its multi-service optical transport product (“NetRingTM”).

 

Included in accountsreceivable at September 30, 2005 and December 31, 2004 were $22.7 millionand $86.8 million, respectively, related to these agreements. Customeradvances were $5.4 million at September 30, 2005 and $5.5 million at December 31,2004, respectively.  Deferred revenue was$5.6 million and $0.5 million as of September 30, 2005 and December 31,2004, respectively.

 

During thethird quarter 2005, we have continued to experience product repair issues. Assuch we recorded additional warranty charges of approximately $9.0 millionprimarily related to NetRing and iAN8000 equipment sold to Japan Telecom, anaffiliate of SOFTBANK CORP and SOFTBANK America Inc. During the first quarter of2005, we incurred a special warranty charge for certain asynchronous digitalsubscriber line (“ADSL”) equipment sold to SBBC, an affiliate of SOFTBANK CORPand SOFTBANK America Inc., during 2003 and 2004.  Since the agreement to repair these partsexceeds our normal warranty terms, we recorded an additional warranty charge inthe first quarter of $9.5 million.

 

During August 2004, weentered into several agreements with Japan Telecom Co., Ltd (“JT”), a whollyowned subsidiary of SOFTBANK Corp. 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.The total gross value of this agreement is $534.1 million. We have determinedthat the service activities revenue should be recorded net of expectedpromotional spending.

 

Because we have not providedthese activities in the past and cannot estimate the fair value of theseservices, we determined under the guidance of SAB 104 that all revenue relatedto these agreements would be deferred and included in customer advance, untilthe above-mentioned promotional obligations were complete. As of March 31,2005, we have delivered and received final acceptance for all equipmentcontemplated under these agreements.  Inaddition, $217.5 million was included in customer advance as ofDecember 31, 2004 relating to these agreements.

 

The promotional servicesdiscussed above involved contracting with third party promotional vendors who,in turn, facilitated the marketing and subscriber recruitment for the JTfiber-to-the-home program. During the fourth quarter of 2004, we determinedthat we would end our involvement with the JT promotional program aftercompletion of the contract discussed above. Accordingly, late in the fourthquarter of 2004 and during the first quarter of 2005, we either cancelled orassigned to another party all third party contracts with promotional vendorsrelated to the JT contract. Such termination or assignment of all third partypromotional agreements, as well as effective satisfaction of obligations withJT under such agreements, satisfied the revenue recognition criteria for theseagreements and as such, the net value of the promotional services and the valueof equipment delivered, which totaled $204.8 million, was reported in thequarter ended March 31, 2005.

 

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We also entered into anagreement during the third quarter of 2004 to supply chassis equipment with anapproximate value of $75 million. The equipment shipped under this agreement isconsidered linked to the Multi-Service Access Node (“*i*AN-8000”)sale noted above and as such, revenue was also deferred until the completion ofthe above-mentioned promotional activities. As discussed above, the revenue recognition criteria related to the saleof the *i*AN-8000 equipment wassatisfied in the first quarter of 2005 and as such, the revenue related to thechassis sale of $66.5 million was reported in the quarter ended March 31,2005.

 

We recognized revenue of$2.5 million and $278.6 million for the three and nine months ended September30, 2005, respectively, with respect to sales of telecommunications equipmentto JT.  At September 30, 2005, deferredrevenue from JT was $14.5 million and $3.9 million was included in accountsreceivable due from JT.

 

We have invested in SoftbankChina and Restructuring Fund No. 1, which are investment vehiclesestablished by SOFTBANK CORP. and its affiliates.  For additional information see Note 12 to ourcondensed consolidated financial statements.

 

On July 17, 2003, weentered into a Mezzanine Loan Agreement with BB Modem Rental PLC (“BB Modem”),an affiliate of SOFTBANK CORP. Under the terms of the agreement, we loaned BBModem $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 SBBC. SBBC will continue to service such modems and modemrental agreements. Our loan is subordinated to certain senior lenders of BBModem, and repayments are payable to us over a 42-month period throughJanuary 31, 2007, with a substantial portion of the principal amount ofthe loan scheduled to be repaid during the last 16 months of this period.Our recourse for nonpayment of the loan is limited to the assets of BB Modem,the account into which subscriber payments are made and its rights under thesecuritization transaction documents. The value of BB Modem’s modems that serveas collateral for the loan may decrease over time and may not be sufficientupon sale to pay the outstanding amounts on the loans. We assess the loan forimpairment whenever events or changes in circumstances indicate that thecarrying amount may not be recoverable. We periodically review the underlyingquality of the asset pool securing the loan to assess whether impairment hasincurred and needs to be recorded. During the three and nine months endedSeptember 30, 2005, we recorded $0.3 million and $1.0 million, respectively, ininterest income in respect to this loan. The loans receivable at September 30,2005 and December 31, 2004 were approximately $10.7 million and $11.8million, respectively, and were included in other long-term assets.

 

On April 5, 2003, werepurchased 8.0 million shares of common stock beneficially owned bySOFTBANK America Inc., at a purchase price of $17.385 per share. The totalcost of the repurchase was $139.6 million including transaction fees. Inconnection with this repurchase transaction, SOFTBANK America Inc.entered into an agreement with us to not offer, sell or otherwise dispose ofthe Company’s common stock for a period of one year, subject to a number ofexceptions. As of September 30, 2005, SOFTBANK America Inc. beneficiallyowned approximately 12.2% of our outstanding stock.

 

On August 29, 2002, wecompleted the repurchase of 6.0 million shares of our common stock for $72.9million from SOFTBANK America, Inc.

 

*Cellon*

 

In October 2002, weentered into a license and a royalty agreement with Cellon InternationalHolding Corporation (“Cellon”), in which we have a 9% ownership interest. Perthe terms of the royalty agreement, we are required to pay Cellon $3.00 perunit shipped for a minimum of 0.1 million units. This agreement is not materialto the overall financial results of Cellon. We have evaluated our relationshipwith Cellon under FIN 46, and determined that consolidation is not necessary.

 

*Fiberxon*

 

We have an outstandingpurchase commitment with Fiberxon, in which we have an 11% ownership interest,to purchase component parts for optical networking products. We anticipate thatwe will be able to fulfill this commitment without material adverseconsequences to our operations or financial condition. Purchases from Fiberxontotaled $0.1 million and $6.7 million during the three and nine months endedSeptember 30, 2005. As of September 30, 2005, we had $0.5 million in accountspayable and $2.9 million of open purchase commitments to Fiberxon.

 

*StarcomProducts, Inc.*

 

We obtain engineeringconsulting and employee placement services from Starcom Products, Inc. (“Starcom”),which is 31% owned by an individual related to a member of our Board ofDirectors. We paid $1.1 million to Starcom in 2004.  We obtained services amounted to $0.1 millionand $0.6 million, respectively, from this entity in the three and nine monthsended September 30, 2005.

 

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*XaltedNetworks*

* *

In May and August2005, the Company invested $2.0 million and $1.0 million, respectively,in Xalted Networks (“Xalted”), a development stage company in thetelecommunication industry.  The Company has less than a 10%ownership interest in Xalted and the investment is accounted for under the costmethod.  The Company made a purchase of $0.5 million for licenserights and services from SysTeam, an affiliated company of Xalted, inthe quarter ended September 30, 2005.

 

*MatsushitaJoint Venture*

 

In July 2002, we entered into ajoint venture agreement with Matsushita Communication Industrial Co., Ltd., a stockholderof ours, to jointly design and develop, manufacture and sell telecommunicationproducts. We paid $14.2 million in cash and hold a 49% ownership interest inthe joint venture company. We do not have voting control over significantmatters of the joint venture company; the investment in and results ofoperations of the joint venture company are accounted for using the equitymethod of accounting.  At September 30,2005, we had $3.1 million in customer advance received from the joint venturefor a research project which we expect to complete in the fourth quarter of2005.  For the nine months endedSeptember 30, 2005, there was no sales revenue recorded and purchases from thejoint venture were immaterial.

 

**RESULTS OF OPERATIONS**

 

Wehistorically managed our business as a single reportable segment.  Effective with the fourth quarter of 2004, itwas determined that our chief operating decision makers, in accordance withSFAS No. 131, “Disclosures about Segments of an Enterprise and RelatedInformation,” were evaluating performance, making operating decisions andallocating resources based on two operating segments, (i) China and(ii) all other regions referred to as International (“International”).

 

On November 1, 2004,we acquired selected assets of the wireless handset division of AudiovoxCorporation. The acquired business has been integrated into our operation as aseparate and distinct operating division referred to as the Personal CommunicationsDivision, (“PCD”). As a result, as of December 31, 2004, we wereorganized, principally based on geographical market locations, in threeoperating segments, China, International and PCD, and each segment consisted ofone reporting unit.

 

Effectivein the first quarter of 2005, we decided to reorganize our business basedprincipally upon product families and realigned our business into fiveoperating units, (i) Broadband Infrastructure, (ii) WirelessInfrastructure, (iii) Handsets, (iv) PCD and (v) Service.

 

Broadbandinfrastructure is primarily comprised of the iAN-8000, IP-Based DigitalSubscriber Line Access Multiplexer (“IP-DSLAM”) (“AN-2000”), GEPON,NetRingTM and other wireline products. Wireless infrastructure is primarilycomprised of the PAS and CDMA products. The handsets and customer premiseequipment products include PAS handsets, and CPE. The PCD products principallycomprise of CDMA handsets.  We alsoprovide installation and certain maintenance services. For each of the periodspresented, total services sales accounted for less than 10% of net sales.

 

Forthe three and nine months ended September 30, 2005, our net sales were $635.3million and $2,260.1 million, respectively,  in comparison to $645.0 million and $1,956.9million, respectively, in the corresponding periods last year.  Net sales may not grow at the same rate ormay even decline in the future. Net sales increased in the Service segment, anddecreased in Broadband, Wireless and Handsets segments in the three monthsended September 30, 2005 compared to the corresponding period of 2004.  Net sales increased in the Broadband andService segments, and decreased in the Wireless and Handsets segments in thenine months ended September 30, 2005 compared to the corresponding periodof 2004.  PCD sales revenue wasincremental in comparison to the same periods in 2004 as a result of theselected assets acquisition from Audiovox in November 2004.

 

Costof sales consists primarily of material and labor costs associated withmanufacturing, assembly and testing of products, costs associated withinstallation and customer training, warranty costs, fees to agents, inventoryprovision and overhead.  Cost of salesalso includes import taxes and tariffs on components and assemblies. Somecomponents and materials used in our products are purchased from a single supplieror a limited group of suppliers and, in some cases, are subject to ourobtaining Chinese import permits and approvals. We also rely on third partymanufacturers to manufacture and assemble most of our CDMA handsets.

 

Asa result of a reduction in current and projected market demand for certainproducts, we announced and initiated in the second quarter of 2005 arestructuring plan to rationalize our cost structure and product offering.  This action has resulted in reduction ofpersonnel and other operating costs.

 

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Ourgross profit has been affected by average selling prices, material costs,product mix and the impact of warranty charges as well as inventory reserves.  In addition, the acquisition of PCD inNovember 2004 has resulted in a higher percentage of revenue associatedwith a product offering at lower margins. Our gross profit, as a percentage of net sales, varies among our productfamilies. We expect that our overall gross profit, as a percentage of netsales, will fluctuate from period to period as a result of shifts in productmix, stage of product life cycle, anticipated decreases in average sellingprices and our ability to reduce cost of sales.

 

Selling,general and administrative expenses (“SG&A”) include compensation andbenefits, professional fees, sales commissions, provision for doubtful accountsreceivable and travel and entertainment costs. A portion of our SG&A costsare fixed and are difficult to quickly reduce in periods of reduced sales.  Research and development expenses consistprimarily of compensation and benefits of employees engaged in research, designand development activities, costs of parts for prototypes, equipmentdepreciation and third party development expenses. A portion of our costs arefixed and are difficult to quickly reduce in periods of lower sales. However,during the second quarter of 2005, we announced and initiated a restructuringplan which resulted in the reduction of certain SG&A and research and developmentcosts. We believe that continued investment in research and development iscritical to our long-term success.

 

Income tax expense is based upon a blendedeffective tax rate based upon our expectation of the amount of income to beearned in each tax jurisdiction and isaccounted under the liability method. Deferred income taxes are recognized forthe differences between the tax bases of assets and liabilities and theirfinancial statement amounts based on enacted tax rates. Valuation allowancesare established when necessary to reduce deferred tax assets to the amountexpected to be realized. We expect to maintain a full valuation allowance onour remaining net deferred tax assets until an appropriate level ofprofitability that generates taxable income is sustained or until we are ableto develop tax strategies that would enable us to conclude that it is morelikely than not that a portion of our deferred tax assets will be realizable.Any reversal of valuation allowances will favorably impact our results ofoperations in the period of the reversal.

 

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**NET SALES**

 

Sales by geography

 
| ** **         | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|--------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **         | ** ** | ** **                           | ** ** | **% of net**                        | ** ** | ** ** | ** ** | **% of net** | ** ** | ** ** | ** ** | **% of net** | ** ** | ** ** | ** ** | **% of net** | ** ** |
| **(in thousands)** | ** ** | **2005**                             | ** ** | **sales**                           | ** ** | **2004** | ** ** | **sales** | ** ** | **2005** | ** ** | **sales** | ** ** | **2004** | ** ** | **sales** | ** ** |
|               |       |                                 |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| United  States     |       | $                                    | 359,131    |                                | 57%        |   |   | $ | 13,211 |   | 2% |   |   | $ | 987,524 |   | 44% |   |   | $ | 44,969 |   | 2% |   |   |
| China              |       | 210,954                              |       | 33%                                 |       |   | 589,552 |   | 92% |   |   | 727,653 |   | 32% |   |   | 1,778,440 |   | 91% |   |   |
| Japan              |       | 13,794                               |       | 2%                                  |       |   | 34,075 |   | 5% |   |   | 398,853 |   | 18% |   |   | 75,607 |   | 4% |   |   |
| Other              |       | 51,428                               |       | 8%                                  |       |   | 8,178 |   | 1% |   |   | 146,033 |   | 6% |   |   | 57,919 |   | 3% |   |   |
| Total net  sales   |       | $                                    | 635,307    |                                | 100%       |   |   | $ | 645,016 |   | 100% |   |   | $ | 2,260,063 |   | 100% |   |   | $ | 1,956,935 |   | 100% |   |   |

 

## ***Three months and nine months endedSeptember 30, 2005 and 2004***

## *** ***

Netsales were $635.3 million in the three months ended September 30, 2005, adecrease of 2% compared to $645.0 million in the corresponding period of 2004.Although sales generated from China decreased, the decrease was nearly offsetby the incremental sales in the United States derived from PCD, resulting fromthe selected assets we acquired from Audiovox in November 2004.

 

As we have experienced in recent quarters, thedemand for our PAS/iPAS products, including PAS/iPAS system-based handsets inthe China market continued to mature, resulting in lower demand and averageselling prices.  We believe that demandfor our PAS products has weakened as telecommunication service providers delaydeploying new systems in anticipation of the introduction of new technology fornext generation telecommunication equipment. However, we expect long-term demand for our PAS/iPAS products willcontinue as we believe PAS will remain an important technology and market inChina for the foreseeable future.

 

Netsales were $2,260.1 million in the nine months ended September 30, 2005,an increase of 15% from $1,956.9 million in the corresponding period of2004.  The overall increase in net saleswas primarily due to the incremental revenue derived from PCD, resulting fromthe selected assets we acquired from Audiovox in November 2004. Inaddition, net sales were higher as a result of stronger first quarter salesrevenue in our Broadband Infrastructure segment primarily due to recognition ofrevenue for products delivered to Japan Telecom in the third and fourthquarters of 2004 which had been previously deferred, which was offset by thedecrease in Wireless and Handset sales in China.

 

Net sales increased in ourBroadband Infrastructure and Service segments. Net sales decreased in Wirelessand Handsets segments, offset by incremental sales derived from PCD, in thenine months ended September 30, 2005, compared to the corresponding periodin 2004.

 

Netsales revenue by geography shifted significantly in comparison to thecorresponding period of 2004, attributable in part to our continuous efforts togrow our business internationally. Revenue derived from China accounted forapproximately 33% and 32%, respectively, of our net sales revenue in the three monthsand nine months ended September 30, 2005, in comparison to approximately 92%and 91%, respectively, in the corresponding period last year.

 

We group our China customersby province, the level at which purchasing decisions are made, and treat each province as one customer. AtSeptember 30, 2005 and 2004, we had 33 and 31 such customers, respectively.

 

We have one customer in theUnited States that contributed approximately 18% of our net sales for the threemonths ended September 30, 2005.  Twoprovinces in China contributed approximately 13% and 12% of our net sales forthe three months ended September 30, 2004.

 

Sales to one customer in theUnited States contributed approximately 11% and one customer in Japan accountedfor 12% of our sales for the nine months ended September 30, 2005. Twoprovinces in China accounted for 14% and 12% of our net sales for the ninemonths ended September 30, 2004.

 

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Sales by Segment

 
| ** **         | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|--------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **         | ** ** | ** **                           | ** ** | **% of net**                        | ** ** | ** ** | ** ** | **% of net** | ** ** | ** ** | ** ** | **% of net** | ** ** | ** ** | ** ** | **% of net** | ** ** |
| **(in thousands)** | ** ** | **2005**                             | ** ** | **sales**                           | ** ** | **2004** | ** ** | **sales** | ** ** | **2005** | ** ** | **sales** | ** ** | **2004** | ** ** | **sales** | ** ** |
|               |       |                                 |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Broadband          |       | $                                    | 32,934     |                                | 5%         |   |   | $ | 51,928 |   | 8% |   |   | $ | 422,588 |   | 19% |   | $ | 148,895 |   | 8% |   |   |
| Wireless           |       | 113,431                              |       | 18%                                 |       |   | 419,630 |   | 65% |   |   | 371,541 |   | 16% |   | 1,176,433 |   | 60% |   |   |
| Handsets           |       | 106,294                              |       | 17%                                 |       |   | 161,028 |   | 25% |   |   | 380,416 |   | 17% |   | 591,799 |   | 30% |   |   |
| PCD                |       | 363,637                              |       | 57%                                 |       |   | — |   | 0% |   |   | 1,021,452 |   | 45% |   | — |   | 0% |   |   |
| Service            |       | 19,011                               |       | 3%                                  |       |   | 12,430 |   | 2% |   |   | 64,066 |   | 3% |   | 39,808 |   | 2% |   |   |
|               |       |                                 |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net sales          |       | $                                    | 635,307    |                                | 100%       |   |   | $ | 645,016 |   | 100% |   |   | $ | 2,260,063 |   | 100% |   | $ | 1,956,935 |   | 100% |   |   |

 

*Broadband Infrastructure*

 

Revenue from externalcustomers for the Broadband Infrastructure operating segment was $32.9 millionin the three months ended September 30, 2005, as compared to $51.9 million inthe corresponding quarter in 2004.  Thedecline in revenue growth was mainly due to a delay of revenue recognition on “IPTV”products sold to Softbank in Japan. There was a shift in product mix towards newer products such as GEPONand NetRingTM product lines.  These twoproduct lines made up 39% of the total Broadband segment compared to aninsignificant amount for the corresponding period in 2004.

 

Revenue from external customersfor this operating segment was $422.6 million in the nine months endedSeptember 30, 2005, as compared to $148.9 million in the corresponding periodin 2004.  The increase in net sales wasdue to the completion of revenue recognition of certain agreements entered intowith Japan Telecom for the iAN8000 product that had been recorded as deferredrevenue in prior quarters. We do not expect our sales to Japan Telecom tomaintain this pace in the future.

 

The Broadband Infrastructure sales are highly correlated to subscribergrowth.  Our ability to grow theBroadband Infrastructure segment is dependent on the expansion of our currentproduct base and further successful introduction and acceptance of new andinnovative Broadband Infrastructure product offerings such as mVision and IPTVin China, Japan and other geographic regions.

 

*Wireless Infrastructure*

 

Revenue from externalcustomers for the Wireless Infrastructure operating segment was $113.4 millionin the three months ended September 30, 2005, as compared to $419.6 million inthe corresponding quarter in 2004. The decrease in net sales was primarily aresult of (i) our customers in China continuing the transition from new systeminstallations to system expansions as PAS/iPAS systems reach product maturationand (ii) our customers delayingcapital spending in anticipation of next generation technology.

 

Revenue from externalcustomers for this operating segment was $371.5 million in the nine monthsended September 30, 2005, as compared to $1,176.4 million in the correspondingperiod in 2004.  The decrease in netsales primarily was a result of (i) our customers in China changing theirbuying patterns since late 2004 from new system installations to systemexpansions as PAS/iPAS systems which have reached product maturation, and (ii) customers delaying capital spendingin anticipation of next generation technology.

 

We willcontinue to support our customers in China as they manage subscriber demand fortheir PAS networks over the next several years. We expect the subscriber growth of the PAS market in China andour Wireless Infrastructure sales to stabilize in the near term and we believewe will maintain our market position.  Inaddition, we believe we are positioned to grow the Wireless segment with productssupporting the emerging 3G market in China.

 

*Handsets*

 

Revenue from externalcustomers in the Handsets operating segment totaled $106.3 million in the threemonths ended September 30, 2005 as compared to $161.0 million in thecorresponding quarter of 2004. The decrease in net sales was primarilyattributable to decreasing unit volume and pricing pressure in the Chinatelecommunications market since the later part of 2004.  The number of PAS handsets sold during thisquarter was 2.3 million units compared to 3.2 million units during thecorresponding quarter in 2004 while the average selling price per unit declined19%.

 

 

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Revenue from externalcustomers in the PAS/iPAS systems Handsets operating segment totaled $380.4million in the nine months ended September 30, 2005 as compared to $591.8million in the corresponding period of 2004. As noted above, the decrease innet sales was primarily attributable to both decreasing unit volume and pricingpressure in the China telecommunications market since the later part of2004.  The number of PAS handsets soldduring the nine months ended September 30, 2005 was 8.7 million units comparedto 11.3 million units for the corresponding period in 2004 while the averageselling price per unit declined 18%.

 

We have recently begun tosell both GSM and CDMA handsets in China. Such sales accounted forapproximately 12% of our Handset revenue in China for the third quarter of2005.  As new technologies are adopted inthe China market, we believe handset sales will increase.  We intend to continue to expand our globalproduct offering through our development activities.

 

*PCD*

 

Revenue from externalcustomers for the PCD operating segment was $363.6 million in the three months endedSeptember 30, 2005. No revenue was recorded in the corresponding quarterlast year due to the fact that the acquisition of the wireless handset divisionof Audiovox Corporation and the creation of PCD did not occur untilNovember 2004.

 

Revenue from externalcustomers for the PCD operating segment was $1,021.5 million in the nine monthsended September 30, 2005. No revenue was recorded in the corresponding periodlast year due to the fact that the acquisition of the wireless handset divisionof Audiovox Corporation and the creation of PCD did not occur untilNovember 2004.

 

*Service*

 

Service Revenue fromexternal customers for the Service operating segment was $19.0 million in thethree months ended September 30, 2005 as compared to $12.4 million in thecorresponding quarter last year.  Theincrease was due to the continuing development of our service productofferings.

 

Service Revenue fromexternal customers for the Service operating segment was $64.1 million in thenine months ended September 30, 2005 as compared to $39.8 million in thecorresponding quarter last year.  Revenuefor the Service operating segment for the nine months ended September 30, 2005included $12.6 million of revenue and gross profit associated with promotionalservices for Japan Telecom recognized in the first quarter of 2005.

 

**GROSSPROFIT**

 
| ** **         | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|--------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **         | ** ** | ** **                           | ** ** | **Gross**                           | ** ** | ** ** | ** ** | **Gross** | ** ** | ** ** | ** ** | **Gross** | ** ** | ** ** | ** ** | **Gross** | ** ** |
| **(in thousands)** | ** ** | **2005**                             | ** ** | **Profit %**                        | ** ** | **2004** | ** ** | **Profit %** | ** ** | **2005** | ** ** | **Profit%** | ** ** | **2004** | ** ** | **Profit %** | ** ** |
|               |       |                                 |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Broadband          |       | $                                    | (14,086    | )                                   | -43%       |   |   | $ | 5,885 |   | 11% |   |   | $ | 168,194 |   | 40% |   | $ | 41,062 |   | 28% |   |   |
| Wireless           |       | 32,477                               |       | 29%                                 |       |   | 104,797 |   | 25% |   |   | 104,041 |   | 28% |   | 322,764 |   | 27% |   |   |
| Handsets           |       | 13,646                               |       | 13%                                 |       |   | 23,680 |   | 15% |   |   | 51,145 |   | 13% |   | 111,330 |   | 19% |   |   |
| PCD                |       | 13,199                               |       | 4%                                  |       |   | — |   | — |   |   | 42,881 |   | 4% |   | — |   | — |   |   |
| Service            |       | 8,710                                |       | 46%                                 |       |   | 2,772 |   | 22% |   |   | 35,321 |   | 55% |   | 14,283 |   | 36% |   |   |
|               |       |                                 |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Gross Profit       |       | $                                    | 53,946     |                                | 8%         |   |   | $ | 137,134 |   | 21% |   |   | $ | 401,582 |   | 18% |   | $ | 489,439 |   | 25% |   |   |

 

### *Threeand nine months ended September 30, 2005 and 2004*

 

Gross profit was $53.9 million, or 8% of net sales, in the three monthsended September 30, 2005, compared to $137.1 million, or 21% of net sales, inthe corresponding quarter of 2004.  Theabsolute decrease in gross profit dollars is primarily the result of a 73%decline in Wireless revenue reflective of the maturing market in China.  We attribute the decrease in gross profit, asa percentage of sales, to several factors including pricing pressure, warrantyand inventory reserves and the impact of lower margins from PCD businessacquired in November 2004.  Handsetssales through PCD have a gross profit margin of approximately 4%, which islower than gross profit margins realized on PAS/iPAS system basedhandsets.  PCD contributed $13.2 millionin gross margin for the three months ended September 30, 2005 and had nocontribution in the corresponding quarter in fiscal 2004 because we did notacquire PCD until November 2004.

 

Our Broadband Infrastructure operating segmentreported a negative gross margin of 43% during the three months ended September30, 2005 primarily due to $9.0 million of additional costs incurred relating tocertain contracts in Japan where quality issues were encountered.  The gross profit percentage decreased in ourBroadband and Handsets operating segments, and improved in our Wireless andService segments in the three months ended September 30, 2005.  We believe our gross profit as a percentageof net sales will fluctuate in the future.

 

Gross profit was $401.6million, or 18% of net sales, in the nine months ended September 30, 2005,compared to $489.4 million, or 25% of net sales, in the corresponding period of2004. Gross profit dollars declined primarily attributable to the weakness ofWireless Infrastructure and Handset sales in China offset by an increase inBroadband Infrastructure sales in Japan, primarily in the first quarter.  The decline of the gross profit, as apercentage of sales, is primarily due to the inclusion of PCD with gross profitat approximately 4% of sales.  Grossprofit for the nine months ended September 30, 2005 excluding PCD was 29%.

 

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*Broadband Infrastructure*

 

The Broadband Infrastructureoperating segment reported a negative gross margin from external customers of$14.1 million in the three months ended September 30, 2005, as compared toa gross profit of $5.9 million in the corresponding quarter in 2004.  The loss was primarily attributable toadditional warranty costs of approximately $9.0 million incurred relating tocertain contracts in Japan where quality issues were encountered. In addition,there were inventory reserves of approximately $5.3 million due to the aging ofcertain inventory primarily in China.

 

Gross profit from external customersfor the segment was $168.2 million in the nine months ended September 30, 2005,as compared to $41.1 million in the corresponding period in 2004.  The gross margin improvement, both inabsolute dollars and as a percentage of net sales, in the nine months endedSeptember 30, 2005 was largely due to the margins achieved on our iAN8000products relating to the Japan Telecom agreements in the first quarter.

 

Our ability to continue to grow the Broadband Infrastructure operating segmentis dependent on the expansion of our current product base and furthersuccessful introduction and acceptance of new and innovative BroadbandInfrastructure product offerings such as mVision and IPTV in China, Japan andother geographic regions.

 

*Wireless Infrastructure*

 

Gross profit contributionfrom external customers for the Wireless Infrastructure operating segmenttotaled $32.5 million in the three months ended September 30, 2005, as comparedto $104.8 million in the corresponding quarter in 2004.  The gross profit as a percentage of net salesfor the three months ended September 30, 2005 improved slightly comparedto the corresponding quarter in 2004.

 

Gross profit from externalcustomers for the Wireless Infrastructure operating segment totaled $104.0million in the nine months ended September 30, 2005, as compared to $322.8million in the corresponding period in 2004. The gross profit in absolute dollars declined proportionally to therevenue decrease in the nine months ended September 30, 2005. As such, grossprofit as a percentage of net sales for the nine months ended September 30,2005 remained relatively constant compared to the nine months endedSeptember 30, 2004.

 

We willcontinue to support our customers in China as they manage subscriber demand fortheir PAS networks over the next several years. In addition, we believe we are positioned to grow the WirelessInfrastructure operating segment with products supporting the emerging 3Gmarket in China.

 

*Handsets*

 

Gross profit contributionfrom external customers for the Handsets operating segment totaled $13.6million in the three months ended September 30, 2005, as compared to $23.7million in the corresponding quarter in 2004. The gross profit as a percentage of net sales for the three months endedSeptember 30, 2005 declined 2% compared to the corresponding quarter in2004.

 

Decreasing unit volume drivenby a declining growth rate of PAS subscribers along with price erosioncontributed to the downward gross profit for the Handsets segment in the threemonths ended September 30, 2005.  Thenumber of PAS handsets sold this quarter was 2.3 million units compared to 3.2million units for the corresponding quarter in 2004, while the average sellingprice per unit declined 19%.

 

As noted above, the decreasein net sales was primarily attributable to a continuous trend of pricingpressure in the China telecommunications market since the later part of2004.  Decreasing unit volume along withprice erosion contributed to the downward gross profit for the handset segmentin the nine months ended September 30, 2005. The number of PAS handsets sold during the nine months ended September30, 2005 was 8.7 million units compared to 11.3 million units for thecorresponding period in 2004, while the average selling price per unit declined18%.

 

We have recently begun tosell both GSM and CDMA handsets in China. Such sales accounted forapproximately 12% of our Handsets segment revenue in China for the thirdquarter of 2005.  As new technologies areadopted in the China market, we believe Handset segment sales will increase.  We are positioned to introduce products thatsupport future growth.

 

*PCD*

 

Gross profit from externalcustomers for the PCD operating segment was $13.2 million in the three monthsended September 30, 2005. The gross profit as a percentage of net salesrecognized on handset sales through PCD was approximately 4% and is typicallylower than that realized on PAS/iPAS systems based handsets.  No revenue was recorded in the correspondingperiod last year due to the fact that the acquisition of PCD did not occuruntil November 2004.

 

Gross profit from externalcustomers for the PCD operating segment was $42.9 million in the nine monthsended September 30, 2005. The gross profit as a percentage of net sales wasapproximately 4% and is expected to remain stable for the remainder of 2005.

 

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*Service*

 

The gross profit fromexternal customers for the Service operating segment was $8.7 million, or 46%of net service revenue, in the three months ended September 30, 2005 comparedto $2.8 million, or 22% of net service revenue, in the same period in the prioryear.  The increase is due to an increasein overall net sales for this segment performed by a relatively consistentheadcount as well as an increase in China services which have lower associatedcosts.  Gross profit from externalcustomers for the Service operating segment totaled $35.3 million in the ninemonths ended September 30, 2005, as compared to $14.3 million in the correspondingperiod in 2004.  $12.6 million of revenueand gross profit associated with promotional services for Japan Telecomrecognized in the first quarter of 2005 contributed significantly to the totalgross profit for the nine months ended September 30, 2005.

 

**OPERATINGEXPENSES**

 

The following tablesummarizes our operating expenses:

 
| ** **                          | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|-------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                          | ** ** | ** **                           | ** ** | **% of net**                        | ** ** | ** ** | ** ** | **% of net** | ** ** | ** ** | ** ** | **% of net** | ** ** | ** ** | ** ** | **% of net** | ** ** |
| **(in thousands)**                  | ** ** | **2005**                             | ** ** | **sales**                           | ** ** | **2004** | ** ** | **sales** | ** ** | **2005** | ** ** | **sales** | ** ** | **2004** | ** ** | **sales** | ** ** |
| Selling, general and administrative |       | $                                    | 88,708     |                                | 14%        |   |   | $ | 74,916 |   | 11% |   |   | $ | 299,728 |   | 13% |   | $ | 209,689 |   | 10% |   |   |
| Research and development            |       |                                 | 60,797     |                                | 9%         |   |   |   | 56,026 |   | 9% |   |   |   | 193,078 |   | 8% |   |   | 154,276 |   | 8% |   |   |
| In-process research and development |       |                                 | —     |                                | 0%         |   |   |   | — |   | 0% |   |   |   | 660 |   | 0% |   |   | 1,400 |   | 0% |   |   |
| Amortization of intangible assets   |       |                                 | 6,643      |                                | 1%         |   |   |   | 3,639 |   | 1% |   |   |   | 20,391 |   | 1% |   |   | 9,946 |   | 1% |   |   |
| Restructuring costs                 |       |                                 | 3,378      |                                | 1%         |   |   |   | — |   | 0% |   |   |   | 18,505 |   | 1% |   |   | — |   | 0% |   |   |
| Asset Impairment                    |       |                                 | 218,094    |                                | 34%        |   |   |   | — |   | 0% |   |   |   | 218,094 |   | 10% |   |   | — |   | 0% |   |   |
|                                |       |                                 |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total operating expenses            |       | $                                    | 377,620    |                                | 59%        |   |   | $ | 134,581 |   | 21% |   |   | $ | 750,456 |   | 33% |   | $ | 375,311 |   | 19% |   |   |

 

*SELLING,GENERAL AND ADMINISTRATIVE*

 

Three months ended September30, 2005 and 2004

 

Selling, general and administrativeexpenses (“SG&A”) were $88.7 million and $74.9 million in the three monthsended September 30, 2005 and 2004, respectively. SG&A expenses as apercentage of net sales were 14% and 11% in the three months ended September30, 2005 and 2004, respectively.

 

The increase in SG&Aexpenses in absolute dollars of $13.8 million was primarily due to severalfactors, including headcount and overhead of $6.0 million to support our PCDoperations which did not exist in the corresponding period in 2004 and increasedprofessional fees of $5.4 million associated with the supply chain management,system integration, Sarbanes-Oxley Act compliance projects and legal fees.

 

Nine months ended September30, 2005, and 2004

 

SG&A expenses were$299.7 million and $209.7 million in the nine months ended September 30, 2005and 2004, respectively. SG&A expenses as a percentage of net sales were 13%and 10% in the nine months ended September 30, 2005 and 2004, respectively.

 

The increase of $90.0million in absolute dollars in SG&A expenses was primarily due to i) anincrease in professional services fees of $23.3 million associated withsupply chain management, system integration, Sarbanes-Oxley Act complianceprojects and legal fees, ii) an increase in allowance for doubtful accountsexpense of $20.6 million during the first nine months of 2005 compared to thecorresponding period of 2004 reflecting a continued deterioration of agedreceivables primarily in China, iii) increased headcount and overhead of$17.2 million to support our PCD operations which did not exist in thecorresponding period in 2004, iv) and increase headcount and overhead in otheroperations of $15.7 million incurred during the first two quarters of 2005 ascompared to the same quarters in 2004 and (v) and increase in facilitiesexpense of $3.8 million for the Hangzhou, China office.

 

The Company expects theactions associated with the restructuring plan will reduce its current run rateand reduce SG&A as a percentage of sales.

 

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*RESEARCHAND DEVELOPMENT*

 

Three months ended September30, 2005 and 2004

 

Researchand development (“R&D”) expenses were $60.8 million, or 9% of net sales, inthe three months ended September 30, 2005, compared to $56.0 million, or 9% ofnet sales, in the corresponding period of 2004. The increase of $4.8 million in absolutedollars of R&D expenses can be primarily attributed to the net increasedheadcount of approximately 221 employees resulting from various acquisitions tosupport both product enhancements and new product development offset by therestructuring related headcount reduction. The higher head count contributed to an increase of $4.8 million inpersonnel related expenses, and $1.2 million in depreciation and facility expenses,partially offset by a decrease of professional costs of $3.2 million associatedwith outsourced projects in new designs and product development.

 

Nine months ended September30, 2005, and 2004

 

R&D expenses were $193.1 million and $154.3million, or 8% and 8% of net sales, in the nine months ended September 30, 2005 and2004, respectively. In absolute dollars, R&D expenses increased by $38.8million, primarily due to the hiring of additional technical personnel tosupport product enhancements and development, as well as retention of employeesfrom various acquisitions and offset by the restructuring related headcountreduction which we initiated in the second quarter of 2005.  Personnel expenses, including payroll,payroll taxes and benefits, increased by $19.7 million due to the net increasedhead count.  In addition, the increase inR&D expenses also can be attributed to increased professional costs of $6.3 millionassociated with outsourced projects driven by numerous product developmentprojects.

 

*IN-PROCESS RESEARCH ANDDEVELOPMENT*

 

Ninemonths ended September 30, 2005 and 2004

 

The $0.7 million and $1.4million charges to in-process research and development (“IPR&D”) for thenine months ended September 30, 2005 and 2004, respectively, were related toour acquisitions of Pedestal Networks and TELOS.  All charges to IPR&D were based, in part,upon independent valuations.  Inassessing IPR&D projects, we considered key product characteristicsincluding each product’s development stage at the acquisition date, eachproduct’s life cycle and each product’s future prospects.  We also considered the rate at whichtechnology changes in the relevant industry, the industry’s competitiveenvironment and the economic market outlook.

 

*AMORTIZATIONOF INTANGIBLE ASSETS*

 

Three months ended September30, 2005 and 2004

 

Amortization of intangibleassets expenses were $6.6 million and $3.6 million, or 1% and 1% of net salesin the three months ended September 30, 2005 and 2004, respectively.  The increase in the amortization ofintangible assets for the three months ended September 30, 2005 was due to theacquisitions of the wireless handset division of Audiovox Corporation inNovember 2004 and Giga in January 2005, which are in the results ofthe current year but not in the same period last year. The increase inamortization of intangible assets expense in the three months endedSeptember 30, 2005 was partially offset by the write-off of intangiblesrelating to HSI of $4.5 million in the fourth quarter of 2004.

 

Nine months ended September30, 2005 and 2004

 

Amortization of intangibleassets expenses were $20.4 million and $9.9 million, or 1% and 1% of net salesin the nine months ended September 30, 2005 and 2004, respectively. In absolutedollars, amortization expense increased by $10.4 million.  The increase in the amortization ofintangible assets for the nine months ended September 30, 2005 was due to afull nine months of amortization expense associated with the intangibles recordedupon our acquisition of TELOS in May 2004, the wireless handset divisionof Audiovox Corporation in November 2004 and Giga in January 2005, ascompared to the four months expense related to TELOS recorded in thecorresponding period of 2004.

 

*RESTRUCTURING COSTS*

 

Threeand nine months ended September 30, 2005

 

In the second quarter offiscal 2005, we announced and initiated a restructuring plan to rationalize ourcost structure in response to the decline in demand for certain of ourproducts.  In addition, the restructuringplan is designed to allow us to

 

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reduce operating costs foreach product line, align investments with key growth opportunities andfacilitate the process of globalization. The primary goal of these improvements is to optimize our cost structureand enable us to deliver consistent and sustainable profitability for ourstockholders.

 

During the three months endedSeptember 30, 2005, the Company incurred approximately $3.4 millionin expenses in relation to the restructuring plan actions, consisting of $2.1million related to severance payments and $1.2 million in asset impairmentsprimarily related to the write-off of equipment and licenses associated withdiscontinued products.

 

During the nine months endedSeptember 30, 2005, the Company incurred approximately $18.5 million inoperating expenses in relation to the restructuring plan actions, primarilyconsisting of $9.8 million related to severance payments and $8.7 million inasset impairments primarily related to the impairment of equipment and licensesassociated with discontinued products. Included in the restructuring costs of $18.5 million are non-cashcharges of $7.6 million in asset impairments. We made cash payments of $10.5 millionfor severance and other benefits, and $1.1 million of accrued expenses will besettled in the fourth quarter of 2005. As part of the restructuring plan, during the nine months endedSeptember 30, 2005 we recorded $5.5 million in inventory write-off which isassociated with discontinued products. Restructuring expense related to the inventory write-off is included incost of sales in the Consolidated Statements of Operations.

 

As of the end of the thirdquarter of 2005 approximately 965 employees had been terminated or placed inworkforce reduction programs.

 

*ASSETIMPAIRMENT*

 

Due to the existence ofimpairment indicators in September 2005, it was determined that there weresignificant adverse changes in the business outlook which could indicate thecarrying value of certain of our long-lived assets groups may not berecoverable and could indicate the fair value of our reporting units may bebelow their carrying value.  We performedinterim impairment tests on goodwill and certain other long lived assets.  As a result of the impairment test, werecorded an impairment charge of long-lived assets of $218.1 million for thequarter ended September 30, 2005.  Thisimpairment charge consisted of $192.9 million of goodwill, $1.7 million ofintangible assets and $23.5 million of property, plant and equipment.

 

*INTERESTINCOME*

 

Three months ended September30, 2005 and 2004

 

Interest income was $1.7million and $1.3 million for the three months ended September 30, 2005 and2004, respectively. Although there was a decrease in cash and short-term investmentbalances in the three months ended September 30, 2005 as compared to thecorresponding period of 2004, an increase in the average interest rate resultedin an increase in interest income.

 

Nine months ended September30, 2005 and 2004

 

Interest income was $4.5million and $4.5 million for the nine months ended September 30, 2005 and 2004,respectively. Interest income was generated from cash and short-term investmentbalances which declined in the nine months ended September 30, 2005 as comparedto the corresponding period of 2004, such decline being offset by an increasein the interest rate.

 

*INTERESTEXPENSE*

 

Three months ended September30, 2005 and 2004

 

Interest expense was $3.9million and $1.2 million for the three months ended September 30, 2005 and2004, respectively.  The increase ininterest expense for the three months ended September 30, 2005 was attributableto the increase in short-term borrowings in the form of bank loans as well asan increase in the borrowing rate.

 

Nine months ended September30, 2005 and 2004

 

Interest expense was $12.9million and $3.4 million for the nine months ended September 30, 2005 and 2004,respectively.  The increase in interestexpense for the nine months ended September 30, 2005 was attributable to anincrease in short-term borrowings in the form of bank loans as well as anincrease in the borrowing rate.

 

44

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*GAIN ONEXTINGUISHMENT OF DEBT*

 

Threeand nine months ended September 30, 2005

 

Gainon extinguishment of debt, net of write-off of unamortized issuance expenses,was $20.3 million and $31.4 million for the three and nine months endedSeptember 30, 2005, respectively.  InJune 2005, 1,482,000 shares of our common stock with a fair value ofapproximately $10.6 million and approximately $15.8 million in cash wereexchanged for $38.0 million aggregate principal amount of our outstanding 7/8%Convertible Subordinated Notes due 2008. In the third quarter of 2005, we completed four additional exchangeswherein we exchanged a total of 3,506,100 shares of our common stock with afair value of approximately $27.0 million and approximately $41.4 million incash for $89.9 million aggregate principal amount of our Notes.

 

*OTHERINCOME (EXPENSES)*

 

Three months ended September30, 2005 and 2004

 

Net other income was $7.4million and $1.2 million for the three months ended September 30, 2005 and2004, respectively. Net other income for the three months ended September 30,2005 primarily consisted of foreign exchange gains of $7. 3 million. Theforeign exchange gains are primarily the result of gains for the company’sChina subsidiaries attributed to the appreciation of the Chinese Renminbi on USdollar denominated short-term debt and payables, offset by a loss attributedto the appreciation of the US dollar on Japanese Yen denominated cash andaccounts receivable. For the three months ended September 30, 2004, net otherincome of $1.2 million was primarily due to net investment gains of $1.1million and consumption tax refunds in Japan of $0.7 million offset by currencyexchange losses of $0.5 million.

 

Nine months ended September30, 2005 and 2004

 

Net other expense was $1.7million for the nine months ended September 30, 2005 and net other income was$14.2 million for the nine months ended September 30 2004. Net other expensefor the nine months ended September 30, 2005 primarily consisted of a foreignexchange loss of $7.3 million offset by a $6.0 million consumption tax refundin Japan.  The foreign exchange losses primarily consist of lossesattributed to the appreciation of the US dollar on Japanese Yen denominatedcash and accounts receivable, offset by gains for the company’s Chinasubsidiaries attributed to the appreciation of the Chinese Renminbi on USdollar denominated short-term debt and payables.  Yen-denominated salesand accounts receivable were significantly higher during the nine months endedSeptember 30, 2005 as compared to the same period last year.

 

For the nine months endedSeptember 30, 2004, net other income of $14.2 million can be attributedprimarily to a $10.2 million financial subsidy from the local Chinesegovernment relating to our investment in local research and development andmanufacturing and a Japanese consumption tax refund of $2.1 million.

 

*INCOME TAXEXPENSE (BENEFIT)*

 

Three months ended September 30, 2005 and 2004

 

In establishing our deferredincome tax assets and liabilities, we make judgments and interpretations basedon the enacted tax laws and published tax guidance applicable to our operationsas well as the amount and jurisdiction of future taxable income.  We record deferred tax assets and liabilitiesand evaluate the need for valuation allowances to reduce the deferred taxassets to realizable amounts. As of September 30, 2005, we did not believe itwas more likely than not that we would generate a sufficient level and propermix of taxable income within the appropriate period to utilize all the deferredtax assets. As a result of the review undertaken at September 30, 2005, we haveconcluded that it was appropriate to establish a full valuation allowance forthe net deferred tax assets which the cumulative losses weigh heavily in theoverall assessment.  Accordingly, werecorded a $93.1 million non-cash charge at September 30, 2005 in theUnited States and China.

 

Income taxexpense was $103.6 million and a benefit of $1.9 million for the three monthsended September 30, 2005 and 2004, respectively. The increase in incometax expense was primarily attributable to the $93.1 million non-cash charge toprovide a full valuation allowance on our remaining net deferred tax assets atSeptember 30, 2005 in the United States and China.

 

Nine months ended September June 30, 2005 and 2004

 

Income tax expense was$110.0 million and $22.8 million for the nine months ended September 30,2005 and 2004, respectively.   Theincrease in income tax expense was primarily attributable to an $93.1 millionnon-cash charge to provide a full valuation allowance on our remaining netdeferred tax assets at September 30, 2005 in the United States and China.

 

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*EQUITY INNET LOSS OF AFFILIATED COMPANIES*

 

Three months ended September30, 2005 and 2004

 

Equity in net loss ofaffiliated companies was $0.8 million and $0.7 million for the three monthsended September 30, 2005 and 2004, respectively. The loss in both periods wasprimarily attributable to the loss recognized from our joint ventureinvestments with Matsushita Communication Industrial Co., Ltd., and MatsushitaElectronic Industrial Co., Ltd.

 

Nine months ended September30, 2005 and 2004

 

Equity in net loss ofaffiliated companies was $1.8 million and $2.9 million for the nine monthsended September 30, 2005 and 2004, respectively. The loss in both periods wasprimarily attributable to the loss recognized from our joint ventureinvestments with Matsushita Communication Industrial Co., Ltd., and MatsushitaElectronic Industrial Co., Ltd.

 

*Segment reporting*

 

Wehistorically managed our business as a single reportable segment.  Effective with the fourth quarter of 2004, itwas determined that our chief operating decision makers, in accordance withSFAS No. 131, “Disclosures about Segments of an Enterprise and RelatedInformation,” were evaluating performance, making operating decisions andallocating resources based on two operating segments, (i) China and(ii) all other regions referred to as International (“International”).

 

OnNovember 1, 2004, we acquired selected assets of the wireless handsetdivision of Audiovox Corporation. The acquired business has been integratedinto our operation as a separate and distinct operating division referred to asthe Personal Communications Division, (“PCD”). As a result, as ofDecember 31, 2004, we were organized, principally based on geographicalmarket locations, in three operating segments, China, International and PCD,and each segment consisted of one reporting unit.

 

Effectivein the first quarter of 2005, we decided to reorganize our business basedprincipally upon product families and realigned our business into fiveoperating units, (i) Broadband Infrastructure, (ii) WirelessInfrastructure, (iii) Handsets, (iv) PCD and (v) Service.

 

Eachoperating unit represents its own reporting segment and each operating unit isresponsible for its own production and sales management.  We currently evaluate the operatingperformance of and allocate resources to the reporting segments based onsegment gross profit.  Cost of sales anddirect expenses in relation to production are assigned to the reportingsegments.  Corporate headquartersexpenses and non-operating items are not allocated to the segments.  The accounting policies used in measuringsegment assets and operating performance are the same as the corporate andamong segments.

 

Summarizedbelow are our segment sales revenue and gross profit for the three and ninemonths ended September 30, 2005 and 2004, respectively, based on the currentreporting segment structure.

 

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| ** **                       | ** ** | **Three months ended September 30, 2005** | ** ** | ** **   | ** ** |
|----------------------------------|------------|-------------------------------------------|------------|--------------|------------|
| **(in thousands)**               | ** ** | **Broadband**                             | ** ** | **Wireless** | ** ** | **Handsets** | ** ** | **PCD** | ** ** | **Service** | ** ** | **Total** | ** ** |
| Revenue from  external customers |       | $                                         | 32,934     |         | $          | 113,431 |   | $ | 106,294 |   | $ | 363,637 |   | $ | 19,011 |   | $ | 635,307 |   |
| Gross profit                     |       | (14,086                                   | )          | 32,477       |       | 13,646 |   | 13,199 |   | 8,710 |   | 53,946 |   |
|                                  |            |                                           |            |              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                       | ** ** | **Three  months ended September 30, 2004** | ** ** | ** **   | ** ** |
|----------------------------------|------------|--------------------------------------------|------------|--------------|------------|
| ** **                       | ** ** | **Broadband**                              | ** ** | **Wireless** | ** ** | **Handsets** | ** ** | **PCD** | ** ** | **Service** | ** ** | **Total** | ** ** |
| Revenue from  external customers |       | $                                          | 51,928     |         | $          | 419,630 |   | $ | 161,028 |   | $ | — |   | $ | 12,430 |   | $ | 645,016 |   |
| Gross profit                     |       | 5,885                                      |       | 104,797      |       | 23,680 |   | — |   | 2,772 |   | 137,134 |   |
| ** **                       |       |                                       |       |
| ** **                       | ** ** | **Nine  months ended September 30, 2005**  | ** ** | ** **   | ** ** |
| ** **                       | ** ** | **Broadband**                              | ** ** | **Wireless** | ** ** | **Handsets** | ** ** | **PCD** | ** ** | **Service** | ** ** | **Total** | ** ** |
| Revenue from  external customers |       | $                                          | 422,588    |         | $          | 371,541 |   | $ | 380,416 |   | $ | 1,021,452 |   | $ | 64,066 |   | $ | 2,260,063 |   |
| Gross profit                     |       | 168,194                                    |       | 104,041      |       | 51,145 |   | 42,881 |   | 35,321 |   | 401,582 |   |

 
| ** **                       | ** ** | **Nine  months ended September 30, 2004** | ** ** | ** **   | ** ** |
|----------------------------------|------------|-------------------------------------------|------------|--------------|------------|
| ** **                       | ** ** | **Broadband**                             | ** ** | **Wireless** | ** ** | **Handsets** | ** ** | **PCD** | ** ** | **Service** | ** ** | **Total** | ** ** |
| Revenue from  external customers |       | $                                         | 148,895    |         | $          | 1,176,433 |   | $ | 591,799 |   | $ | — |   | $ | 39,808 |   | $ | 1,956,935 |   |
| Gross profit                     |       | 41,062                                    |       | 322,764      |       | 111,330 |   | — |   | 14,283 |   | 489,439 |   |
| ** **                       | ** ** | ** **                                | ** ** |
| ** **                       | ** ** | **As of September 30, 2005**              | ** ** | ** **   | ** ** |
| **(in thousands)**               | ** ** | **Broadband**                             | ** ** | **Wireless** | ** ** | **Handsets** | ** ** | **PCD** | ** ** | **Service** | ** ** | **Total** | ** ** |
| Total  long-lived assets         |       | $                                         | 51,086     |         | $          | 94,332 |   | $ | 51,606 |   | $ | 1,506 |   | $ | 52,479 |   | $ | 251,009 |   |
| Total assets                     |       | 471,209                                   |       | 848,997      |       | 471,334 |   | 413,698 |   | 108,369 |   | 2,313,607 |   |
| ** **                       | ** ** |                                      |       |
| ** **                       | ** ** | **As of  December 31, 2004**              | ** ** | ** **   | ** ** |
| ** **                       | ** ** | **Broadband**                             | ** ** | **Wireless** | ** ** | **Handsets** | ** ** | **PCD** | ** ** | **Service** | ** ** | **Total** | ** ** |
| Total  long-lived assets         |       | $                                         | 50,454     |         | $          | 106,003 |   | $ | 46,325 |   | $ | 1,330 |   | $ | 64,647 |   | $ | 268,759 |   |
| Total assets                     |       | 1,018,608                                 |       | 1,184,649    |       | 676,022 |   | 363,298 |   | 73,428 |   | 3,316,005 |   |

 

**LIQUIDITYAND CAPITAL RESOURCES**

 

*OPERATING ACTIVITIES*

 

*2005*

 

Net cash provided byoperating activities for the nine months ended September 30, 2005 was$83.6 million. Operating cash was primarily affected by changes in accountsreceivable, inventory, and current and non-current assets, offset by changes incustomer advances, income tax payable and accounts payable.

 

The $197.9 million reductionin accounts receivable was primarily attributable to the stronger collectionsin the third quarter of 2005, and offset by the incremental sales and relatedreceivables from PCD.  Days sales outstanding was 154 days, excluding PCD,at September 30, 2005 as compared to 102 days at September 30, 2004.Days sales outstanding was 82 days including PCD at September 30,2005.   The longer days sales outstandingis a direct result of longer collection cycles in China due to the slow-down inthe telecommunication industry which has necessitated a corresponding increasein the provision for doubtful accounts. We do not expect a significant improvement to shorten days salesoutstanding in the near future.

 

The decreases in inventorybalance of $88.5 million and other current and non-current assets of $79.6million have contributed to our increase in operating cash.

 

Customer advances decreasedby $167.7 million and income tax payable decreased by $118.6 million for thenine months ended September 30, 2005.  In addition, accounts payabledecreased by $120.5 million.  All ofthese factors contributed to a

 

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decrease in operatingcash.  Customer advances represent cashdeposits we have received from our customers for orders that have not yetreceived final acceptance.  Uponsubsequent receipt of final acceptances and revenue recognition, customeradvances are reduced and revenue and cost of sales are recorded.

 

The reduction of customeradvances in the nine months ended September 30, 2005 was primarily due tothe completion of the revenue earning process for most of the agreements withJapan Telecom, Inc. (“JT”), an affiliate of Softbank Corp., as well as thedecline in sales and the corresponding cash advances for product sold inChina.  All cash received from JT inadvance of revenue recognition and in advance of spending for promotional activities was reflected asa customer advance in prior periods.  Revenue for certain of theseagreements has been recognized in the nine months ended September 30,2005.  For additional information, refer to Note 18, “Related PartyTransactions,” to our condensed consolidated financial statements.

 

Non-cash charges for thenine months ended September 30, 2005 included a change of $173.7 indeferred income taxes as a result of recording the valuation allowance, a$218.1 million asset impairment charge, $78.5 million of depreciation andamortization, a $38.1 million provision for doubtful accounts and a $42.1million inventory provision, excluding $5.5 million write-off of inventoryassociated with the Restructuring.  Inthe nine months ended September 30, 2005, we recorded a $31.4 millionnon-cash gain on extinguishment of debt which offsets activities that increaseoperating cash.

 

2004

 

Net cash used in operatingactivities for the nine months ended September 30, 2004 was $19.6 million.Operating cash was affected by changes in accounts receivable, inventory andcustomer advances offset by changes in deferred costs/inventories at customersites under contract and accounts payable.

 

The $385.0 million increasein accounts receivable was attributable to longer collection periodsexperienced during the nine months ended September 30, 2004 as compared tothe same period in the prior year.  Days sales outstanding was 102 days atSeptember 30, 2004 as compared to 64 days at September 30,2003.  Also contributing to the increase was larger volume of sales, from$1.3 billion for the nine months ended September 30, 2003 to $2.0 billionfor the same period in 2004.

 

Inventory increased by$202.2 million, due to the increase in sales volume noted above, offset by anincrease in the rate of inventory turnover for the third quarter of 2004.

 

Customer advances decreasedby $183.1 million for the nine months ended September 30, 2004. Customer advances represented cash deposits we received from our customers fororders that have not yet received final acceptance. Upon subsequent receipt offinal acceptances and revenue recognition, customer advance is reduced andrevenue and cost of sales is recorded.  The reduction of customer advancesin the nine month period ending September 30, 2004 was primarily a resultof our customers in China transitioning from new system installations to systemexpansions, which results in a shorter period between customer advance andacceptance.  The decrease in customer advance attributable to shorteracceptance periods was offset by an increase of a customer advance from JapanTelecom, Inc. (“JT”) an affiliate of SOFTBANK Corp.  All cash received fromJT in advance of revenue recognition and in advance of spending for suchpromotional activities was reflected as a customer advance.  As ofSeptember 30, 2004, there was $214 million included in customer advancesrelated to JT.  Refer to Note 18, Related Party Transactions.

 

Offsetting the activity thatdecreased operating cash for the period were net income and non-cash chargesincluding depreciation and amortization and changes in deferredcosts/Inventories at customer sites under contracts and accounts payable. Netincome was $103.6 million, adjusted for non-cash charges including $52.6million of depreciation and amortization.  Deferred costs/Inventory atcustomer sites under contracts decreased by $390.1 million.  The decreasein deferred costs was a result of increased revenues and a greater number ofcustomer acceptances, corresponding to the decrease in customer advances. Accounts payable increased by $82.6 million, consistent with increasedinventory purchasing**.**

 

*INVESTINGACTIVITIES*

 

*2005*

 

Net cash provided byinvesting activities for the nine months ended September 30, 2005 totaling$32.5 million was primarily due to $121.2 million of net proceeds from thepurchase and sale of short-term investments. The cash outflow was principally attributable to $24.3 million relatedto our acquisitions of Giga Telecom, Inc. and Pedestal Networks and $60.9million in purchases of property, plant and equipment.

 

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*2004*

 

Net cash used in investingactivities for the nine months ended September 30, 2004 of $166.9 millionwas primarily due to purchases of property, plant and equipment to support ourexpansion.  Of the total $105.2 million invested in property, plant andequipment, construction costs incurred on our Hangzhou manufacturing facilitywere $50.8 million during the period.  Also contributing to net cash usedin investing activities was our purchases of TELOS and HSI, which resulted in acash outflow of $44.0 million.

 

*FINANCINGACTIVITIES*

 

*2005*

 

Net cash used in financingactivities was $182.8 million for the nine months ended September 30,2005.  This was primarily due to the netrepayment of short-term borrowing of $131.8 million and $57.1 million cashpayment in connection with an early debt extinguishment.  We received $4.3 million for the issuance ofcommon stock through the employee stock purchase plan and the exercise of stockoptions for the nine months ended September 30, 2005.

 

*2004*

 

Net cash provided byfinancing activities was $560.4 million for the nine months endedSeptember 30, 2004.  This was primarily due to proceeds raised fromour selling 12.1 million shares of common stock at $39.25 per share to Banc ofAmerica Securities, LLC, for net proceeds of approximately $474.6 million. Inaddition, we incurred net borrowing of $175 million during the period, mostlyfrom existing lines of credit in China.  We also received $18.4 millionfor the issuance of common stock through stock option and warrant exercises.Offsetting cash provided by financing activities, we used a portion of thecapital raised to repurchase a total of 3.6 million shares of our common stockat an average price of $30.25 per share for a total cost of $107.6 million,including transaction fees.

 

*LIQUIDITY*

 

Our working capital was $0.9billion and $1.3 billion at September 30, 2005, and 2004,respectively.  This decrease in workingcapital mainly consists of (i) a decrease in cash on hand, to $496.1million in cash and cash equivalents and $15.1 million of short terminvestments at September 30, 2005 from $755.1 million of cash and cashequivalents and $44.9 million of short-term investments at September 30,2004 and (ii) an increase in short-term debt to $226.4 million atSeptember 30, 2005 compared to the corresponding period in the prior year.The decrease in working capital is primarily attributable to the funding of ourglobalization efforts and a series of acquisitions completed in 2004.   The decrease in working capital was also dueto lower balances in customer advances and accounts payable and higher balancesin inventories and deferred costs/inventories at customer sites undercontracts, as well as the early extinguishment a portion of our convertiblesubordinated notes due March 1, 2008, offset by lower accounts receivable balances.

 

Our China sales aregenerally denominated in local currency. Due to the limitations on convertingRenminbi, we are limited in our ability to engage in foreign currency hedgingactivities in China. We cannot guarantee that fluctuations in foreign currencyexchange rates in the future will not have a material adverse effect onrevenues from international sales and, correspondingly, on our business,financial condition and results of operations. We have contracts negotiated inJapanese Yen and we maintain a bank account in Japanese Yen for purchasingportions of our inventories and supplies. The balance of this Japanese Yenaccount at September 30, 2005 was approximately $71.9 million.  We may hedge certain Japanese Yen-denominatedbalance sheet exposures against future movements in foreign currency exchangerates by using foreign currency forward contracts. Gains and losses on thesefair value hedges are intended to offset gains and losses from the revaluationof our Japanese Yen-denominated recognized assets and liabilities. Inaccordance with Statement of Financial Accounting Standards No. 133 (“SFAS133”), “Accounting for Derivative Instruments and Hedging Activities,” werecognize derivative instruments and hedging activities as either assets or liabilitieson the balance sheet and measure them at fair value.  We do not intend to utilize derivativefinancial instruments for speculative trading purposes.

 

We accept commercial notesreceivable with maturity dates of between three and six months from ourcustomers in China in the normal course of business. Notes receivable availablefor sale was $22.9 million and $27.0 million at September 30, 2005and December 31, 2004, respectively. We may discount these notes withbanking institutions in China. Any notes that have been sold are not includedin our consolidated balance sheets as the criteria for sale treatmentestablished by Statement of Financial Accounting Standards No. 140, “Accountingfor Transfers and Servicing of Financial Assets and Extinguishment ofLiabilities” (“SFAS 140”), have been met.

 

In March 2003, wecompleted an offering of $402.5 million of convertible subordinated notesdue March 1, 2008 to qualified institutional buyers pursuant toRule 144A under the Securities Act of 1933, as amended. The notes bearinterest at a rate of 7/8% per annum, are convertibleinto our common stock at a conversion price of $23.79 per share and aresubordinated to all of our present and future senior debt.  Concurrent with the issuance of theconvertible notes, we entered into a convertible bond hedge and a call optiontransaction with respect to our common stock. Both the bond hedge and calloption transactions may be settled at our option either in cash or net sharesand expire on March 1, 2008.

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In the second quarter of 2005, we completed an exchange ofapproximately 1.5 million shares of our common stock and approximately $15.8million in cash for $38.0 million aggregate principal amount of outstanding notes.  In the third quarter of 2005, we completedfour additional exchanges wherein we exchanged a total of 3.5 million shares ofour common stock and approximately $41.4 million in cash for $89.9 millionaggregate principal amounts of outstanding notes.  As a result of the earlyextinguishment, we also amended the above convertible bond hedge and calloption transactions to reflect the change in principal amount of the underlyingnotes.

 

OnAugust 1, 2005, we entered into a 364-day $100.0 million committed receivablespurchase facility with a financial institution. The initial termof the Agreement will expire one year from execution but shall be extendedautomatically.  Pursuant to the terms of the receivable purchase facility, we may sellcertain receivables arising from the sale of telecommunications equipment tothis financial institution.  As ofSeptember 30, 2005 no receivables had been sold, pursuant to this arrangement.

 

We believe that our existingcredit facilities and cash and cashequivalents, short-term investments and cash from operations will besufficient to finance our operations and any cash used for plannedrestructuring activities through at least the next 12 months. As ofSeptember 30, 2005, we had cash, restricted cash, short-term investmentsand restricted short-term investments of $548.1 million and lines of credittotaling $589.6 million available for future borrowings. $283.5 million ofthese facilities expire in 2005 and $306.1 million of these facilities expirein 2006.  We are proceeding with the extension or renewal of these creditfacilities; however, such renewal is not certain.   Of our total cash and short-term investmentbalance, $325.6 million is held in China where currency exchange controlsexist.  As a result, our ability to make payments in other jurisdictionscould be limited by our ability to move money from China to the otherjurisdictions**.**

 

In the event that our current cash balances, futurecash flows from operations and current lines of credit are not sufficient to meetour obligations or strategic needs or in the event that market conditions arefavorable, we would consider raising additional funds in the capital or equitymarkets. If additional financing is needed, there can be no assurance that suchfinancing will be available to us on commercially reasonable terms, or at all.

 

*CONTRACTUALOBLIGATIONS AND OTHER COMMITMENTS*

 

Our obligations undercontractual obligations and commercial commitments are as follows:

 
| ** **                              | ** ** | **September 30, 2005**     | ** ** |
|-----------------------------------------|------------|----------------------------|------------|
| ** **                              | ** ** | **Payments Due by Period** | ** ** |
| ** **                              | ** ** | ** **                 | ** ** | **Less than** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **(in thousands)**                      | ** ** | **Total**                  | ** ** | **1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** |
| ** **                              | ** ** | ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Notes  payable                          |       | $                          | 93         |   | $ | 93 |   | $ | — |   | $ | — |   |
| Bank loans                              |       | $                          | 226,607    |   | $ | 226,307 |   | $ | 300 |   | $ | — |   |
| Convertible  subordinated notes         |       | $                          | 274,600    |   | $ | — |   | $ | 274,600 |   | $ | — |   |
| Interest payable  on subordinated notes |       | $                          | 6,007      |   | $ | 2,403 |   | $ | 3,604 |   | $ | — |   |
| Standby  letters of credit              |       | $                          | 50,657     |   | $ | 50,168 |   | $ | 489 |   | $ | — |   |

 

*Notes Payable*

 

Occasionally, we issueshort-term notes payable to our vendors in lieu of trade accountspayable.  The payment terms are normally three to nine months and aretypically non-interest bearing.

 

*Bank Loans*

 

At September 30, 2005,we had loans with various banks totaling $218.0 million with interest ratesranging from 3.58% to 5.02% per annum. These bank loans mature within twelve months and are included inshort-term debt.

 

We have a bank loan inconnection with an equipment purchase resulting from the consolidation of MDCHolding Limited and its affiliated entities (“MDC”).  On January 10, 2003, a third partyestablished a bank loan with Shanghai Pudong Development Bank for the purchaseof the equipment.  The obligations of thebank loan and related equipment were assumed by us on January 23, 2003,and subsequently transferred to MDC on December 31, 2003.  The bank loan of $8.3 million bears interestat a rate of 4.94% per annum, and expires on January 10, 2006.  We do not serve as legal obligor for theloan.

 

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We have a bank loan inconnection with a joint venture which we consolidate.  As of September 30, 2005, the jointventure had an outstanding loan to its other investor, and we bore the loanresulting from the consolidation.   The bankloan amounts to $0.3 million, at an interest rate of 9.00% per annum, and expireson June 15, 2008.  We do not serveas legal obligor for the loan.

 

*Convertible Subordinated Notes*

 

As of September 30,2005, we have $274.6 million of convertible subordinated notes, dueMarch 1, 2008, that bear interest at a rate of 7/8% per annum, payablesemiannually on May 1 and September 1, which are convertible into ourcommon stock at a conversion price of $23.79 per share and are subordinated toall our present and future senior debt. The principal is due only at maturityof the notes.

 

*Operating Leases*

 

We lease certain facilitiesunder non-cancelable operating leases that expire at various dates through2010.

 

*Standby Letters Of Credit*

 

We issue standby letters ofcredit primarily to support international sales activities outside of China.When we submit a bid for a sale, often the potential customer will require thatwe issue a bid bond or a standby letter of credit to demonstrate our commitmentthrough the bid process. In addition, we may be required to issue standbyletters of credit as guarantees for advance customer payments upon contractsigning or performance guarantees. The standby letters of credit usually expiresix to twelve months from date of issuance without being drawn by thebeneficiary thereof.

 

*Purchase commitments*

 

We are obligated to purchaseraw materials and work-in-process inventory under various orders from varioussuppliers, all of which should be fulfilled without adverse consequencesmaterial to our operations or financial condition. As of September 30,2005 total open commitments under these purchase orders were approximately$654.1 million which is primarily related to purchase commitments of the PCDbusiness unit.

 

*Investment commitments*

 

As of September 30,2005, we had invested a total of $2.5 million in Global Asia Partners L.P.that is recorded as a long-term investment. The fund size is anticipated to be$10.1 million and the fund was formed to make private equity investmentsin private or pre-IPO technology and telecommunications companies in Asia. Wehave a commitment to invest up to a maximum of $5.0 million. The remainingamount is due at such times and in such amounts as shall be specified in one ormore future capital calls to be issued by the general partner.

 

*Intellectual property*

 

Certain sales contracts includeprovisions under which customers would be indemnified by us in the event of,among other things, a third-party claim against the customer for intellectualproperty rights infringement related to our products. There are no limitationson the maximum potential future payments under these guarantees. We have notaccrued any amounts in relation to these provisions as no such claims have beenmade and we believe we have valid enforceable rights to the intellectualproperty embedded in our products.

 

*Off balancesheet arrangements*

 

Underthe definition contained in Item 303(a)(4)(ii) of Regulation S-K, we donot have any off-balance sheet arrangements.

 

***RECENTACCOUNTING PRONOUNCEMENTS***

 

InDecember 2004, the Financial Accounting Standards Board, “FASB” issuedSFAS No. 123 (revised 2004), “Share-Based Payment,” (“SFAS 123(R)”).  SFAS 123(R) will require the Company tomeasure all employee stock-based compensation awards using a fair value methodand record such expense in its consolidated financial statements.  In addition, the adoption of SFAS 123(R) willrequire additional accounting related to the income tax effects and additionaldisclosure regarding the cash flow effects resulting from share-based paymentarrangements.

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InMarch 2005, the Securities and Exchange Commission (the “SEC”) issuedStaff Accounting Bulletin no. 107 (“SAB 107”) which provides guidance regardingthe application of SFAS 123(R). SAB 107 expresses views of the staff regardingthe interaction between SFAS No. 123(R), Share-Based Payment, and certainSEC rules and regulations and provides the staff’s views regarding thevaluation of share-based payment arrangements for public companies. Inparticular, SAB 107 provides guidance related to share-based paymenttransactions with non-employees, the transition from nonpublic to public entitystatus, valuation methods (including assumptions such as expected volatilityand expected term), the accounting for certain redeemable financial instrumentsissued under share-based payment arrangements, the classification ofcompensation expense, non-GAAP financial measures, first-time adoption of SFAS123(R) in an interim period, capitalization of compensation cost related toshare-based payment arrangements, the accounting for income tax effects ofshare-based payment arrangements upon adoption of SFAS 123(R), the modificationof employee share options prior to adoption of SFAS 123(R) and disclosures inManagement’s Discussion and Analysis (“MD&A”) subsequent to adoption ofSFAS 123(R).

 

On April 14, 2005, theSEC approved a new rule that delays the effective date for SFAS 123(R) toannual periods beginning after June 15, 2005.  The adoption of SFAS 123(R) onJanuary 1, 2006 is expected to have a material impact on the Company’sconsolidated results of operations, financial position and statement of cashflows.  The Company is evaluating thetransition method and pricing model alternatives upon adoption.

 

InDecember 2004, the FASB issued FSP No. FAS 109-2, “Accounting andDisclosure Guidance for the Foreign Earnings Repatriation Provision within theAmerican Jobs Creation Act of 2004.”  TheAmerican Jobs Creation Act of 2004 provides a one-time 85% dividends receiveddeduction for certain foreign earnings that are repatriated under a plan forreinvestment in the United States, provided certain criteria are met.  FSP No. FAS 109-2 is effectiveimmediately and provides accounting and disclosure guidance for the repatriationprovision.  FSP No. FAS 109-2 allowscompanies additional time to evaluate the effects of the law on its unremittedearnings for the purpose of applying the “indefinite reversal criteria” underAPB Opinion No. 23, “Accounting for Income Taxes—Special Areas,” andrequires explanatory disclosures from companies that have not yet completed theevaluation.  The Company is currentlyevaluating the effects of the repatriation provision and their impact on itsconsolidated financial statements.  TheCompany does not expect to complete this evaluation before the end of2006.  The range of possible amounts ofunremitted earnings that is being considered for repatriation under thisprovision is between zero and $540 million and the related potential range ofincome tax is between zero and $28 million.

 

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs, anamendment of ARB No. 43, Chapter 4,” (“SFAS 151”). SFAS 151 clarifies thatabnormal inventory costs such as costs of idle facilities, excess freight andhandling costs, and wasted materials (spoilage) are required to be recognizedas current period charges. The provisions of SFAS 151 are effective for thefiscal year beginning after June 15, 2005. The adoption of SFAS 151 is notexpected to have a material impact on the Company’s consolidated financialposition, results of operations and cash flows.

 

In June 2005, the FASB’s Emerging Issues Task Force (“EITF”) issuedEITF Issue No. 05-02 “The Meaning of ‘Conventional Convertible Debt Instrument’in EITF Issue 00-19 ‘Accounting for Derivative Financial Instruments Indexedto, and Potentially Settled in, a Company’s Own Stock,’” which retains theexception in paragraph 4 of EITF Issue No. 00-19 for conventional convertibledebt instruments. Those instruments in which the holder has an option to convertthe instrument into a fixed number of shares (or a corresponding amount of cashat the issuer’s discretion) and its ability to exercise the option is based oneither (a) the passage of time or (b) a contingent event, should be considered “conventional”for purposes of applying that exception. The consensus should be applied on aprospective basis for new or modified instruments starting from the thirdquarter of 2005. The adoption of EITF No.** **05-02 isnot expected to have a material effect on the Company’s consolidated financialstatements or results of operations.

 

OnJune 1, 2005, FASB issued FASB Statement No. 154, Accounting Changesand Error Corrections (“SFAS 154”), which will require entities thatvoluntarily make a change in accounting principles to apply that changeretrospectively to prior periods’ financial statements, unless this would beimpracticable. SFAS 154 supersedes Accounting Principles Board OpinionNo. 20, Accounting Changes (“APB 20”), which previously required that mostvoluntary changes in accounting principle be recognized by including in thecurrent period’s net income the cumulative effect of changing to the newaccounting principle. SFAS 154 also makes a distinction between “retrospectiveapplication” of an accounting principle and the “restatement” of financialstatements to reflect the correction of an error.

 

Under SFAS 154, if an entitychanges its method of depreciation, amortization, or depletion for long-lived,non-financial assets, the change must be accounted for as a change inaccounting estimate. Under APB 20, such a change would have been reported as achange in accounting principle. SFAS 154 applies to accounting changes anderror corrections that are made in fiscal years beginning afterDecember 15, 2005. The adoption of FAS 154 is not expected to have amaterial effect on our consolidated financial statements or results ofoperations.

 

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**FACTORS AFFECTING FUTURE OPERATING RESULTS**

**RISKS RELATED TO OUR COMPANY**

 

*Our future product salesare unpredictable and, as a result, our operating results are likely tofluctuate from 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 that may affect our future operatingresults include:

 

•      the timing and size of the orders for ourproducts;

 

•      changes in our customers’ subscriber growthrate;

 

•      the lengthy and unpredictable sales cyclesassociated with sales of our products;

 

•      cancellation, deferment or delay inimplementation of large contracts;

 

•      cash collection cycles in China and otheremerging markets;

 

•      issues that might arise from the integrationof acquired entities or the inability to achieve expected results from suchacquisitions;

 

•      revenue recognition, which is based onacceptance, is unpredictable;

 

•                  thedecline in business activity we typically experience during the Lunar New Year,which leads to decreased sales during our first fiscal quarter;

 

•      shift in our product mix or market focus; and

 

•                  qualityissues resulting from the design or manufacture of the products, or from thesoftware used in the product.

 

Asa result of these and other factors, period-to-period comparisons of ouroperating results are not necessarily meaningful or indicative of futureperformance. In addition, the factors noted above may make it difficult for usto forecast and provide in a timely manner public guidance (including updatesto prior guidance) related to our projected financial performance of theCompany. Furthermore, it is possible that in some future quarters our operatingresults will fall below the expectations of securities analysts or investors.If this occurs, the trading price of our common stock could decline.

 

*Competition in our marketsmay lead to reduced 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 presently offering competing products mayalso enter our target markets. Many of our competitors have significantlygreater financial, technical, product development, sales, marketing and otherresources than we do. As a result, our competitors may be able to respond morequickly to new or emerging technologies and changes in service providerrequirements. Our competitors may also be able to devote greater resources thanwe can to the development, promotion and sale of new products. Thesecompetitors may be able to offer significant financing arrangements to serviceproviders, which may give them a competitive advantage in selling systems toservice providers with limited financial and currency 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, our competitors may have or be able toestablish better relationships with local governmental telecommunicationsagencies than we have, which could result in their ability to influencegovernmental policy formation and interpretation to their advantage.Additionally, our competitors might have better relationships with their thirdparty suppliers and obtain component parts at a reduced rate, allowing them tooffer their end products at reduced prices. Moreover, the telecommunicationsand cable industries have experienced significant consolidation, and we expectthis trend to continue. If we have fewer significant customers, we may be morereliant on such large customers and our bargaining position and profit marginsmay suffer. Increased competition is likely to result in price reductions,reduced gross profit as a percentage of net sales and loss of market share, anyone of which could materially harm our business, cash flows, financialcondition including potential impairment in value of our tangible andintangible assets and goodwill if extended losses were incurred.

 

*If we seek to secure additional financing and arenot able to do so, our ability to expand strategically may be limited. If weare able to secure additional financing, our stockholders may experiencedilution of their ownership interest, or we may be subject to limitations onour operations and increased leverage.*

* *

Wecurrently anticipate that our available cash resources, which include existingcash and cash equivalents, short-term investments and cash from operations,will be sufficient to meet our anticipated needs for working capital andcapital expenditures for the foreseeable future. If we are unable to generatesufficient cash flows from operations, we may need to raise additional funds todevelop new or enhanced products, respond to competitive pressures, takeadvantage of acquisition

 

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opportunitiesor raise capital for strategic purposes. If we raise additional funds throughthe issuance of equity securities, our stockholders will experience dilution oftheir ownership interest, and the newly issued securities may have rightssuperior to those of common stock. If we raise additional funds by issuingdebt, we may be subject to limitations on our operations and our leverage mayincrease. For example, in connection with the sale of convertible debtsecurities in March 2003, we incurred $402.5 million of indebtedness.  As a result of this indebtedness, ourprincipal and interest payment obligations have increased substantially.  Approximately $127.9 million of thisindebtedness was exchanged with the holders for cash and shares of the Company’scommon stock during the nine months ended September 30, 2005.  A total of 4,988,100 shares were issued inrelation to these debt exchanges.  Thedegree to which we are leveraged could materially and adversely affect ourability to obtain financing for working capital, acquisitions or other purposesand could make us more vulnerable to industry downturns and competitivepressures. Our ability to meet our debt service obligations will be dependentupon our future performance, which will be subject to financial, business andother factors affecting our operations, many of which are beyond our control.Finally, we are not certain that we can maintain our existing unsecured creditline available to our China operations or additional sources of financing maynot be available on reasonable terms or at all if and when we require it,either of which could harm our business.

 

*The average selling prices of our products maydecrease, which may reduce our revenues and our gross profit. As a result, wemust introduce new products and reduce our costs in order to maintainprofitability.*

* *

Theaverage selling prices for communications access and switching systems andhandsets have historically declined as a result of a number of factors,including:

 

•                  increasedcompetition;

 

•                  aggressiveprice reductions by competitors;

 

•                  rapidtechnological 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, includingwireless handsets, have historically had low gross profit margins, and anyfurther deterioration of our profit margins on such products could result inlosses with respect to such products. Therefore, we must continue to developand introduce new products and enhancements to existing products thatincorporate features that can be sold at higher average selling prices. Failureto do so could cause our revenues and gross profit to decline.

 

Ourcost reduction efforts may not allow us to keep pace with competitive pricingpressures or lead to improved gross profit, as a percentage of net sales. Inorder to be competitive, we must continually reduce the cost of manufacturingour products through design and engineering changes. We may not be successfulin these efforts or in delivering our products to market in a timely manner. Inaddition, any redesign may not result in sufficient cost reductions to allow usto reduce the prices of our products to remain competitive or to improve ormaintain our gross profit, as a percentage of net sales, which would cause ourfinancial results to suffer.

 

*Sales in China have historically accounted for amaterial portion of our total sales, and our business, financial condition andresults of operations are to a significant degree subject to economic,political and social events in China.*

* *

Approximately$211.0 million, or 33%, and $727.7 million, or 32%, of our net sales for thethree and nine months ended September 30, 2005, respectively, occurred inChina.  Approximately $589.6 million, or92%, and $1,778.4 million, or 91%, of our net sales for the three and ninemonths ended September 30, 2004, respectively, occurred in China. While weanticipate expansion into other markets, a significant portion of our net saleswill be derived from China for the foreseeable future. In addition, we havemade substantial investments in China and our business, financial condition andresults of operations are to a significant degree subject to economic,political, legal and social developments and other events in China. Please readthe risks detailed below under the heading “Risks Related to ConductingBusiness in China” for additional information about the risks we face inconnection with our China operations.

 

*Our market is subject to rapid technological change,and to compete effectively, we must continually introduce new products andproduct enhancements that achieve market acceptance.*

* *

Themarket for communications equipment is characterized by rapid technologicaldevelopments, frequent new product introductions and evolving industry andregulatory standards. Our success will depend in large part on our ability toenhance our technologies and develop and introduce new products and productenhancements that anticipate changing service provider requirements andtechnological developments. 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 andintroduce new products or enhancements to existing products that effectivelyrespond to technological change on a timely basis, our business, financialcondition and results of operations could be materially adversely affected.Certain of our

 

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products, including wirelesshandsets, have a short product life. Moreover, from time to time, ourcompetitors or we may announce new products or product enhancements,technologies or services that have the potential to replace or shorten the lifecycles of our products and that may cause customers to defer purchasing ourexisting products, resulting in inventory reserve due to obsolescence.Future technological advances in the communications industry may diminish orinhibit market acceptance of our existing or future products or render ourproducts obsolete.

 

Evenif we are able to develop and introduce new products, they may not gain marketacceptance. Market acceptance of our products will depend on various factors,including:

 

•      ourability to obtain necessary approvals from regulatory organizations within thecountries in which we operate and for any new technologies that we introduce;

 

•      thelength of time it takes service providers to evaluate our products, causing thetiming of purchases to be unpredictable;

 

•      ourproducts being compatible with legacy technologies and standards existing inpreviously deployed network equipment;

 

•      ourability to attract customers who may have preexisting relationships with ourcompetitors;

 

•      productpricing relative to performance;

 

•      thelevel of customer service available to support new products; and

 

•      thetiming 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 key suppliers, aswell as international sources, for handsets, base stations, components andmaterials used in our products. If we cannot secure adequate supplies of highquality products at competitive prices or in a timely manner from thesesuppliers or sources, or if the suppliers successfully market their productsdirectly to our customers, our competitive position, reputation and businesscould be harmed.*

* *

Wehave contracts with a single supplier or with a limited group of suppliers topurchase some components and materials used in our products. If any supplier isunwilling or unable to provide us with high-quality components and materials inthe quantities required and at the costs specified by us, we may not be able tofind alternative sources on favorable terms, in a timely manner, or at all.Further, a supplier could market its products directly to our customers. Inparticular, our PCD segment is highly dependent on a single supplier for ourhandset devices. The possibility of a supplier marketing its own products wouldcreate direct competition and may affect our ability to obtain adequatesupplies. Our inability to obtain or to develop alternative sources if and asrequired could result in delays or reductions in manufacturing or productshipments. From time to time, there could be shortages of certain products orcomponents. Moreover, our suppliers may supply us with inferior qualityproducts. 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 competitive position, 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. Werequire a significant number of imported components to manufacture ourproducts, and imported electronic components and other imported goods used inthe operation of our business may be limited by a variety of permitrequirements, approval procedures, import duties and registration requirements.Moreover, import duties on such components increase the cost of our productsand may make them less competitive.

 

*Product defects or performance quality issues couldcause us to lose customers and revenue or to incur unexpected expenses.*

* *

Manyof our products are highly complex and may have quality issues resulting fromthe design or manufacture of such product, or from the software used in theproduct. For example, in the first quarter of 2005 we recorded a specialwarranty charge of $9.5 million for certain asynchronous digital subscriberline (“ADSL”) equipment sold to SBBC, an affiliate of SOFTBANK CORP andSOFTBANK America Inc., during 2003 and 2004. Often these issues are identified prior to the shipment of the productsand may cause delays in market acceptance of our products, delays in shippingproducts to customers, or the cancellation of orders. In other cases, we mayidentify the quality issues after the shipment of products. In such cases, wemay incur unexpected expenses and diversion of resources to replace defectiveproducts or correct problems. Such pre-shipment and post-shipment qualityissues could result in delays in the recognition of revenue, loss of revenue orfuture orders, and damage to our reputation and customer relationships. Inaddition, we may be required to pay damages for failed performance undercertain customer contracts.

 

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*Our transformation, including the recent cost savinginitiatives, has strained our resources, and if we are unable to manage thistransformation, our operating results will be negatively affected.*

 

Weexperienced a period of rapid growth and anticipate that we must continue totransform our operations to address market demands and potential marketopportunities globally. This transformation will place a significant strain onour management, operational, financial and other resources. To manage thistransformation effectively, we will need to take various actions, including:

 

•      enhancing management information systems,including forecasting procedures;

 

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

 

•      managing our working capital and sources offinancing;

 

•      maintaining close coordination among ourengineering, accounting, finance, marketing, sales and operationsorganizations;

 

•      retaining, training and managing our employeebase;

 

•      enhancing human resource operations andimproving employee hiring and training programs;

 

•      reorganizing our business structure to moreeffectively allocate and utilize our internal resources;

 

•      improving and sustaining our supply chaincapability;

 

•      managing both our direct and indirect saleschannels in a cost-efficient and competitive manner; and

 

•      fully reviewing our new customers’ credithistories to ensure their financial stability before finalizing contracts.

 

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

 

*Our success is dependent on continuing to hire andretain qualified personnel, and if we are not successful in attracting andretaining these personnel, our business will suffer.*

* *

Thesuccess of our business depends in significant part upon the continuedcontributions of key technical and senior management personnel, many of whomwould be difficult to replace. In particular, our success depends in large parton the knowledge, expertise and services of Hong Liang Lu, our Chairman of theBoard, President and Chief Executive Officer, Ying Wu, our Chairman and ChiefExecutive Officer of China Operations, and Philip Christopher, President andChief Executive Officer of our Personal Communications Division. The loss ofany key employee, the failure of any key employee to perform satisfactorily inhis or her current position or our failure to attract and retain other keytechnical and senior management employees could have a significant negativeimpact on our operations.

 

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 recruitingpersonnel in all fields, including technology, research and development, salesand marketing, administration and managerial personnel with the combination ofskills and attributes required to execute our business strategy can be difficult,time-consuming and expensive. As we grow globally, we must implement hiring andtraining processes that are capable of quickly deploying qualified localresidents to knowledgeably support our products and services. Alternatively, ifthere is an insufficient number of qualified local residents available, wemight incur substantial costs importing expatriates to service new globalmarkets. For example, we have historically experienced difficulty findingqualified accounting personnel knowledgeable in both U.S. and Chineseaccounting standards who are Chinese residents. If we fail to attract, hire,assimilate or retain qualified personnel, our business would be harmed.

 

Competitorsand others have in the past, and may in the future, attempt to recruit our employees.In addition, companies in the telecommunications industry whose employeesaccept positions with competitors frequently claim that the competitors haveengaged 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 theseclaims may result in material litigation and disruption to our operations. Wecould incur substantial costs in defending ourselves against these claims,regardless of their merit.

 

*Any acquisitions that we undertake could bedifficult to integrate, disrupt our business, dilute our stockholders and harmour operating results.*

* *

Wehave acquired other businesses, products and technologies. For example, duringthe second quarter of 2004, we completed our acquisitions of TELOS Technology,Inc. and Hyundai Syscomm, Inc. (“HSI”) for $30.0 million and $14.1 million,respectively. On November 1, 2004, we completed our selected assetacquisition of Audiovox Communications Corporation (“ACC”) for $165.1 million.Additionally, in January and May 2005, we completed the acquisitionsof selected

 

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assets,including research and development of various products, from GigaTelecom, Inc. and Pedestal Networks, Inc. Anticipated benefits of these acquisitions may not be realized. We havein the past and will continue to evaluate acquisition prospects that wouldcomplement our existing product offerings, augment our market coverage, enhanceour technological capabilities, or that may otherwise offer growthopportunities. Acquisitions may result in dilutive issuances of equitysecurities, use of our cash resources, the incurrence of debt and theamortization of expenses related to intangible assets. In addition, acquisitionsinvolve numerous risks, including difficulties in the assimilation ofoperations, technologies, products and personnel of the acquired company,diversion of management’s attention from other business concerns, risks ofentering markets in which we have no direct or limited prior experience, thepotential loss of key employees of the acquired company, unanticipated costsand, in the case of the acquisition of financially troubled businesses,challenges as to the validity of such acquisitions from third party creditorsof such businesses. For example, in the fourth quarter 2004, we encountereddifficulties in integrating HSI’s legacy operations into our operations anddetermined to abandon a substantial amount of HSI’s legacy operations. As aresult, in the fourth quarter 2004, we wrote off the entire goodwill andintangibles associated with HSI. In addition, the acquisitions of businessesinvolved in the manufacturing or sales of handset products could introducespecific litigation risk such as the potential harmful effects of electric andmagnetic fields (“EMF”).

 

*We may be unable toadequately protect the loss or misappropriation of our intellectual property,which could substantially harm our business.*

 

Werely on a combination of patents, copyrights, trademarks, trade secret laws andcontractual obligations to protect our technology. We have applied for patentsin the United States and internationally. Additional patents may not be issuedfrom our pending patent applications, and our issued patents may not be upheld.In addition, we have, from time to time, chosen to abandon previously filedapplications. Moreover, we may face difficulties in registering our existingtrademarks in new jurisdictions in which we operate, and we may be forced toabandon or change product or service trademarks because of the unavailabilityof our existing trademarks. We cannot guarantee that the intellectual propertyprotection measures that we have taken will be sufficient to preventmisappropriation of our technology or trademarks or that our competitors willnot independently develop technologies that are substantially equivalent orsuperior to ours. In addition, the legal systems of many foreign countries donot protect or honor intellectual property rights to the same extent as thelegal 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 very difficult, time-consuming and costly for usto attempt to enforce our intellectual property rights in these jurisdictions.

 

*We may be subject to claimsthat we infringe the intellectual property rights of others, which couldsubstantially harm our business.*

 

Theindustry in which we compete is moving towards aggressive assertion, licensing,and litigation of patents and other intellectual property rights. From time totime, we have become aware of the possibility or have been notified that we maybe infringing certain patents or other intellectual property rights of others.Regardless of their merit, responding to such claims could be time consuming,divert management’s attention and resources and cause us to incur significantexpenses. In addition, although some of our supplier contracts provide forindemnification from the supplier with respect to losses or expenses incurredin connection with any infringement claim, certain contracts with our keysuppliers do not provide for such protection. Moreover, certain of our salescontracts provide that we must indemnify our customers against claims by thirdparties for intellectual property rights infringement related to our products.There are no limitations on the maximum potential future payments under theseguarantees. Therefore, we may incur substantial costs related to anyinfringement claim, which may substantially harm our results of operations andfinancial 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 benecessary to enforce and protect our trade secrets and other intellectualproperty rights. Any intellectual property litigation or threatenedintellectual property litigation could be costly, and adverse determinations orsettlements could result in the loss of our proprietary rights, subject us tosignificant liabilities, require us to seek licenses from or pay royalties tothird parties which may not be available on commercially reasonable terms, ifat all, and/or prevent us from manufacturing or selling our products, whichcould cause disruptions to our operations.

 

In the event that thereis a successful claim of infringement against us and we fail to developnon-infringing technology or license the propriety rights on commerciallyreasonable terms and conditions, our business, results of operations andfinancial condition could be materially and adversely impacted.

 

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* *

*Our multinational operations subject us to variouseconomic, political, regulatory and legal risks.*

* *

Wemarket and sell our products globally, with significant portion of our saleshistorically made in China. The expansion of our existing multinational operationsand entry into new markets will require significant management attention andfinancial resources. Multinational operations are subject to a variety ofrisks, such as:

 

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

 

•      the burden of complying with United Stateslaws and regulations for foreign operations, including the Foreign CorruptPractices Act;

 

•      difficulty complying with continuallyevolving and changing global product and communications standards andregulations for both our end products and their component technology;

 

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

 

•      reliance on local original equipmentmanufacturers (“OEMs”), third party distributors and agents to effectivelymarket and sell our products;

 

•      unusual contract terms required by customersin developing markets;

 

•      changes in local governmental control orinfluence over our customers;

 

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

 

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

 

•      reduced protection for intellectual propertyrights in some countries;

 

**•****     **unproven business operation models developedor operated in specific countries or regions;

 

•      longer accounts receivable collectionperiods; and

 

•      difficulties and costs of staffing andmanaging multinational operations, including but not limited to internalcontrols and compliance.

 

*We do business in markets that are not fullydeveloped, which subjects us to various economic, political, regulatory andlegal risks unique to developing economies.*

* *

Lessdeveloped markets present additional risks, such as the following:

 

•      customers that may be unable to pay for ourproducts in a timely manner or at all;

 

•      new and unproven markets for our products andthe telecommunications services that our products enable;

 

•      inconsistent infrastructure support;

 

•      lack of a large, highly trained workforce;

 

•      difficulty in controlling local operationsfrom our headquarters;

 

•      variable ethical standards and an increasedpotential for fraud;

 

•      unstable political and economic environments;and

 

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

 

Inparticular, these factors create the potential for physical loss of inventoryand misappropriation of operating assets. We have in the past experienced casesof vandalism and armed theft of our equipment that had been or was beinginstalled in the field. If disruptions for any of these reasons become toosevere in any particular market, it may become necessary for us to terminatecontracts and withdraw from that market and suffer the associated costs and lostrevenue.

 

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*Our wireless handset products are subject to a widerange of environmental, health and safety laws, and may expose us to potentialhealth 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 theUnited States, these laws often require parties to fund remedial actionregardless of fault. Factors such as the discovery of additional contaminants,the extent of remediation and compliance expenses, and the imposition ofadditional cleanup obligations could cause us to incur substantial costsrelating 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. In addition, restrictions on the use ofcertain materials in our facilities or products in the future could have anegative 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 nolink established between wireless handset use and cancer, the negativepublicity and possible litigation could have a material adverse effect on ourbusiness.  In the past, severalplaintiffs’ groups have brought class actions against wireless handsetmanufacturers and distributors, alleging that wireless handsets have causedcancer. To date, we have not been named in any of these actions and none ofthese actions has been successful. In the future we could incur substantialcosts in defending ourselves against similar claims, regardless of their merit.Also, claims may be successful in the future and may have a material adverseeffect on our business.

 

*We are subject to risks relating to currency ratefluctuations and exchange controls.*

* *

Becausemost of our sales are made in foreign countries, we are exposed to market riskfor changes in foreign exchange rates on our foreign currency denominatedaccounts and notes receivable balances. Historically, the majority of our saleshave been made in China and denominated in Renminbi; as such, the impact ofcurrency fluctuations of Renminbi thus far has been insignificant as it wasfixed to the U.S. dollar.  InJuly 2005, China 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%against the U.S. dollar; however, it is uncertain what further adjustments maybe made in the future.  The Renminbi-U.S.dollar exchange rate could float, and the Renminbi could appreciate relative tothe U.S. dollar. For example, the Renminbi- U.S. dollar exchange rate was 8.28to the U.S. dollar at the beginning of the third quarter and 8.08 Renminbi tothe U.S. dollar at the end of the third quarter.  Any significant revaluation of the Renminbimay materially and adversely affect our cash flows, revenues, operating resultsand financial position.

 

Weenter into transactions that may expose us to foreign currency rate fluctuationrisk. Historically, the largest component of our foreign currency exchange losshas resulted from our purchasing inventory denominated in foreign currencies.If we continue to purchase inventory in foreign currencies, we may incuradditional foreign currency exchange losses, causing our operating results tosuffer. Additionally, we have experienced increases in sales in both JapaneseYen and in Euros. Fluctuations in currency exchange rates in the future mayhave a further material adverse effect on our results of operations.

 

Wemay, from time to time, enter into foreign exchange forward contracts to hedgecertain exposures, due to fluctuation of the U.S. dollar to the Japanese Yen,resulting from Japanese Yen-dominated balance sheet accounts. However, thehedging may not be effective in limiting our exposure to a decline in operatingresults.

 

Moreover,some of the foreign countries in which we do business might impose currencyrestriction that may limit the ability of our subsidiaries and joint venturesin such countries to obtain and remit foreign currency necessary for thepurchase of imported components and may limit our ability to obtain and remitforeign currency in exchange for foreign earnings. For example, China employscurrency controls restricting Renminbi conversion, limiting our ability toengage in currency hedging activities in China. Various foreign exchangecontrols may also make it difficult for us to repatriate earnings, which couldhave a material adverse effect on our ability to conduct business globally.

 

*Business interruptions could adversely affect ourbusiness.*

* *

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 manufacturing facility’s ability to producesufficient products is dependent upon a continuous power supply. However, theHangzhou facility has in the past been subject to power shortages, which hasaffected our ability to produce and ship sufficient products. We do not have adetailed disaster recovery plan, and the occurrence of any events like thesethat disrupt our business could harm our business and operating results.

 

*We may suffer losses with respect to equipment heldat customer sites, which could harm our business.*

* *

Weface the risk of loss relating to our equipment held at customer sites. In somecases, our equipment held at customer sites is under contract, pending finalacceptance by the customer. We generally do not hold title or risk of loss onsuch equipment, as title and risk of loss are typically transferred to thecustomer upon delivery of our equipment. However, we do not recognize revenueand accounts receivable with respect to the sale of such equipment until weobtain acceptance from the customer. If we do not obtain final acceptance, wemay not be able to collect the contract price and recover this equipment or

 

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itsassociated costs. In other cases, particularly in China, where governmentalapproval is required to finalize certain contracts, inventory not undercontract may be held at customer sites. We hold title and risk of loss on thisinventory until the contracts are finalized and, as such, are subject to anylosses incurred resulting from any damage to or loss of this inventory. If ourcontract 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 all losses incurred if our inventory atcustomer sites not under contract is damaged prior to contract finalization. Ifwe incur a loss relating to inventory for any of the above reasons, ourfinancial condition, cash flows, and operating results could be harmed.

 

*Restrictions on the use of handsets while drivingcould affect our future growth.*

* *

Severalforeign governments and U.S. state and local governments have adopted or areconsidering adopting legislation that would restrict or prohibit the use ofwireless 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 in securitieslitigation and other lawsuits, as well as lawsuits in the ordinary course ofbusiness.*

* *

Weare currently a defendant in several securities litigation class actions andother lawsuits, as well as lawsuits in the ordinary course of our business. Inthe future, we may be subject to similar litigation. The defense of theselawsuits may divert our management’s attention, and we may incur significantexpenses in defending these lawsuits (including substantial fees of lawyers andother professional advisors and potential obligations to indemnify officers anddirectors who may be parties to such actions). In addition, we may be requiredto pay judgments or settlements that could have a material adverse effect onour results of operations, financial condition and liquidity.

 

*We Face Risks Related to the PendingSecurities and Exchange Commission Investigation.*

 

InOctober 2005, we received notice of a formal order of investigation by theStaff of the SEC into our accounting practices. The Company is cooperating fully with the investigation, but cannotpredict when this investigation will be completed or what the outcome willbe.  The SEC investigation could harmrelationships with existing customers and our ability to obtain new customersand partners.  If the SEC makes a determinationthat the Company has violated federal securities laws, the Company may facesanctions including, but not limited to, fines and injunctive relief.  It is also possible that the findings andoutcome of the SEC investigation may affect other lawsuits that are pending.  Finally, the investigation could divertmanagement attention and resources, which could harm our business.

 

*F**ailure to achieve and maintaineffective internal controls in accordance with Section 404 of theSarbanes-Oxley Act of 2002 could have a material adverse effect on our businessand stock price.*

 

Section 404of the Sarbanes-Oxley Act of 2002 (the “Sarbanes-Oxley Act”) requires that weestablish and maintain an adequate internal control structure and proceduresfor financial reporting and include a report of management on our internalcontrol over financial reporting in our annual report on Form 10-K. Thatreport must contain an assessment by management of the effectiveness of ourinternal control over financial reporting and must include disclosure of anymaterial weaknesses in internal control over financial reporting that we haveidentified. In addition, our independent registered public accounting firm mustattest to and report on management’s assessment of the effectiveness of ourinternal control over financial reporting.

 

Wehave identified material weaknesses in our internal control over financialreporting. See “Item 9A—Controls and Procedures—Management’s Report on InternalControl Over Financial Reporting” in our Annual report on Form 10-K forthe year ended December 31, 2004 for a discussion of these materialweaknesses. As of the date of the filing of this quarterly report onForm 10-Q, we are still in the process of implementing remedial measuresrelated to the material weaknesses identified. If our efforts to remedy 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 ofSection 404 of the Sarbanes-Oxley Act are ongoing and also apply to futureyears. In addition, as part of our 2005 assessment, we will apply therequirements of the Sarbanes-Oxley Act to our November 2004 acquisition ofACC, which was exempted from our 2004 assessment as permitted under theSarbanes-Oxley Act. We expect that our internal control over financialreporting will continue to evolve as we continue in our efforts to transformour business. Although we are committed to continue to improve our internalcontrol processes and we will continue to diligently and vigorously review ourinternal control over financial reporting in order to ensure compliance withthe Section 404 requirements, any control system, regardless of how welldesigned, operated and evaluated, can provide only reasonable, not absolute,assurance that its objectives will be met. Therefore, we cannot be certain thatin the future additional material weaknesses or significant deficiencies willnot exist or otherwise be discovered.

 

*Recently enacted changes in securities laws andregulations may result in additional expenses.*

* *

TheSarbanes-Oxley Act has required and will continue to require changes in some ofour corporate governance and securities disclosure or compliance practices. TheSarbanes-Oxley Act also requires the SEC to promulgate new rules on a

 

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varietyof subjects, in addition to rule proposals already made, and NASDAQ hasrevised its requirements for companies that are quoted on it. Thesedevelopments (i) have required and may continue to require us to devoteadditional resources to our operational, financial and management informationsystems procedures and controls to ensure our continued compliance with currentand future laws and regulations, (ii) will make it more difficult and moreexpensive for us to obtain director and officer liability insurance, and mayrequire us to accept reduced coverage, increase our level of self-insurance, orincur substantially higher costs to obtain coverage, and (iii) could makeit more difficult for us to attract and retain qualified members on our boardof directors, or qualified executive officers. To implement plans and measuresto comply with Section 404 of the Sarbanes-Oxley Act and other relatedrules, we expect to expend significant resources and incur additionalexpenses.  We continue to evaluate andmonitor regulatory developments and cannot estimate the timing or magnitude ofadditional costs that we may incur as a result of such developments.

 

*Changes in accounting rules.*

* *

Weprepare our financial statements in conformity with accounting principlesgenerally accepted in the United States of America. These principles aresubject to interpretation by the SEC and various bodies formed to interpret andcreate appropriate accounting policies. A change in these policies can have asignificant effect on our reported results and may even retroactively affectpreviously reported transactions. For example, there have been changes to FASBguidelines relating to accounting for stock-based compensation that willincrease our compensation expense, could make our net income less predictablein any given reporting period and could change the way we compensate ouremployees or cause other changes in the way we conduct our business.

 

*Our ability to complete our planned restructuringand cost-reduction actions and the impact of such actions on our business maybe affected by a variety of factors. These actions may, in turn, expose us toadditional operation risks and have an adverse effect on our sales andprofitability*.

 

During the second quarter of 2005, we announced ourplans to undertake certain restructuring efforts to reduce costs and simplifyour product portfolios in all of our business units.  As a result, we consolidated certainoperations in research and development and manufacturing and reduced ouremployee population.  The impact of theseactions on our sales and profitability may be influenced by a variety offactors, including but not limited to our ability to successfully execute ourplans, our ability to achieve the anticipated level of cost savings, and ourability to retain key employees. We may reprioritize our new productdevelopment initiatives, which may delay new product introductions to themarket and may harm our sales.  We mayface additional costs associated with future actions in streamlining of ouroperations, including but not limited to, outsourcing of certain operations toother parties.

 

An importantcost-reduction action has been to reduce the number of employees. While we haveassessed the appropriateness of the size of our work force and made adjustmentsaccordingly, the reduced work force could cause disruption to our operations ifthis were to occur, we could have difficulties fulfilling our orders and oursales and profits could suffer.  Anothercost-reduction alternative we may consider is to develop outsourcingarrangements for operations such as supply-chain and information technologymanagement. If we implement these measures, and the third parties we select toprovide such services fail to deliver quality services on time and atreasonable costs, we could have difficulties operating efficiently and ouroperating results may be harmed.

 

# **RISKS RELATED TO CONDUCTING BUSINESS IN CHINA**

# ** **

*China’s governmental and regulatory reforms mayimpact our ability to do business in China.*

* *

Since1978, the Chinese government has been in a state of evolution and reform. Thereforms have resulted in and are expected to continue to result in significanteconomic and social development in China. Many of the reforms are unprecedentedor experimental and may be subject to change or readjustment due to a varietyof political, economic and social factors. Multiple government bodies areinvolved in regulating and administrating affairs in the telecommunicationsindustry, among which the Ministry of Information Industry (“MII”), theNational Development and Reform Commission (“NDRC”) and the State-owned AssetsSupervision and Administration Commission (“SASAC”) play the leading roles.These government agencies have broad discretion and authority over all aspectsof the telecommunications and information technology industry in China,including but not limited to, setting the telecommunications tariff structure,granting carrier licenses and frequencies, approving equipment and products,granting product licenses, specifying technological standards as well asappointing carrier executives, all of which may impact our ability to dobusiness in China.

 

Whilewe anticipate that the basic principles underlying the reforms will remainunchanged, any of the following changes in China’s political and economicconditions and governmental policies could have a substantial impact on ourbusiness:

 

•      the promulgation of new laws and regulationsand the interpretation of those laws and regulations;

 

•      inconsistent enforcement and application ofthe telecommunications industry’s rules and regulations by the Chinesegovernment between foreign and domestic companies;

 

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•      the restructuring of telecommunicationscarriers in China, including policy making governing 3G network infrastructureand licensing;

 

•      the introduction of measures to controlinflation or stimulate growth;

 

•      the introduction of new guidelines for tariffsand service rates, which affect our ability to competitively price our productsand services;

 

•      changes in the rate or method of taxation;

 

•      the imposition of additional restrictions oncurrency conversion and remittances abroad; or

 

•      any actions that limit our ability todevelop, manufacture, import or sell our products in China, or to finance andoperate our business in China.

 

Forexample, on November 1, 2004, as a continuation of the restructuring oftelecom carriers relating to the initial public offering of China Netcom GroupCorporation (Hong Kong) Limited (“China Netcom”) in 2004, SASAC decided to swapthe senior executives of China Mobile Communications Corporation (“China Mobile”),China United Telecommunications Corporation (“China Unicom”), ChinaTelecommunications Corporation (“China Telecom”) and China Netcom in an effortto ease competition among carriers. This led to business interruption betweenChina Telecom and China Netcom, which had an adverse impact of delaying revenuerecognition in the fourth quarter of 2004. Moreover, we are not certain whetherthere may be additional government interference, including government imposedmergers or spin-offs of the existing carriers.

 

Inaddition to modifying the existing telecommunications regulatory framework, theChinese government is currently preparing a draft of a standard, nationaltelecommunications law (the “Telecommunications Law”) to provide a uniformregulatory framework for the telecommunications industry. We do not yet knowthe final nature or scope of the regulations that would be created if theTelecommunications Law is passed. Accordingly, we cannot predict whether itwill have a positive or negative effect on us or on some or all aspects of ourbusiness.

 

Under China’s current regulatorystructure, the communications products that we offer in China must meetgovernment and industry standards. In addition, a network access license forthe equipment must be obtained. Without a license, telecommunications equipmentis not allowed to be connected to public telecommunications networks or sold inChina. 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.

 

Theproduct quality supervision department of the China State Council, in concertwith the MII, performs spot checks to track and supervise the quality oflicensed telecommunications equipment and publishes the results of such spotchecks.

 

*China’s changing economic environment may impact ourability to do business in China.*

* *

Since1978, the Chinese government has been reforming the economic system in China toincrease the emphasis placed on decentralization and the utilization of marketforces in the development of China’s economy. These reforms have resulted insignificant economic growth. However, any economic reform policies or measuresin China may from time to time be modified or revised by the Chinesegovernment. 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 economic environment has been changing as a result of China’s entry, inDecember of 2001, into the World Trade Organization (the “WTO”). Entryinto the WTO requires that China reduce tariffs and eliminate non-tariffbarriers, including quotas, licenses and other restrictions in 2005 and it isstill too early to evaluate the impact of these changes on China’s economy.Moreover, although China’s entry into the WTO and the related relaxation oftrade restrictions may lead to increased foreign investment, it may also leadto increased competition in China’s markets from other foreign companies. 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 andforeign investment 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 the Chinese legalsystem 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 internalrules promulgated by governmental agencies may not

 

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bepublished in time, or at all. As a result, we may operate our business inviolation of new rules and policies without having any knowledge of theirexistence. In addition, there are uncertainties regarding the interpretationand enforcement of laws, rules and policies in China. The Chinese legalsystem is based on written statutes, and prior court decisions have limitedprecedential value. Because many laws and regulations are relatively new andthe Chinese legal system is still evolving, the interpretations of many laws,regulations and rules are not always uniform. Moreover, the relativeinexperience of China’s judiciary in many cases creates additional uncertaintyas to the outcome of any litigation, and the interpretation of statutes andregulations may be subject to government policies reflecting domestic politicalchanges. Finally, enforcement of existing laws or contracts based on existinglaw may be uncertain and sporadic, and it may be difficult to obtain swift andequitable enforcement, or to obtain enforcement of a judgment by a court ofanother jurisdiction. Any litigation in China may be protracted and result insubstantial costs and diversion of resources and management’s attention.

 

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

* *

The Chinese government isconsidering the imposition of a “unified” corporate income tax that would phaseout, over time, the preferential tax treatment to which foreign investmententerprises, such as our Company, are currently entitled. While it is notcertain whether the government will implement such a unified tax structure orwhether we will be grandfathered under into any new tax structure, if a new taxstructure is implemented, such new tax structure may adversely affect ourfinancial condition. Moreover, 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 or repealeddue to changes in tax laws, our business could suffer.

 

*Our ability to continue successful deployment of PASsystem and sales of PAS handsets are limited by certain factors, including thefollowing:*

* *

*Maturing PAS market and increased competition inhandsets and tariffs.*

* *

Themarket for PAS exceeded 84 million users as of the end of September 2005and is available in most of the provinces throughout China. We believe the PASmarket has matured. For example, during the first nine months of 2005, netsales of the PAS/IPAS system and the wireless infrastructure market declinedsignificantly as compared to sales in the same period of 2004.  In addition, the increase in handsetcompetitors entering the market during 2004 has resulted in decreased averageselling prices and margins. * *If additional handset competitorsenter the market or if competitors decide to further reduce pricing, our salesof 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 may experience asharp decline if China Telecom or China Netcom obtain licenses allowing them todeliver mobile services.*

* *

China’smedia sources have widely reported that the MII may grant 3G mobile licenses toChina Telecom or China Netcom, or to both in late 2005 or 2006. If ChinaTelecom or China Netcom obtain 3G mobile licenses, they may re-allocate capitalexpenditures to construct 3G networks, and as a consequence, may significantlyreduce capital expenditures relating to PAS networks that utilize our existingproducts. In addition, it is possible that current PAS frequency bands utilizedby PAS networks may be reallocated for use by 3G networks, resulting in therestriction of or shutting down of PAS networks. If this were to occur, wecould lose current and potential future customers of our products, and ourfinancial condition and results of operations could be significantly harmed.

 

*We only have trial licenses for the PAS system andhandsets 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 to obtainthe required licenses, we could be prohibited from making further sales of theunlicensed products, including our PAS systems and handsets, in China, whichwould substantially harm our business, financial condition and results ofoperations. The regulations implementing these requirements are not verydetailed, have not been applied by a court and may be interpreted and enforcedby regulatory authorities in a number of different ways. Our legal counsel inChina has advised us that China’s governmental authorities may interpret orapply the regulations with respect to which licenses are required and theability to sell a product while a product is in the trial period in a mannerthat is inconsistent with the information received by our legal counsel in China,and either of these conditions could have a material adverse effect on ourbusiness, financial condition and results of operations.

 

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

* *

MostChinese carriers have three levels of operations; the central headquarterslevel, the provincial level and the local city/county level. Both central andprovincial levels are independent legal persons and have their own corporatemandate. The purchasing decision making process may take various forms fordifferent projects and may also differ significantly from carrier to carrier.

 

Inthe case of PAS systems, all China Netcom contracts are negotiated and enteredinto between the provincial operators and the Company. However, the centralheadquarters of China Telecom has, in the past, exerted its influence, and may,in the future, choose to exert its influence in the purchasing decision-makingprocess by negotiating contractual terms, such as purchase price, paymentterms, and acceptance clauses at the central level. The provincial operatorthen further negotiates the contract based on the guidelines provided by theheadquarters. Final contracts are entered into between the provincial operatorand the Company. However, if this trend of centralized decision-making expandsto unified purchasing, resulting in the negotiation and execution of contractsat the central headquarter level, there may be a concentration of customerswhich could have a significant impact on our business.

 

**RISKS RELATED TO OUR STOCK PERFORMANCE ANDCONVERTIBLE 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 subjectto wide fluctuations in the future in response to many events or factors,including those discussed in the preceding risk factors relating to our operations,as well as:

 

•      actual or anticipated fluctuations inoperating results, actual or anticipated gross profit as a percentage of netsales, levels of inventory, our actual or anticipated rate of growth and ouractual or anticipated earnings per share;

 

•      changes in expectations as to futurefinancial performance or changes in financial estimates or buy/sellrecommendations of securities analysts;

 

•      changes in governmental regulations orpolicies in China;

 

•      our, or a competitor’s, announcement of newproducts, services or technological innovations;

 

•      the operating and stock price performance ofother comparable companies; and

 

•      news and commentary emanating from the media,securities analysts or government bodies in China relating to us and to theindustry 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 or financialresults. In addition, following periods of volatility in a company’ssecurities, securities class action litigation against a company is sometimesinstituted. This type of litigation could result in substantial costs and thediversion of management’s time and resources.

 

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 our stock.The price of our stock may react to such announcements.

 

*SOFTBANK CORP. with its related entities, includingSOFTBANK America Inc., has significant influence over our management andaffairs, which it could exercise against the best interests of our stockholders.*

* *

SOFTBANKCORP. and its related entities, including SOFTBANK America Inc. (collectively, “SOFTBANK”),beneficially owned approximately 12.2% of our outstanding stock as ofSeptember 30, 2005. As a result, SOFTBANK has the ability to influence allmatters submitted to our stockholders for approval, as well as our managementand affairs. Matters that could require stockholder approval include:

 

•      election and removal of directors;

 

•      merger or consolidation of our Company; and

 

•      sale of all or substantially all of ourassets.

 

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 our Company, which could decrease the marketprice of our common stock.

 

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*Delaware law and our charter documents containprovisions that could discourage or prevent a potential takeover, even if thetransaction would benefit our stockholders.*

* *

Othercompanies may seek to acquire or merge with us. An acquisition or merger of ourCompany could result in benefits to our stockholders, including an increase inthe value of our common stock. Some provisions of our Certificate ofIncorporation and Bylaws, as well as provisions of Delaware law, maydiscourage, delay or prevent a merger or acquisition that a stockholder mayconsider favorable. These provisions include:

 

•      authorizing the board of directors to issueadditional preferred stock;

 

•      prohibiting cumulative voting in the electionof directors;

 

•      limiting the persons who may call specialmeetings of stockholders;

 

•      prohibiting stockholder action by writtenconsent;

 

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

 

•      establishing advance notice requirements fornominations for election to the board of directors and for proposing mattersthat can be acted on by stockholders at stockholder meetings.

 

*Together with the holders of our convertiblesubordinated notes due in 2008, we face a variety of risks related to thenotes.*

* *

Holdersof our convertible subordinated notes due in 2008 (the “Notes”) and we face avariety of risks with respect to the Notes, including the following:

 

•      we may be limited in our ability to purchasethe Notes in the event of a change in control, either for cash or stock, whichcould result in our defaulting on the Notes at the time of the change incontrol, and purchases for stock would be subject to market risk;

 

•      an event of default under our senior debt,including one of our subsidiaries, could restrict our ability to purchase orpay any or all amounts due on Notes, and after paying our senior debt in full,we may not have sufficient assets remaining to pay any or all amounts due onthe Notes;

 

•      there is no listed trading market for theNotes, which could have a negative impact on the market price of the Notes;

 

•      we have significantly increased our leverageas a result of the sale of the Notes which could have an adverse impact on ourability to obtain additional financing for working capital;

 

•      hedging transactions related to the Notes andour common stock and other transactions, as well as changes in interest ratesand our creditworthiness, may affect the value of the Notes and of our commonstock; and

 

•      the Notes might not be rated or may receive alower rating than anticipated by investors, ultimately having a negative effecton the price of the Notes and of our common stock.

 

In addition, we are subjectto various covenants and obligations pursuant to the terms of the indenturegoverning the Notes (the “Indenture”). Should we default on certain of theseobligations, then all unpaid principal and accrued interest on the Notes thenoutstanding could become immediately due and payable. For example, fromApril 1, 2005 to April 15, 2005, we were in technical noncomplianceunder the Indenture due to the untimely filing of our Annual Report onForm 10-K for the year ended December 31, 2004 (the “Annual Report”).If in the future we fail to file all reports and other information anddocuments which we are required to file with the SEC pursuant toSection 13 or 15(d) and we fail to cure such technical non compliancewithin 60 days of written notice being provided to us by either the trusteeunder the Indenture or the holders of at least 25% in aggregate principalamount of the Notes then outstanding, an event of default under the Indenturewill be deemed to occur. If an event of default under the Indenture occurs andif payment of principal and accrued interest on the Notes is accelerated, ourbusiness could be seriously harmed.

 

**ITEM 3—QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKETRISKS**

 

We are exposed to the impactof interest rate changes, changes in foreign currency exchange rates andchanges in the stock market.

 

*InterestRate Risk.*  Ourexposure to market risk for changes in interest rates relates primarily to ourinvestment portfolio. The fair value of our investment portfolio would not besignificantly affected by either a 10% increase or decrease in interest ratesdue mainly to the short-term nature of most of our investment portfolio.However, our interest income can be sensitive

 

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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 thesafety of invested funds by generally attempting to limit market risk. Funds inexcess of current operating requirements are mostly invested ingovernment-backed notes, commercial paper, floating rate corporate bonds, fixedincome corporate bonds and tax-exempt instruments. In accordance with ourinvestment policy, all short-term investments are invested in “investment grade”rated securities with minimum A or better ratings. Currently, most of ourshort-term investments have AA or better ratings.

 

The table below representscarrying amounts and related weighted-average interest rates of our investmentportfolio at September 30, 2005:

 
| **(in thousands, except interest  rates)**              | ** ** | ** ** | ** ** |
|---------------------------------------------------------|------------|------------|------------|
| Cash and  cash equivalents                              |       | $          | 496,126    |   |
| Average  interest rate                                  |       | 1.43       | %          |
|                                                    |       |       |       |
| Restricted  cash                                        |       | 36,922     |       |
| Average  interest rate                                  |       | 3.21       | %          |
|                                                    |       |       |       |
| Short-term  investments                                 |       | 15,091     |       |
| Average  interest rate                                  |       | 1.44       | %          |
|                                                    |       |       |       |
| Long-term  securities                                   |       | 489        |       |
| Average  interest rate                                  |       | 3.23       | %          |
|                                                    |       |       |       |
| Total cash,  cash equivalents and investment securities |       | $          | 548,628    |   |
| Average interest rate                                   |       | 1.55       | %          |

 

*ForeignExchange Rate Risk.* We are exposed to foreign currency exchange rate risk because our salesgenerated from China, which accounts for a significant portion of our totalsales, are denominated in Renminbi. Due to the limitations on convertingRenminbi, we are limited in our ability to engage in foreign currency hedgingactivities in China. Although the impact of currency fluctuations ofRenminbi to date has been insignificant, fluctuations in foreign currencyexchange rates in the future may have a material adverse effect on our resultsof operations.  In July 2005, Chinauncoupled the Renminbi from the dollar and let it float in a narrow bandagainst a basket of foreign currencies. The move revalued the Renminbi by 2.1% against the U.S. dollar.  During the quarter ended September 30, 2005,the Renminbi appreciated by 2.24% against the U.S. Dollar. The exchange rate isclosely watched by policy making bodies in China but the extent of furtheradjustments taken by the Chinese government in governing their exchange ratepolicies is still uncertain.

 

Beginning in the firstquarter of 2004, we hedged certain Japanese Yen-denominated balance sheetexposures against future movements in foreign currency exchange rates by usingforeign currency forward contracts. Gains and losses on these fair value hedgesare intended to offset gains and losses from the revaluation of our JapaneseYen-denominated recognized liabilities. In accordance with Statement ofFinancial Accounting Standards No. 133 (“SFAS 133”), “Accounting forDerivative Instruments and Hedging Activities,” we recognize derivativeinstruments and hedging activities as either assets or liabilities on thebalance sheet and measure them at fair value. There were no hedging activitiesin the three and nine months ended September 30, 2005.  The net result of gains and losses oncontracts and revaluation included in interest and other income (expense) wasinsignificant for the three and nine months ended September 30, 2004. Ourforeign currency forward contracts generally mature within three months. We donot intend to utilize derivative financial instruments for speculative tradingpurposes. We held no foreign currencyforward contracts at September 30, 2005. Movements in currency exchangerates could cause variability in our other income (expense).

 

In the three months endedSeptember 30, 2005, we recorded foreign exchange gains of $7.3 million mainlydue to the revaluation of the Renminbi, which was offset by foreign exchangelosses on our Japanese Yen denominated cash and accounts receivable balances. During the period when the Renminbi was revalued, the company's subsidiaries inChina had over $350.0 million in US dollar denominated payables, of which$255.0 million were outstanding US dollar denominated short-term bankloans.  The Renminbi appreciated 2.24% against the US dollar from June 30,2005 to September 30, 2005.  In the nine months ended September 30, 2005,we incurred a foreign exchange loss of $7.3 million, which was predominatelycomprised of unrealized and realized losses on our Japanese Yen denominatedaccounts receivable and cash balances, offset by the Renminbi gains during thethird quarter.  We maintain bank accounts in Japanese Yen for purchasingportions of our inventories and supplies.  The balance of the Japanese Yenaccounts as of September 30, 2005 was approximately $71.9 million. Thecompany's subsidiaries in China had over $290 million in US dollar denominatedpayables, of which $150 million were outstanding US dollar denominatedshort-term banks loans, as of September 30, 2005.

 

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*Equity Investment Risk.*Our investment portfolio includes equity investments in publicly tradedcompanies, the values of which are subject to market price volatility. Economicevents could adversely affect the public equities market and general economicconditions may worsen. Should the fair value of our publicly traded equityinvestments decline below their cost basis in a manner deemed to beother-than-temporary, our earnings may be adversely affected. We have alsoinvested in several privately held companies as well as investment funds whichinvest primarily in privately held companies, many of which are foreigncompanies and may still be considered in the start-up or development stages.These investments are inherently risky, as the business environment in foreigncountries are less uncertain and predictable and the market for thetechnologies or products they have under development are typically in the earlystages and may never materialize.  We mayhave potential impairment in value of these investments if business conditionsworsen in those foreign countries or difficulties encountered in technology orproduct development.

 

#### **ITEM 4—CONTROLS AND PROCEDURES**

####  

# **Evaluation of Disclosure Controls and Procedures**

# ** **

UTStarcom, Inc.(the “Company”) maintains disclosure controls and procedures that are designedto ensure that information required to be disclosed in the reports the Companyfiles or submits under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”), is recorded, processed, summarized and reported within the time periodsspecified in the Securities and Exchange Commission’s rules and forms, andthat such information is accumulated and communicated to the Company’smanagement, including its Chief Executive Officer (“CEO”) and Chief FinancialOfficer (“CFO”), as appropriate, to allow timely decisions regarding requiredfinancial disclosure.

 

Inconnection with the preparation of this Quarterly Report on Form 10-Q, theCompany carried out an evaluation under the supervision and with theparticipation of the Company’s management, including the CEO and CFO, as ofSeptember 30, 2005 of the effectiveness of the design and operation of theCompany’s disclosure controls and procedures, as such term is defined in Rules13a-15(e) and 15d-15(e) under the Exchange Act. Based upon thisevaluation, the CEO and CFO concluded that as of September 30, 2005 theCompany’s disclosure controls and procedures were not effective because of thematerial weaknesses described under “Management’s Report on Internal ControlOver Financial Reporting” in Item 9A of the Company’s Annual Report onForm 10-K for the year ended December 31, 2004 (the “2004Form 10-K”), which the Company is still in the process of remediating.Investors are directed to Item 9A of the 2004 Form 10-K for thedescription of these weaknesses.

 

Toaddress the material weaknesses described in “Management’s Report on InternalControl” in Item 9A of the 2004 Form 10-K, the Company performedadditional analyses and other procedures (as further described below under thesubheadings “Interim Measures” under “Management’s Remediation Initiatives andInterim Measures”) to ensure that the Company’s consolidated financialstatements included in this Quarterly report on Form 10-Q were prepared inaccordance with accounting principles generally accepted in the UnitedStates.  Accordingly, the Company’smanagement believes that the consolidated financial statements included in thisQuarterly Report on Form 10-Q fairly present in all material respects theCompany’s financial condition, results of operations and cash flows for theperiods presented and that this Quarterly Report on Form 10-Q does notcontain any untrue statement of a material fact or omit to state a materialfact necessary to make the statements made, in light of the circumstances underwhich such statements were made, not misleading with respect to the periodcovered by this report.

 

Managementexcluded Audiovox Communication Corporation (“Audiovox”) from its assessment ofthe Company’s internal control over financial reporting as of December 31,2004 because Audiovox was acquired by the Company through a purchase businesscombination in November 2004. Audiovox’s total assets and total revenuerepresent approximately 18% and approximately 57%, respectively, of the Company’srelated consolidated financial statement amounts as of and for the three monthsended September 30, 2005.

 

**Management’s Remediation Initiatives and InterimMeasures**

 

Inresponse to the matters discussed in “Management’s Report on Internal ControlOver Financial Reporting” in Item 9A of the 2004 Form 10-K, the Companyplans to continue to review and make necessary changes to the overall design ofits control environment, including the roles and responsibilities of eachfunctional group within the organization and reporting structure, as well aspolicies and procedures to improve the overall internal control over financialreporting. In particular, the Company has implemented and/or plans to implementduring 2005 the specific measures described below to remediate the materialweaknesses described in “Management’s Report on Internal Control Over FinancialReporting” in Item 9A of the 2004 Form 10-K.  In addition, in the absence of full implementationof these remediation measures in the first three quarters of 2005 andsubsequent to September 30, 2005 in connection with the September 30,2005 quarter-end reporting process, the Company has undertaken the additionalmeasures described under the subheadings “—Interim Measures” below to providereasonable assurance regarding the reliability of financial reporting and thepreparation of the Company’s financial statements included in this QuarterlyReport on Form 10-Q and to ensure that material information relating tothe Company and its consolidated subsidiaries was made known to management inconnection with the preparation of this Quarterly Report on Form 10-Q.

 

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***Material weaknesses described initem 1 of “Management’s Report on Internal Control Over Financial Reporting”******in Item 9A of the 2004 Form 10-K***

 

*Remediation Initiatives*.   TheCompany’s failure to have a sufficient complement of personnel with a level ofaccounting knowledge, experience and training in the application of generallyaccepted accounting principles commensurate with the Company’s financialreporting requirements contributed to the Company’s failure to maintaineffective controls over the financial reporting process. To remediate thematerial weaknesses described in item 1 of “Management’s Report on InternalControl Over Financial Reporting” in Item 9A of the 2004 Form 10-K, theCompany has implemented or plans to implement the measures described below, andwill continue to evaluate and may in the future implement additional measures.

 

1.     General plan for hiring and training ofpersonnel—The Company’s planned remediation measures are intended to generallyaddress this material weakness by ensuring that the Company will have sufficientpersonnel with knowledge, experience and training in the application ofgenerally accepted accounting principles commensurate with the Company’sfinancial reporting requirements. These measures include the following:

 

(a)   The Company promoted the chief financialofficer to executive vice president and chief operating officer inJune, 2005 and hired a new chief financial officer in August, 2005.  The Company’s chief financial officer, withassistance from senior financial staff and outside consultants, other than theCompany’s independent registered public accounting firm, has reviewed and willcontinue to review and adapt the overall design of the Company’s financialreporting structure, including the roles and responsibilities of eachfunctional group within the Company;

 

(b)   The Company hired regional controllers withrelevant accounting experience, skills and knowledge for each of theAsia-Pacific region, the Central America and Latin America region, the Europe,Middle East and Africa region and Japan in late 2004 and early 2005;

 

(c)   The Company hired a consolidation manager in China with relevantaccounting experience, skills and knowledge in February, 2005;

 

(d)   The Company hired a senior manager for SECreporting with relevant accounting experience, skills and knowledge inFebruary, 2005;

 

(e)   The Company hired a senior manager ofinternational tax with relevant accounting and tax experience, skills andknowledge in May, 2005;

 

(f)    The Company retained and intends to continueto retain the services of outside consultants, other than the Company’sindependent registered public accounting firm, with relevant accountingexperience, skills and knowledge, working under the supervision and directionof the Company’s management, to supplement the Company’s existing accountingpersonnel;

 

(g)   The Company hired a vice president of financefor the Company’s China operations with relevant accounting experience, skillsand knowledge in April, 2005;

 

(h)   The Company plans to continue to hire, and has allocated resources tohire, additional accounting personnel in the U.S., China and Japan, in theareas of tax, external financial reporting, revenue recognition, treasury,financial planning and analysis and corporate accounting with relevantaccounting experience, skills and knowledge; and

 

 (i)   The Company in February, 2005implemented an enhanced formal training process for the training of financialstaff and plans to continue this process to ensure that personnel have thenecessary competency, training and supervision for their assigned level ofresponsibility and the nature and complexity of the Company’s business.

 

2.     Revenue Recognition—The Company’s plannedremediation measures are intended to address material weaknesses related torevenue and deferred revenue accounts and associated cost of sales. Thesematerial weaknesses were evidenced by the identification of six separatetransactions aggregating approximately $5 million in which revenue wasinitially included in the Company’s fourth quarter 2004 financial statementsbefore all criteria for revenue recognition were met. In addition, there wereother transactions for which there was insufficient initial documentation forrevenue recognition purposes, but which did not

 

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result in any adjustments to the Company’s fourthquarter 2004 financial statements. If unremediated, these material weaknesseshave the potential of misstating revenue in future financial periods. TheCompany’s planned remediation measures include the following:

 

(a)   The Company plans to design a contract review process in Chinarequiring financial and legal staff to provide input during the contractnegotiation process to ensure timely identification and accurate accountingtreatment of non-standard contracts;

 

(b)   In March, 2005, the Company conducted a training seminar regardingrevenue recognition, including identification of non-standard contracts, in theU.S. and in April, 2005, the Company conducted a similar seminar in China.In May, the Company conducted additional training seminars in variousinternational locations regarding revenue recognition and the identification ofnon-standard contracts; and

 

(c)   At the end of 2004, the Company began requiring centralized retentionof documentation evidencing proof of delivery and final acceptance for revenuerecognition purposes.

 

3.     Inventory Management—The Company’s plannedremediation measures are intended to address material weaknesses related toinventory, deferred costs, inventory reserve accounts and cost of sales thathave the potential of misstating inventory and deferred costs and expectedrecoverability of inventory in future financial periods. The Company’s plannedremediation measures include the following:

 

(a)    The Company is in the process of continuing to implement additionalOracle reports and other automated controls to more effectively track inventoryand evaluate deferred costs;

 

(b)    The Company implemented in late 2004 its process to confirm theexistence of off-site inventory by obtaining customer confirmations,investigating discrepancies in the confirmed results, and properly recordingand reporting the results of the investigation;

 

(c)    During the fourth quarter of 2004, the Company initiated a process toaccumulate information necessary to evaluate inventory and deferred costcontracts for impairment. The Company plans to continue to enhance this processin 2005 by better coordinating the accumulation of such information fromnon-U.S. locations;

 

(d)    The Company plans to implement in 2005 more robust controls over therelease of costs to the income statement by better utilizing the Oracle system;

 

(e)    The Company is in the process of selecting a service provider withexpertise and systems to more effectively manage and track the Company’sinventory in Japan, to whom the Company plans to outsource this function in2005; and

 

(f)     The Company deployed the Oracle system in Japan during the thirdquarter of 2005.

 

4.     Accounting for Goodwill—The Company’s plannedremediation measures are intended to address a material weakness related to theCompany’s accounting for goodwill that has the potential of misstating goodwillamounts and the impairment of the Company’s goodwill in future financialperiods. The Company’s planned remediation measures include the following:

 

(a)     In the first quarter of 2005, the Company implemented a process ofreallocating goodwill to the Company’s five reporting units in a mannerreflective of the Company’s new organization; and

 

 (b)   As part of the process described in(a) above, the Company retained an outside consultant, working under thesupervision and direction of the Company’s management, to assist in a valuationanalysis that was used in the allocation process. During the third quarter of2005, the Company used this consultant to assist in the valuation andimpairment analysis which has resulted in a write down of goodwill.

 

5.     Foreign Exchange Translations—The Company’splanned remediation measures are intended to address a material weaknessrelated to the Company’s controls over its processes and procedures related tothe translation of its accounts and transactions denominated in a currencyother than U.S. dollars that has the potential of misstating various accountsin future financial periods. The Company’s remediation measures include theimplementation in the first quarter of 2005 of an enhanced foreign exchangeaccounting process utilizing the actual month-end exchange rates.

 

6.     Recording of Accrued Expenses and OpenPurchase Orders—The Company’s planned remediation measures are intended toaddress a material weakness related to the Company’s recording of accruedexpenses, primarily in China and Japan, that has the potential of misstatingaccrued expenses and related income statement accounts in future financialperiods. The Company’s planned remediation measures include the implementationduring 2005 of a process of enhanced review of open purchase orders and reviewof invoices and receipts after the end of each quarter to ensure proper recordingof accrued expenses and open purchase order commitments.

 

7.     Accurate Preparation and Review of FinancialStatements, Reconciliations, Journal Entries and Segment Reporting—The Company’splanned remediation measures are intended to address material weaknessesrelated to the

 

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financialclose and reporting process that have the potential of preventing the accuratepreparation and review of the Company’s consolidated financial statements infuture financial periods. The Company’s planned remediation measures includethe following:

 

(a)     During the first three quarters of 2005, the Company began toimplement, and plans to continue to improve, new and enhanced procedures toensure that non-routine transactions are identified and escalated to seniorfinancial management during the close process to help ensure proper accountingtreatment. Specific steps include training and ongoing monitoring of financialstaff, expansion of the officer sub-certifications and active review ofcontracts by knowledgeable financial and legal staff, from the contractnegotiation process through recognition of revenue for such contracts;

 

(b)    During the fourth quarter of 2004, the Company implemented, and plansto continue to enhance, its month-end closing procedures, includingreconciliations and controls over spreadsheets, and standardized checklists toensure such procedures are consistently and effectively applied throughout theorganization; and

 

(c)     The Company plans to enhance in 2005 the communication and distributionof its accounting policies and procedures and development of a process to moreeffectively accumulate and analyze information required for financial statementfootnote disclosures.

 

8.     Income Tax Analysis—The Company’s plannedremediation measures are intended to address material weaknesses related to thecalculation of its provision for income taxes that have the potential ofmisstating the provision for income taxes and related balance sheet accounts infuture financial periods. The Company’s planned remediation measures includethe following:

 

(a)    During the second and third quarters of 2005, the Company hired threeadditional experienced tax managers to closely monitor reporting from China andJapan, to assist in managing audits and to monitor tax compliance matters;

 

(b)    During the first three quarters of 2005, the Company utilized outsideconsultants, other than the Company’s independent registered public accountingfirm, to assist the Company’s management, working under its supervision anddirection, in its analysis and calculation of its income tax provision, and theCompany plans to continue to utilize outside consultants, other than theCompany’s independent registered public accounting firm, to assist the Company’smanagement, working under its supervision and direction, in its analysis ofsuch matters in future periods; and

 

(c)   The Company is developing a comprehensiveprocess to accumulate and organize financial and tax data used in connectionwith income tax calculation and reporting.

 

9.     Utilization of Automated Controls—The Company’splanned remediation measures are intended to address a material weaknessrelated to the segregation of duties and user access to certain Oracle businessprocess applications that have the potential of misstating of various accountsin future financial periods. The Company’s planned remediation measures includethe following:

 

(a)     During the first three quarters of 2005, the Company outsourced to athird-party expert the position of chief security officer to, among otherduties, assess and implement an appropriate framework of security policies andpractices related to our information technology environment;

 

(b)    The Company plans to improve utilization of current functionality andcontinue to upgrade and expand functionality of the Oracle financial reportingsystem through utilization of additional reports and other automated controlsto reduce manual procedures and the utilization of spreadsheets;

 

(c)     The Company deployed the Oracle system in Japan during the thirdquarter of 2005;

 

(d)    The Company is in the process of continuing to implement additionalOracle reports and other automated controls to more effectively track inventoryand evaluate deferred costs; and

 

(e)     The Company plans to implement in 2005 more robust controls over therelease of costs to the income statement by better utilizing the Oracle system.

 

*Interim Measures*. Management has not yet implemented all ofthe measures described in items 1 through 9 above and/or tested them.Nevertheless, management believes those measures identified above as havingbeen implemented, together with the other measures undertaken by the Companydescribed below, all of which were undertaken during the first three quarters

 

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of2005 or subsequent to September 30, 2005 in connection with theSeptember 30, 2005 quarter-end reporting process, address the materialweaknesses described in item 1 of “Management’s Report on Internal Control OverFinancial Reporting” in Item 9A of the 2004 Form 10-K.  These other measures include the following:

 

•      The Company retained on an interim basis outside consultants, otherthan the Company’s independent registered public accounting firm, with relevantaccounting experience, skills and knowledge, working under the supervision anddirection of the Company’s management, to assist with the September 30,2005 quarter-end reporting process.

•      In connection with the 2004 year-end reporting process, the Companyconducted an additional review of a substantial majority of itsrevenue-generating contracts for compliance with revenue recognition criteriaand continued this review during the third quarter of 2005. As part of thisreview, the Company gathered and analyzed evidence of delivery and finalacceptance.

•      The Company performed the following reviews of inventory-relatedmatters: it reviewed consolidated revenue schedules from the third quarter of2005 to determine the proper recording of cost of goods sold; it performed aroll forward analysis of inventory balances from June 30, 2005 toSeptember 30, 2005 and reviewed various supporting documentation; and itconducted physical inventory counts at selected locations.

•      The Company conducted a review of the processes to record inventoryreserves and a review of the manual procedures by which the Company tracks thecost of its products.

•      The Company conducted a variety of manual review procedures, such as anextensive review of journal entry postings into the Oracle system and anextensive review of account reconciliations.

•      The Company conducted a detailed and extensive review of the followingmatters: non-routine transactions and internal representations; financialstatements, as well as certifications from decentralized locations, foraccuracy and journal entries.

•      The Company reviewed its reserves and related schedules and reportedits findings to the Audit Committee.

 

***Material weakness described in item2 of “Management’s Report on Internal Control Over Financial Reporting”******in Item 9A of the 2004 Form 10-K***

 

*Remediation Initiatives*.   TheCompany’s failure to ensure that key management fully understood the nature andpotential significance of related parties and to ensure that a robust processfor the identification of related party transactions contributed to the Company’sfailure to maintain effective controls over the identification of andaccounting for related party relationships and related party transactions withthe Company. To remediate the material weakness described in item 2 of “Management’sReport on Internal Control Over Financial Reporting” in Item 9A of the 2004Form 10-K, the Company has implemented or plans to implement the measuresdescribed below, and will continue to evaluate and may in the future implementadditional measures.

 

1.     The Company conducted an educational seminarwith the Company’s key management in March, 2005 in which the Company’sinternal and outside legal counsel and members of the Audit Committee reviewedcertain key objectives of the Company’s Code of Conduct, including theidentification, recognition and disclosure of related party transactions.

 

2.     In the first quarter of 2005, the Companyexpanded the number of Company personnel required to certify to seniormanagement with respect to identification, recognition and disclosure ofrelated party transactions for SEC reporting purposes, and revised the Company’sinternal certification process concerning identification, recognition anddisclosure of related party transactions.

 

3.     The Company plans to continue to evaluate theCompany’s procedures to ensure the identification, recognition and disclosureof related party transactions.

 

4.     The Company plans to conduct periodictraining sessions with key managers and senior executives regarding the Code ofConduct, including the identification, recognition and disclosure of relatedparty transactions.

 

5.     The Company plans to provide key managers andsenior executives with access to legal and accounting personnel to enable suchmanagers and executives to more accurately and comprehensively comply with theCompany’s internal certification process for SEC reporting purposes.

 

*Interim Measures*.  Management has not yet implemented all of the measures described aboveand/or tested them. Nevertheless, management believes those measures identifiedabove as having been implemented, together with the other measures undertakenby the Company described below, all of which were undertaken during the first,second and third quarters of 2005 or subsequent to September 30, 2005 inconnection with the September 30, 2005 quarter-end reporting process aresufficient to address the material 

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weaknessdescribed in item 2 of “Management’s Report on Internal Control Over FinancialReporting”  in Item 9A of the 2004Form 10-K.  These other measuresinclude the following:

 

•      Management directly interviewed senior executives regarding relatedparty transactions.

 

•      After receiving additional training on related party transactions, keymanagers and senior executives provided new certifications regarding relatedparty transactions.

 

***Material weakness described in item3 of “Management’s Report on Internal Control Over Financial Reporting”******in Item 9A of the 2004 Form 10-K***

 

*Remediation Initiatives*.  Lack of clarity in roles and responsibilities in certain areas affectingthe Company’s financial reporting structure contributed to a material weaknessrelating to the monitoring of non-U.S. operations. To remediate this materialweakness, described in item 3 of “Management’s Report on Internal Control OverFinancial Reporting” in Item 9A of the 2004 Form 10-K, the Company hasimplemented or plans to implement the measures described under “—Materialweaknesses described in item 1 of ‘Management’s Report on Internal Control OverFinancial Reporting’—Remediation Measures—1. General plan for hiring andtraining of personnel” in Item 9A of the 2004 Form 10-K, as well as thosedescribed below. The Company will continue to evaluate and may in the futureimplement additional measures.

 

1.     The Company streamlined the reportingstructure between all non-U.S. accounting functions and the comparable groupsin the corporate headquarters, including tax, treasury and financial planningand analysis groups, in early 2005 to provide for direct reporting to, andoversight by, the U.S. corporate headquarters.

 

2.     The Company plans to expand the size of theinternal audit group, including the retention of services from outsideconsultants other than the Company’s independent registered public accountingfirm, as well as the scope of the internal audit group’s responsibilities tomonitor non-U.S. operations through reviews and audits of such locations.

 

3.     The Company’s chief financial officer, withassistance from senior financial staff and outside consultants, other than theCompany’s independent registered public accounting firm, has reviewed and willcontinue to review and adapt the overall design of the Company’s financialreporting structure, including the roles and responsibilities of eachfunctional group within the Company.

 

4.     The Company has implemented, and plans tocontinue to improve, a closing checklist to standardize its procedures forfinancial review to ensure that U.S. reviewers monitor financial informationfrom non-U.S. locations in a consistent manner, through such measures as use ofstandardized reporting packages and review procedures.

 

*Interim Measures*.  Management has not yet implemented all of the measures described aboveand/or tested them. Nevertheless, management believes those measures identifiedabove as having been implemented, together with the other measures undertakenby the Company described below, all of which were undertaken during the first,second and third quarters of 2005 or subsequent to September 30, 2005 inconnection with the September 30, 2005 quarter-end reporting process,address the material weakness described in item 3 of “Management’s Report onInternal Control Over Financial Reporting” in Item 9A of the 2004Form 10-K.  These other measuresinclude the following:

 

•      The Company utilized outside consultants, other than the Company’sindependent registered public accounting firm, to assist the Company’smanagement, working under its supervision and direction, with the review ofinvoices and cash disbursements in Japan**.**

•      Senior financial staff in the Company’s U.S. headquarters did athorough review of trial balances issued from non-U.S. locations.

•      The Company utilized outside consultants, other than the Company’sindependent registered public accounting firm, to assist the Company’smanagement, working under its supervision and direction, with the quarter-endreview of China operations.

•      Non-routine transactions in non-U.S. locations were documented by staffin such non-U.S. locations and reviewed by senior financial staff in theCompany’s U.S. headquarters.

 

***Material weakness described in item4 of “Management’s Report on Internal Control Over Financial Reporting”******in Item 9A of the 2004 Form 10-K***

 

*Remediation Initiatives*.   TheCompany’s failure to have sufficient personnel with knowledge, experience andtraining in the application of generally accepted accounting principlescommensurate with the Company’s financial reporting requirements contributed toa material weakness relating to the Company’s control environment. To remediatethis material weakness, described in item 4 of “Management’s Report on InternalControl Over Financial Reporting” in Item 9A of the 2004 Form 10-K, theCompany has implemented or plans to implement the measures described under “—Materialweaknesses

 

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describedin item 1 of ‘Management’s Report on Internal Control Over Financial Reporting’—RemediationMeasures—1. General plan for hiring and training of personnel” in Item 9A ofthe 2004 Form 10-K, as well as those described below. The Company willcontinue to evaluate and may in the future implement additional measures.

 

1.     The Company streamlined the reportingstructure between all non-U.S. accounting functions and the comparable groupsin the corporate headquarters, including tax, treasury and financial planningand analysis groups, in early 2005 to provide for direct reporting to, andoversight by, the U.S. corporate headquarters.

 

2.     The Company plans to expand the size of theinternal audit group, including the retention of services from outsideconsultants other than the Company’s independent registered public accountingfirm, as well as the scope of the internal audit group’s responsibilities tomonitor non-U.S. operations through reviews and audits of such locations.

 

3.     The Company’s chief financial officer, withassistance from senior financial staff and outside consultants, other than theCompany’s independent registered public accounting firm, has reviewed and willcontinue to review and adapt the overall design of the Company’s financialreporting structure, including the roles and responsibilities of eachfunctional group within the Company.

 

4.     The Company has implemented, and plans tocontinue to improve, a closing checklist to standardize its procedures forfinancial review to ensure that U.S. reviewers monitor financial informationfrom non-U.S. locations in a consistent manner, through such measures as use ofstandardized reporting packages and review procedures.

 

*Interim Measures*.  Management has not yet implemented all of the measures described aboveand/or tested them. Nevertheless, management believes those measures identifiedabove as having been implemented, together with the other measures undertakenby the Company described below, all of which were undertaken during the first,second and third quarters of 2005 or subsequent to September 30, 2005 inconnection with the September 30, 2005 quarter-end reporting process,address the material weaknesses described in item 4 of “Management’s Report onInternal Control Over Financial Reporting” in Item 9A of the 2004Form 10-K.  These other measuresinclude the following:

 

•      The Company utilized outside consultants, other than the Company’sindependent registered public accounting firm, to assist the Company’smanagement, working under its supervision and direction, with the review ofinvoices and cash disbursements in Japan**.**

•      Senior financial staff in the Company’s U.S. headquarters did athorough review of trial balances issued from non-U.S. locations.

•      The Company utilized outside consultants, other than the Company’sindependent registered public accounting firm, to assist the Company’smanagement, working under its supervision and direction, with the quarter-endreview of China operations.

•      Non-routine transactions in non-U.S. locations were documented by staffin such non-U.S. locations and reviewed by senior financial staff in theCompany’s U.S. headquarters.

 

***Control deficiencies notconstituting material weaknesses***

 

Inaddition to the material weaknesses described in “Management’s Report onInternal Control Over Financial Reporting” in Item 9A of the 2004Form 10-K, management has identified other deficiencies in internalcontrol over financial reporting that did not constitute material weaknesses asof December 31, 2004. The Company has implemented and/or plans toimplement during 2005 various measures to remediate these control deficienciesand has undertaken other interim measures to address these controldeficiencies.

 

***Management’s Conclusions***

 

Managementbelieves the remediation measures described under “Management’s RemediationInitiatives and Interim Measures” above will strengthen the Company’s internalcontrol over financial reporting and remediate the material weaknessesidentified in “Management’s Report on Internal Control Over Financial Reporting”in Item 9A of the 2004 Form 10-K. However, management has not yet implemented all of these measures and/ortested them. Management has concluded that the interim measures described under“Management’s Remediation Initiatives and Interim Measures” above providereasonable assurance regarding the reliability of financial reporting and thepreparation of the Company’s financial statements included in this QuarterlyReport on Form 10-Q and has discussed its conclusions with the Company’sAudit Committee.

 

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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. However, any control system, regardless of how well designed, operated andevaluated, can provide only reasonable, not absolute, assurance that itsobjectives will be met. As management continues to evaluate and work to improvethe Company’s internal control over financial reporting, it may determine totake additional measures to address control deficiencies, and it may determinenot to complete certain of the measures described under “Management’sRemediation Initiatives and Interim Measures” above.

 

**Changes in Internal Control over Financial Reporting**

 

Thediscussion above under “Management’s Remediation Initiatives and InterimMeasures” describes the material planned and actual changes to the Company’sinternal control over financial reporting during the third quarter of 2005 andsubsequent to September 30, 2005 that materially affected, or arereasonably likely to materially affect, the Company’s internal control overfinancial reporting.

 

 

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**PART II—OTHER INFORMATION**

 

**ITEM1—LEGAL PROCEEDINGS**

 

*Securities Class Action Litigation*

 

Beginning inOctober 2004, several shareholder class actions alleging federalsecurities violations were filed against us and various officers anddirectors.  The actions have beenconsolidated in United States District Court for the Northern District ofCalifornia.  The lead plaintiffs in thecase filed a First Amended Consolidated Complaint on July 26, 2005.  The First Amended Complaint allegedviolations of the Securities Exchange Act of 1934, and was brought on behalf ofa putative class of shareholders who purchased our stock after April 16, 2003and before September 20, 2004.  Inaddition to the Company defendants, the plaintiffs also sued Banc of AmericaSecurities LLC and Softbank.  TheComplaint seeks recovery of damages in an unspecified amount.

 

The plaintiffshave indicated that they will file a motion to amend their complaint.  If the motion to amend is granted, plaintiffsmay file an amended complaint that broadens their claims and the putative classperiod.  The plaintiffs’ motion to amendtheir complaint is due on November 28, 2005.

 

Thislitigation is in its preliminary stage, and we cannot predict its outcome.  Our management believes that the claims arenot meritorious.  Nevertheless, anadverse outcome in the litigation, if it occurred, could have a materialadverse effect on our results of operations.

 

*Shareholder Derivative Litigation*

 

Beginning inAugust 2004, several shareholder derivative actions were filed in theSuperior Court of California for Alameda County.  The actions allege claims for breach offiduciary duty against certain of our current and former directors and officersand name us as a nominal defendant. The parties have entered into a settlementagreement.  On October 28, 2005, theCourt approved the parties’ settlement of all claims.

 

*SEC Investigation*

 

We havereceived notice of a formal inquiry by the staff of the Securities &Exchange Commission into certain aspects of our financial disclosures. OurAudit Committee, Board of Directors, and management are fully cooperating inthe inquiry.

 

*IPOAllocation*

 

OnOctober 31, 2001, a complaint was filed in United States District Courtfor the Southern District of New York against us, some of our directors andofficers and various underwriters for our initial public offering.  Substantially similar actions were filedconcerning the initial public offerings for more than 300 different issuers,and the cases were coordinated as *In reInitial Public Offering Securities Litigation*, 21 MC 92 for pretrialpurposes.  In April 2002, aconsolidated amended complaint was filed in the matter against the Company,captioned *In re UTStarcom, Initial PublicOffering Securities Litigation*, Civil Action No. 01-CV-9604.  Plaintiffs allege violations of theSecurities Act of 1933 and the Securities Exchange Act of 1934 throughundisclosed improper underwriting practices concerning the allocation of IPOshares in exchange for excessive brokerage commissions, agreements to purchaseshares at higher 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

 

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February 19,2003, the Court granted in part and denied in part a motion to dismissbrought by defendants including us.  Theorder dismisses 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 dismiss and release allclaims against the participating defendants (including us).  In exchange for this dismissal, D&Oinsurance carriers would agree to guarantee a recovery by the plaintiffs fromthe underwriter defendants of at least $1 billion, and the issuer defendantswould agree to an assignment or surrender to the plaintiffs of certain claimsthe issuer defendants may have against the underwriters.  On February 15, 2005, the Court issued anorder granting conditional preliminary approval of the settlement.  On August 31, 2005, the Court entered anorder confirming its preliminary approval of the settlement.  The settlement remains subject to a number ofconditions, including final court approval. The total amount of the loss associated with the above litigation is notdeterminable at this time.  Therefore, weare unable to currently estimate the loss, if any, associated with thelitigation.

 

*StarentPatent Infringement Litigations*

 

We have sued StarentNetworks Corporation (“Starent”) for patent infringement in the U.S. DistrictCourt for the Northern District of California. On March 22, 2004, we filed our Complaint.  On June 3, 2004, we served ourComplaint on Starent.  OnJuly 30, 2004, Starent filed and served its answer and counterclaims.  On August 30, 2004, we served andfiled our Amended Complaint.  In ourAmended Complaint, we assert that Starent infringes a UTStarcom patent throughthe manufacture, use, offer for sale, and sale of Starent’s ST-16 IntelligentMobile Gateway.  We seek, inter alia,compensatory damages and injunctive relief. Starent filed its answer to the Amended Complaint and counterclaims onSeptember 17, 2004.  In itsanswer and counterclaims, Starent denies our allegations and seeks adeclaration that the patent-in-suit is not infringed, is invalid, and isunenforceable.  The Court held an initialcase management conference on November 2, 2004.  On February 17, 2005, we filed amotion for a preliminary injunction against Starent’s use, sale, and offer forsale of products having the infringing feature. The Court held a hearing on our motion on May 11, 2005 anddenied our motion on June 17, 2005. On June 30, 2005, the Court held a hearing on the proper meaning orconstruction of the claims of the patent-in-suit and entered an orderconstruing these claims on August 11, 2005. On September 20, 2005, Starent filed a motion for summary judgment ofnon-infringement and UTStarcom filed a motion for summary judgment that Starentis estopped from asserting invalidity and unenforceability.  On October 4, 2005, Starent filed a motion tostrike UTStarcom’s final infringement contentions.  All three motions are scheduled for oralargument on November 8, 2005.

 

On February 16, 2005,we filed a second suit against Starent for patent infringement in the U.S.District Court for the Northern District of California.  On May 6, 2005, we served the Complainton Starent.  In the Complaint, we assertthat Starent infringes a UTStarcom patent through Starent’s development andtesting of a software upgrade for its customer’s installed ST-16 IntelligentMobile Gateways.  We seek, inter alia,declaratory and injunctive relief. Starent filed its answer and counterclaims on May 31, 2005, denyingour allegations and seeking a declaration that the patent-in-suit is notinfringed, is invalid, and is unenforceable. On June 16, 2005, we filed a motion to strike Starent’s affirmativedefense and dismiss Starent’s counterclaim alleging inequitable conduct.  On July 19, 2005, the parties stipulatedthat Starent would file an amended answer and counterclaim by July 27,2005 and that we would withdraw our motion to strike.

 

*FennerInvestments Patent Infringement Litigation*

 

OnJanuary 6, 2005, Fenner Investments, Ltd. (“Fenner”) filed suitagainst us and co-defendants Juniper Networks, Inc., Nokia, Inc.,Nortel Networks Corp., Lucent Technologies, Inc., and Cisco Systems, Inc.in the U.S. District Court for the Eastern District of Texas. On May 17,2005, Fenner amended its complaint to add as defendants Ericsson Inc., EricssonAB, Telefonaktiebolaget LM Ericsson, and Alcatel USA Inc.  The suit alleges that unspecified productsand services infringe two Fenner patents and seeks compensatory and injunctiverelief.  The Court has scheduled ahearing to construe the claims of the patents-in-suit for February 28, 2006.  The Court has also scheduled trial forOctober 10, 2006.  This lawsuit is in itsinitial stage and it is not possible to reliably predict the outcome or anyrelief that could be awarded, as the litigation process is inherentlyuncertain..

 

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.

 

In the future we may subjectto other lawsuits.  Any litigation, evenif not successful against us, could result in substantial costs and divertmanagement’s attention and other resources away from our business operations.

 

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**ITEM 2—UNREGISTERED SALES OF EQUITY SECURITIES AND USE OFPROCEEDS**

 

None

 

**ITEM 3—DEFAULTS UPON SENIOR SECURITIES**

 

None

 

**ITEM 4—SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**

 

None

 

**ITEM 5—OTHER INFORMATION**

 

None

 

**ITEM6—EXHIBITS**

 
| **Exhibit  Number** | ** ** | **EXHIBIT DESCRIPTION**                                                                                                                                                        |
|---------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **          | ** ** | ** **                                                                                                                                                                          |
| 10.107(1)           |       | Agreement by and between  Francis P. Barton and UTStarcom, Inc., dated July 29, 2005.                                                                                               |
| 10.108(1)           |       | Change of  Control/Involuntary Termination Severance Agreement by and between Francis P.  Barton and UTStarcom, Inc., dated September 6, 2005.                                      |
| 10.109(1)           |       | Form of Restricted Stock  Agreement.                                                                                                                                                |
| 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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(1)Incorporated by reference to the registrant’s Current Report on Form 8-K,which was filed on September 12, 2005.

 

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**SIGNATURES**

 

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

 

 
|                              | UTSTARCOM, INC. |
|-----------------------------------|-----------------|
| Date: November 9,  2005      | By:             | /s/ Hong Liang Lu |   |
|                              |            | Hong Liang Lu |
| * *                          | * *        | *President,  Chief Executive Officer and Director* |
| * *                          | * *        | *(Principal  Executive Officer)* |
| * *                          | * *        | * * |
| * *                          | * *        | * * |
|  Date: November 9, 2005 | By:             | /s/ Francis P. Barton |   |
|                              |            | Francis P. Barton |
| * *                          | * *        | *Executive  Vice President and Chief Financial Officer* |
| * *                          | * *        | *(Principal  Financial Officer)* |

 

78

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**EXHIBIT INDEX**

 
| **Exhibit  Number** | ** ** | **EXHIBIT DESCRIPTION**                                                                                                                                                        |
|---------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **          | ** ** | ** **                                                                                                                                                                          |
| 10.107(1)           |       | Agreement by and between  Francis P. Barton and UTStarcom, Inc., dated July 29, 2005.                                                                                               |
| 10.108(1)           |       | Change of  Control/Involuntary Termination Severance Agreement by and between Francis P.  Barton and UTStarcom, Inc., dated September 6, 2005.                                      |
| 10.109(1)           |       | Form of Restricted Stock  Agreement.                                                                                                                                                |
| 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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(1)Incorporated by reference to the registrant’s Current Report on Form 8-K,which was filed on September 12, 2005.

 

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